Ativo Capital

Rigorous Thinking


Financial and economic commentary reflecting Ativo’s world view:

American Angst

Tuesday, July 27, 2010

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By Robert Z. Aliber, Professor Emeritus of International Economics and Finance at the University of Chicago

There is a lot of angst in America. The persistent high level of unemployment, and especially the six million individuals who have been unemployed for more than twenty six weeks are a matter of great concern. The foreclosure rate on homes is approaching one million in 2010—a frightening number; Before this episode is over, five percent of seventy-five million homes will have been foreclosed on—and millions more will have left their homes because of short-sales and jingle mail. There is fear that the next generation of Americans will be less well off than their parents as employment in manufacturing declines. Income distribution seems increasingly warped: not only the sports heroes and the movie stars but the take-home pay and bonuses of those involved in finance on Wall Street and elsewhere. Many feel that public sector employees now have more attractive all-in compensation packages than the private sector, with more lavish defined benefit pensions and more secure tenure. Moreover there is sudden recognition that many of these pensions are under-funded—either the states like Illinois and California will go bankrupt because they can’t provide the cash to fulfill their pension obligations or the pensions will go bankrupt because the states have found some way to renege on their commitments. Or these bankrupt pensions will be taken over by the federal government, perhaps by the Pension Benefit Guarantee Corporation (which already owes more than $10 billion to the U.S. Treasury after taking over the pension obligations of GM and various auto suppliers) and become another burden on the taxpayers. The inability or ineptitude of the Congress in extending the estate tax rates and credits from 2009 to 2010 is depressing; the 4,000 estates that would have been taxed in 2010 will have a holiday that will cost the U.S. Treasury $4 billion. Millions believe that government budgets are out of control, and that the Obama Administration isn’t doing enough to bring the deficit down and reduce the burden that will fall on our children and grandchildren. The art of compromise seems lost in Washington. Health costs appear out of control, and very little attention has been given to limit the upward creep in costs. The Congress seems incapable of responding to the widely-felt need for an immigration policy.

The stalemate in Washington over the extension of unemployment benefits is a striking example of a dysfunctional government. The projected cost is $34 billion, a lot of money and yet reasonably small relative to the total fiscal deficit, and five percent of the funds that the Congress voted for the Troubled Assets Relief Program—sort of a save Goldman, JP Morgan, et al program. The irony is that some of the Congressional leaders who were opposed to the extension of unemployment compensation payments because the U.S. fiscal deficit would increase will not accept the increase in the effective tax rates that is scheduled to occur in 2011 when the Bush-inspired reduction in tax rates expires. If the next Congress does not vote to extend the Bush tax cuts of 2001 and 2002, fiscal revenues will increase by $80 billion or $90 billion.

Maybe the problems that Transocean and BP encountered with Bright Horizons were acts of God. But most of these other problems that have led to anxiety are amenable to public policy.

Some are concerned by the coarsening of American public life, the trash talk in professional athletics has spilled over into the political chatter. The feature and cover story on the July 18, 2010 issue of Forbes is “The Celebrity 100”. The industry—music, athletics, movies, authors, “personalities” and the incomes of these individuals are noted. Lady Gaga was in fourth place and earned $62 million. U-2 was number 7 on the list and earned $130 million (wasn’t the U-2 the spy plane that Gary Powers jumped from over Kazakhstan?) while Jay-Z was in spot #15 and earned $63 Million; and AC/DC was in 38th place and earned $114 million. Many of these people must be from Indonesia, since they have only one name, although it is not clear whether AC/DC is one name or two. Rascal Flats was #62 on the list, and earned $45 million. (The relationship between the ranking on this hit parade and the annual incomes is not obvious—and not worth the effort to understand.) “Judge” Judy Sheindlin earned $42 million, more than three times as much as Meryl Streep. Is this my country or is this another era?There is a concern that America’s international standing has declined, despite the affection that many of those in Europe have for President Obama. And there is a fear that the future belongs to China—the Chinese have all the money, they are buying Africa, and acquiring lots of other seemingly strategic assets.

