Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

The Country In a Funk

Monday, November 1, 2010


Mid-September marked the second anniversary of the bankruptcy of Lehman Brothers, probably the most costly U.S. financial policy error ever. The sharp decline in housing starts that began early in 2007 led to a slowdown of growth. The recession started in January 2008; employment declined by 300,000 in the first nine months of that year—on average 30,000 a month. The Lehman bankruptcy triggered a panic and the most severe economic slowdown in 80 years; employment declined by six million in the last two quarters of 2008 and the first two quarters of 2009—an average of 500,000 a month.

Virtually all of the costs associated with the failure of Lehman could have been avoided if the U.S. Treasury and the Fed had been as bold as they were several days later when they put the credit of the U.S. government behind the IOUs of AIG. In effect the commitment of the U.S. Treasury to stand behind the large financial firms forestalled runs because the creditors received 100 percent deposit insurance. Saving Lehman would have cost the U.S. taxpayers $75 billion plus or minus $25 billion—Lehman’s shareholders would have been wiped out, its management banished to northern Siberia. Not saving Lehman will cost the taxpayers more than $2,500 billion. The U.S. government’s TARP (Troubled Asset Recovery Program) assistance to the banks was like a large vulture fund, and will be one of the most profitable investments that the U.S. government has made since the Louisiana Purchase in 1803. (The use of TARP funds to finance the re-start of GM and the housing market is a separate issue.) TARP provided liquidity when private suppliers were hiding under small stones. And it now appears that the investment of the Fed and the U.S. Treasury in AIG will at least break even.

Growth has been positive for the last four quarters and GDP has returned to the level reached at the end of 2007, but unemployment now is 17 million—and employment is six million less than at the peak.

The country is in a funk.

Q. Why all the angst in the country?

A. There’s a lot of unhappiness and concern that the market system isn’t working—except for the very rich—and that politicians are focused on advancing their careers rather than problem-solving. The Democrats and Republicans in Washington seem in perpetual stalemate. The prospect of fiscal deficits until the end of time indicates a U.S. government that is out of control. The spectacle is that of a rich country with many state and local governments that are broke, even though they were solvent when the country was poorer. The Chinese have all the money and seem to be eating our lunch.

Q. Okay, but are your comments reactions to newspaper headlines or the day-to-day observations about the well-being of American families?

A. Good question. Obviously there is a lot of personal grief among those who are out of work or have lost their homes. But my guess is that if you polled 10,000 randomly chosen individuals from around the country and asked whether they are comfortable in their personal circumstances, 80 percent or more would say yes. But they lack the confidence that their children will be better off, and are disheartened by the posturing in Washington and the nastiness of the political rhetoric.

Q. How well off is the country?

A. Do you believe the data or the press? The recession has been over for more than a year, yet there is a lot of chatter that a depression or a double dip is around the corner. The 2010 growth rate will be in the range of three to four percent.

Q. Anything else?

A. Glad you asked. Two members of the House Ways and Means Committee, including the chair, are under investigation for ethics violations. The House of Representatives is an old boys’ club, and it’s a safe bet that their offenses must have been severe before the members of the ethics committee blew the whistle on their colleagues. A member of the House from Texas awarded some scholarship money from the Black Caucus Foundation to members of her family. The chicanery doesn’t end there. The current governor of New York cadged free tickets from the Yankees and then denied it. And then there is the former governor of Illinois, who was convicted on one of 20-plus charges; three of the last six elected governors in Illinois have been sent to the pokey. And the current Secretary of the Treasury—who oversees the Internal Revenue Service—had some problems about 10 years ago because he failed to report all of his income when he worked for the International Monetary Fund.

Q. Can we get back to the economic issues?

A. About once a month the Obama administration seems to say, “We will have a new program to reduce unemployment.” The administration is long on rhetoric, and short, very short, on execution. The president said we will double exports in five years. Great—what has the administration done to promote exports? The promises that were made at the time of President Obama’s stimulus program about its impacts on reducing unemployment haven’t been kept. There’s a lot of uncertainty in the economy about the health insurance bill, taxes, and regulation. President Obama knows that the private sector—the business sector—creates jobs, and yet a lot his statements about the banks and the insurance companies dump on these firms. BP deserved to be spanked hard for the damage caused by the oil spill, but the company’s $20 billion commitment was a Chicago-style shakedown.