Several of the sections of this note are based on a model of an integrated global economy that has three main sectors—households, business, and government. Traditionally, households save, and they finance the deficits of business firms and of governments. A fourth sector is introduced when the global economy is segmented into national economies, each country then has a “foreign sector”—which is an accounting device that measures the pattern of payments in money and in securities between the three sectors in one country and the sectors in other countries.

The direction of money flows between the United States and the rest of the world has changed twice in the last two hundred years. During the 130 years from the birth of the country until World War I households in Britain, France, and the Netherlands bought the IOUs of American firms and governments. Money flowed to the United States and the other “new lands” because the anticipated rates of return were higher than in Europe. Then, for the next seventy years, Americans bought the IOUs of firms and governments—of those in Canada, Europe, and various developing countries—because the anticipated returns were higher than on U.S. dollar securities. The second reversal occurred in the mid-1980s when there was a surge in the foreign demand for U.S. dollar securities and U.S. real assets. Some of this flow was motivated by higher anticipated returns but a large part of these purchases were motivated by the desire of these countries to follow export-led growth policies and maintain undervalued currencies.

If one of the sectors increases its spending relative to its income, economic growth quickens and the unemployment rate declines. If, in contrast, a sector reduces its spending, growth slows. If the foreign demand for U.S goods declines or the U.S. demand for foreign goods increases, U.S. growth slows while growth abroad increases. Some foreign countries—China, Japan, Singapore—have maintained undervalued currencies in the effort to encourage net exports and economic growth. An increase in the flow of money from a country leads to an increase in its income relative to its spending. In effect its exports increase and the flow of money represents that some of the export earnings are used to buy foreign securities and maintain the undervalued currency.

 

ON THE ECONOMIC RECOVERY, THE DOUBLE DIP, AND GROWTH

One of stylized facts from financial history is that the implosion of a bubble is followed by a recession—the story is always the same: households reduce spending to rebuild wealth, and lenders are much more cautious, in part because their capital has been depleted. New home construction declines sharply.

How well is the U.S. economy doing? There is a lot of negativism because the recovery in the last twelve months seems anemic in comparison with the recoveries from recessions between 1950 and 2002. The recession of 2008-2009 is unlike that of any since the Great Depression. Household wealth declined by $11,000 billion, more than ten percent. Several hundred banks failed, the investment banking industry was decimated, General Motors and Chrysler became bankrupt. (Household wealth had increased sharply after 2003 as a result of the sharp increase in real estate prices and a modest increase in stock prices, and household wealth at the end of 2010 was more or less the same as in 2005.)

The recessions between 1950 and 2000 were triggered by move to more contractive monetary policies by the Federal Reserve, which raised interest rates to dampen inflationary pressures; housing starts declined. Then when the Fed reversed policy and moved to greater monetary ease, the increased availability of credit led to sharp increase in housing starts. In contrast, this recession began when there was an excess supply of more than two million homes, which then led to a decline in housing starts.

The recession that began in 2008 differed from the earlier ones because the traditional relationships among the household and the other three sectors were warped by the surge in the foreign demand for U.S. dollar securities, which led to an increase in the price of U.S. securities and to the bubble in U.S real estate prices. The bubble began to deflate at the beginning of 2007, and the financial crisis triggered by the collapse of Lehman led to a credit crunch, and now the economy continues to adjust to the excesses of the bubble. The excess supply of houses may still be approaching two million, housing starts are down sharply but demand has declined as individuals have returned to their parents’ homes or otherwise doubled up. Household balance sheets have been clobbered by the decline in real estate values. (Several weeks ago I was in a taxi in NYC. The driver, from Guatemala, had bought a house forty miles north of Atlanta for $334K; the current market value is $185K.) More than forty state governments have fiscal deficits that are more than ten percent of their total expenditures; they have spent down their rainy day funds and face sharp reductions in their spending. One surprise is that the balance sheets in the corporate sector are in amazingly good shape. The banks have a lot of money to lend and can’t find attractive borrowers. The borrowers feel that the banks have become super-cautious.

Given this heavy ballast, the performance in the U.S. economy in the last year has been brilliant. Nearly a million more people are at work than at the trough. Moreover, the new weekly claims for unemployment compensation have declined dramatically—new weekly claims now are not much higher than they are in a normal period. Corporate profits are up. Auto sales are up, and the auto companies are hiring more workers. Ford has reported great profits. Housing sales appear to be up, although there is a problem because the April 30th expiration date of the $8,000 tax credit brought forward sales that might have occurred at a later date.

Still, the U.S. economy has slowed significantly from the fourth quarter of 2009. In retrospect the surge in the growth rate in the fourth quarter was stimulated by an inventory accumulation.

There is angst that the next decade in America will be like the last several in Japan, where the implosion of the bubble was followed by a credit crunch, deflation, and very slow growth. Maybe. The bubble in Japan in the 1980s was more than ten times larger than the recent bubble in America. Virtually all of the financial institutions became wards of the government. Population growth in Japan is trivially small, and the labor force is shrinking. The household savings rate is several times higher than the U.S. rate.

Some suggest that there is a chance of a double-dip recession. If the growth rate is three percent, then GDP has been increasing by $500 billion a year–$125 billion a quarter. A double dip would require that GDP decline by $125 billion for two consecutive quarters—one of the major sectors would have to reduce its spending relative to its income. The U.S. government might reduce its spending because of the chorus of fiscal restraint. The household sector might be scared into saving more by all the chatter about the double-dip, and the feedback effect would be like a self-fulfilling prophecy. U.S. imports would increase relative to U.S. exports, because of the depreciation of foreign currencies or because the slowdown in growth abroad leads foreign firms to increase their exports to the United States.

The flip of the conditions that would have to be satisfied if there is to be a double dip is the conditions that must be satisfied if the U.S. output gap, now $1,000 billion or seven percent of U.S. potential GDP, is to close. An increase in spending by one of the major sectors is required to reduce the output gap. The likelihood that the U.S. government will increase its spending in a significant way seems trivially small. The household sector seems more likely to increase its saving; although the savings rate has increased sharply, the current rate in the range of four to five percent is still significantly below the historic average rate of seven percent. An increase in spending by the business sector depends on the pace of the economic recovery and the ability of smaller firms to access credit on reasonable terms. The U.S. trade balance is the wild card, much more on this later. By default then the burden of growth will depend on households, and whether the savings rate will continue to increase, or whether this rate which has increased by five percentage points in the last several years will more or less stabilize. (Note this is a statement about the second derivative.)

The concern is the policy toward the high level of unemployment—more hope than plan. The implication of increasing attention to deficit reduction in the Britain and Germany and Greece is that these countries will grow their exports relative to their imports; if the United States continues with its passive attitude toward its trade balance, then the U.S. trade deficit is likely to increase.

 

WILL THE LIVING STANDARDS OF OUR CHILDREN DECLINE?

The primary factor that explains the long term increase in U.S. living standards is the productivity—the ability to produce more with less because of smarter and larger machines and the increase in human capital. Consider the ATMs or the self-service gas pumps or the internet or the electronic bank statements or the internet or the massive improvement in the quality of automobiles and automatic elevators—each of these innovations frees up labor. There is no evidence of a significant decline in productivity. Indeed, this sharp recent recession has increased productivity—when the economy returns toward full employment, per capita incomes will be higher.

The paradox is that households do not feel “better off” despite the increases in household incomes. Spending on healthcare and various public goods appears to be absorbing a large share of the increase in GDP. (Last week we stayed for several days at the Williams Inn in Williamstown MA, which is immediately next to the police station; there were seven police cars in the parking lot, whereas there might have been one when I was a student there fifty years ago.) Homeland security employs several hundred thousand individuals. Americans are better off because of the increase in security against another extremely costly terrorist attack like that on 9/11.

In part the increase in productivity has been obtained at the cost of a decline in job security. Fewer segments of the economy offer protection from changes in the competitive market place. The idea of a thirty-year career in General Motors or IBM is passé. Consider the U.S. Postal System, formerly secure niche for those who wanted to work thirty years and then have a secure pension. The postal system is being hammered by Fed Ex, UPS, and the internet.

Still, segments of the labor force that had formerly benefited from the lack of foreign competition are worse off because of increased competition from imports or because of a shift in location of economic activity. There are two U.S. auto industries; the old industry north of the Ohio River identified with GM and the United Auto Workers, and a new industry south of the Ohio River identified with Toyota and Honda. Workers in the old industry had incomes that were exceptionally high relative to their labor skills because they benefited from a monopoly position. Imports have weakened that position.

American living standards will continue to increase for the vast majority. Many of those who still benefit from a monopoly position in the private or the public sector are likely to find that their monopoly position is weakened. Put the decline in living standards for Americans as a group at the bottom of your angst list.

 

THE PUBLIC SECTOR-PRIVATE SECTOR RIFT

A long time ago the chatter was that the trade-off was that those who worked for the public sector enjoyed more attractive benefits including pensions and much greater job security to offset lower salaries. Now it seems like the employees in the public sector (about sixteen percent of the labor force) have the best of both worlds—higher salaries and richer fringe benefits. A top administrator in the school district in a posh Chicago suburb retired at 55, began to receive an annual pension of $250 thousand, and then moved on to a “second career” as a school administrator in California

It is as if the unions that formerly had monopoly power with GM and US Steel have moved to the public sector. Obviously lots of politicians and administrators still are motivated by the idea of public service, and this is especially true at the local level. But for an increasing number of others, it is the “best job they can get.”

Salary increases are taken for granted—and when there was a super-sized cyclical or transient increase in the tax base much of the increase in revenues was considered permanent and extrapolated to provide the basis for the programmed increases in expenditures. Then when the one-time surge in revenues abated, the states were caught with large deficits.

The pensions in the State of Illinois are underfunded by a massive amount—given the ages of the state employees, and a prospective rate of return on that can be earned on their investment assets, the current assets are modest relative to the assets that should be owned by the pension. Moreover, there is a strong likelihood that the pensions will not be able to earn the projected rates.

One feature of some of these pensions is that they are based on the number of years of employment and the salary for the last year or the average of the last three or five years. Some of these pension plans have been “gamed” by individuals who are about to retire in the next year or two; their last year’s salary is enhanced by overtime and taking the cash counterpart of their vacation time. The tactic is to jump the compensation in the last year or two with overtime and taking unused vacation time as salary.

These defined benefit pension plans are a strong example of “kick the can” down the road. It is as if the state governments are responding to demands for higher salaries by promising larger pensions, which are then not appropriately funded. There are three possible outcomes. Taxes will be raised to reduce or close the gap, the pension funds will go bankrupt, or the promises to past and current retirees will be broken.

 

THE U.S. OUTPUT GAP AND THE U.S. FISCAL DEFICIT

One of the apparent paradoxes of the last several years has been the combination of an American standard of living partly based on “other people’s money”, a U.S. trade deficit of $500 billion—say, four percent of household income. At the same time the U.S. unemployment rate is nearly ten percent, so the U.S. output gap of $1,000 billion has been twice the trade deficit. Some countries live off other people’s money when they consume more than they could produce, but that explanation is not relevant for the United States. Something has gone awry in the pricing of imports; a number of countries including China have been following “beggar thy neighbor” policies and maintaining undervalued currencies. But even if the trade imbalance were resolved, the United States would still have to cope with a fiscal deficit that is too large to be sustained.

There is a lot of chatter that President Obama’s stimulus hasn’t worked. Clearly the government spent the money, and someone’s income increased. To conclude that the stimulus didn’t work requires the assumption some individuals and firms increased their saving by a significant fraction of the increase in the U.S. fiscal deficit and their incomes—sort of a marginal savings rate of fifty or sixty percent. The stimulus hasn’t lived up to the hype promised by the Obama administration, which greatly underestimated the severity of the credit shock and the negative impacts of the excess supply of houses on home prices and residential construction.

There has been a two-stage process in adjusting to the increase in the foreign purchases of U.S. dollar securities. During the first stage, from 2002 to 2006, U.S. real estate prices increased, and the U.S. savings rate declined in response to the increase in the flow of foreign savings to the United States. Then when house prices began to decline and the economy slowed and went into recession, the U.S. fiscal deficit surged—fiscal revenues declined and the unemployment provided the rationale for a surge in government spending.

There are two related questions. One is how much of the U.S. output gap of $1,000 billion can be attributed to the U.S. trade deficit of $500 billion, and the second is how much of the U.S. fiscal deficit of $1,100 billion can be attributed to the U.S. output gap. (This estimate of the U.S. fiscal deficit is a national income accounting measure and is smaller than the deficit of $1,400 billion reported by the Obama Administration.)

First, the metric that relates the U.S. output gap to the U.S. trade deficit. Assume that value added by each worker in the U.S. tradable goods sector is $100,000 a year. (This ballpark number facilitates the arithmetic, the number is nearer $80,000.) Then each increase of $1 million in U.S. imports relative to U.S. exports means a loss of ten jobs, nearly all in U.S. manufacturing; each increase of $1 billion in net imports leads to a loss of 10,000 jobs and each increase of $100 billion in net imports lead to a loss of 1 million jobs. The inference is that the U.S. trade deficit of $500 billion has been associated with a loss of five million jobs; the tradable goods sector has shrunken. (If value added per worker in U.S. manufacturing is $80,000, the job losses associated with the $500 billion trade deficit would total 6.25 million.) That’s somewhat larger than the job losses in U.S. manufacturing, but U.S. imports of petroleum and other commodities are about $200 billion.

Assume that the $500 billion U.S. trade deficit were to “disappear”. (One of the problems associated with a sudden disappearance is that the United States does not have $500 billion of excess productive capacity in tradable goods; it would take two or three years to increase capacity to produce more tradable goods that would correspond with the decline in the U.S. trade deficit.) The U.S. output gap, now about seven percent of U.S. GDP, immediately would decline by $500 billion assuming the capacity is available to increase domestic production of tradable goods. Those newly employed in manufacturing would spend most of their incomes, so total spending would increase by more than the decline in the trade deficit; if the multiplier is 0.5 (which seems conservative, and more likely to be on the low side), domestic spending would increase by a further $250 billion, and the U.S. output gap would decline from $1,000 billion to $250 billion.

A second metric relates the changes in the U.S. fiscal deficit to the changes in the U.S. output gap. If the marginal tax rate is forty percent and U.S. GDP increases by $750 billion, U.S. fiscal revenues would increase by $300 billion.

Moreover, business investment spending would increase. If this increase totaled $200 billion, then given the multiplier the output gap would more or less disappear. The combined increase in U.S. fiscal revenues would be $400 billion. The U.S. fiscal deficit would be $700 billion when the economy is fully employed—about two percent of U.S. GDP. (Some would suggest that the U.S. Government should have a modest fiscal surplus, say $100 billion to $150 billion, when the U.S. economy is fully employed.)

These metrics can be viewed as partial equilibrium estimates, but they do not deal with the consistency across the sectors. The savings balances of the various sectors for the year 2010 are shown in the left column in Figure 1; the output gap is $1,000 billion and the U.S. fiscal deficit is assumed to be $1,100 billion—consider this an underemployment equilibrium. (This fiscal deficit is one based on the national income accounts, and is smaller than the one reported by the Obama Administration, which includes cash transfers to Fannie Mae and Freddie Mac, etc.)

The left column shows the values for savings balances of the four major sectors for 2010. The reduction of the output gap by $1,000 billion requires a comparable increase in spending by various sectors as a group. These balances in the column headed 2012T are one configuration that is consistent with full employment. The major “autonomous change” is that the U.S. trade deficit declines by $500 billion; no explanation is provided for why this reduction occurs. (Some countries that have built their prosperity on having large trade surpluses will be reluctant to see these surpluses decline.) The U.S. government fiscal deficit declines by $400 billion as a result of the increase in the taxable income. The business sector increases its spending by $200 billion in response to the increase in household spending. The household sector increases its saving to seven percent of its income.

Figure 1

SECTORAL SAVINGS BALANCE

Assume now (column 2012H) that household sector again goes on a spending binge, its annual savings declining by $500 billion, or the same amount as the decline in the U.S. trade deficit noted in the previous paragraph. The output gap is eliminated just as it was when the trade deficit declined by $500 billion. Households save two percent of their income, much less than the historic average of seven percent. The fiscal deficit still is too large to be sustained.

Finally, assume that the deficit hawks have their way, and that federal taxes are increased relative to expenditures by $400 billion; consider this the anti-stimulus. The fiscal deficit declines, but household incomes decline, and business spending declines. Assume that the trade deficit remains unchanged at $500 billion. Now the output gap increases perhaps by two percent of GDP—but this is a guess.

 

THE CHINA CHALLENGE

Recently I have been dabbling in John Morton Blum’s “From the Morganthau Diaries” (volume 3 was published in 1967). One of chapters dealt with the financial relationships with the Kumintang Government of China during World War II. Washington was concerned about the U.S. dollar amount of the payment that the U.S. government had agreed to pay to the Chinese government for work on an airbase in Chengdu; the workers had been paid in the Chinese currency. The disagreement centered on the appropriate exchange rate, and the Americans believed that the currency was greatly overvalued.

Seventy years later, the United States and China again disagree about the appropriate value for the Chinese currency; now the Americans believe that the yuan is greatly undervalued. A month ago, the Chinese government announced—immediately before the meeting of the G-20 in Toronto— that it would allow the yuan to appreciate. The yuan has appreciated by less than one percent in the last month.

China’s economic achievements have been impressive—ten percent growth for thirty years—truly a marvelous achievement. The high rate of growth was possible as a result of the very high savings rate, abundant credit, a very adaptable labor force, a striking entrepreneurial tradition, the lack of private property rights, a Japanese-style credit system that in western terms taxed household savers heavily, and a beautiful decision to invite the world’s multinationals into China, including those from Taiwan. These multinationals facilitated the rapid growth in Chinese exports, which in turn contributed to the significant decline in unit production costs.

One fascinating aspect of the Chinese growth experience is the extremely high savings rate—households save, business firms save, and the governments save. Various explanations have been given for the high savings rate. One is the lack of a social safety net. Another is Chinese demographics; the one child-one family policy (there are exceptions) means that there won’t be enough younger people to support the older people. Individuals accumulate financial assets in their working years to support themselves in their retirement.

The fallacy of composition may be relevant, in that as the retirees seek to spend down their assets they may find that there are too few buyers—the asset prices will decline. But that’s another paper.

The unique feature of the Chinese economic experience of the last ten or so years is that it is the only rapid-growth country that has a trade surplus, and a very large trade surplus. Virtually every other country that has achieved high rates of growth has had a trade deficit; the story is that high growth rates are associated with high rates of return, which attracts foreign money. These money inflows led to an appreciation of the currency.

China has maintained a low value for the currency to promote its exports. China is protectionist, repeat protectionist, and abuses the infant-industry argument. The presumption that trade involves exchanges of comparable values is orthogonal to the Chinese view of the world. The rip-offs of intellectual property that are characteristic of the Chinese firms also typify behavior at the national level.

At some stage, the growth rate will decline, and perhaps sharply, because of recognition that there is too much productive capacity relative to demand. China has experienced a fantastic construction boom—a first class infrastructure of airports, roads, railroads. This public sector investment has required a lot of private sector investment in steel, cement, power, etc. Both the private sector investment and the public sector investment have absorbed the high level of saving and provided construction jobs for several tens of millions of individuals. When investment slows, the demand for construction labor will slow; household incomes will grow less rapidly, and the excess capacity in the production of consumer goods will become more intense.

Consider the possible outcomes—China becomes a massive parking lot. The need to absorb the savings and provide continued employment then requires that the planners find more and more projects, more or less like Japan after the implosion of its bubble. Another outcome is that the savings rate declines, and the demand for consumption goods increase.

The experience in Japan and other Asian countries is that as their growth rates decline, their exports increase and their trade surpluses increase.

China indicated before the G-20 meeting in Toronto that it would allow the yuan to appreciate. The yuan has appreciated—by a trivial amount. By announcing the change in policy, they more or less diverted the heat that they would otherwise have received at the Toronto meeting. But the appreciation of a nickel is not a good-faith follow-through.

President Obama indicated that he wants to double U.S. exports in the next five years–a growth rate of fifteen percent a year. Trade often has increased more rapidly than GDP. The goal of the Obama Administration should be to seek an orderly reduction in the U.S. trade deficit, which will require that some other countries accept a reduction in their trade surpluses. China is the country with the largest trade surplus, both absolutely and as a share of its GDP. A reduction in the U.S trade deficit would contribute to a reduction in the unemployment rate, an increase in the U.S growth rate, and a reduction in the U.S. fiscal deficit.

Stay tuned.

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