Q. Sounds like a chip on your shoulder?

A. You’re right. A lot of resentment about the rich pensions of public-sector employees—retire at age 55 after 30 years of work, collect a full pension, and move to a second career. And public-sector employees game the retirement system by taking a lot of vacation pay, sick leave, and overtime in their last year or two, to bulk up their last year’s total income and hence their pension. Public-sector employees are “monopolists” unless one wishes to move across town lines or state lines or to Brazil. The charter school movement is all about circumventing the teachers union and their protection of the tenure of incompetent teachers. The public sector accounts for a bit less than 20 percent of the labor force, but it has probably accounted for less than one percent of the increase in unemployment (after an adjustment for the temporary employees hired for the 2010 census).

Q. Is that all?

A. No, there is a more, a lot more. The rich seem to be getting richer; there is a new class of super-rich, with annual incomes that exceed $10 million. See the homes advertised in the Friday editions of the Wall Street Journal for $20 million and $30 million. I was at the airport on a Saturday in August. Chris—the lineman—was frazzled. When I asked Chris what the problem was, he responded, “Too many jets on the ramp at one time.” Why? “People taking their kids to camp.” In this new world, the cost of getting a few of the young to camp is three, four, or five times the cost of a month at camp. A lot of unhappiness about the bailout of the bankers.

Q. Sounds like the proverbial ball of wax, excuse the mixed metaphor. Can you disentangle the issues?

A. Okay, first it is important to identify why this economic recovery differs from those during previous recessions—and hence why the comparisons with the earlier recoveries are misbegotten. And then the relationship between the U.S. trade deficit and the U.S. output gap is examined, followed by the relationship between the U.S. trade deficit and the U.S. fiscal deficit. A comment on the quality of leadership at the Federal Reserve. Some observations on the China bubble, and some concluding comments on investing the $10 million lottery prize.

Q. This letter looks exceptionally long—how about a preview?

A. Great idea. Happy to oblige. America faces a “trinity” of macro problems: a large output gap and an unemployment rate that is too high by five percentage points, a U.S. trade deficit that is too large because U.S. net international indebtedness has been increasing relative to U.S. GDP, and a U.S. fiscal deficit that is much too large. The output gap could be reduced if U.S. government spending increases or if taxes are reduced, but the U.S. fiscal deficit would then increase and the U.S. trade deficit probably would increase, or the U.S. fiscal deficit could be reduced to a sustainable level but then the output gap and the unemployment rate would increase. The output gap and the unemployment rate can be reduced and the fiscal deficit reduced to a sustainable value ONLY if there is a significant reduction in the U.S. trade deficit—and that can occur only if the U.S. trade imbalance with China declines sharply.

The source of the problem is the unique U.S. position in a dysfunctional international financial arrangement. Every foreign country can manage the value of its currency to achieve the trade surplus or trade deficit that it wants—that it believes will enhance its own economic welfare. Since the sum of the trade deficits and the sum of the trade surpluses must approximate each other, the U.S. trade balance changes to ensure that there is global consistency; if foreign countries as a group want trade deficits, the United States develops the counterpart trade surplus. Conversely, for the last 30 years the United States has had a trade deficit because other countries as a group want trade surpluses. The U.S. trade deficit now is larger than the combined deficits of the next 10 countries with relatively large deficits. The Asian countries want low values for their currencies so they can grow their exports of manufactured goods, and as a result they have large trade surpluses, both absolutely and as a ratio of their GDPs. For example, China and Hong Kong together have a surplus of $298 billion (4.3% of their GDPs), Japan $177 billion (3.6%), Taiwan $40 billion (8.3%), Singapore $34 billion (12.6%), South Korea $33 billion (3.5%), and Malaysia $32 billion (13.0%). The arithmetic is that the U.S. trade deficit is not going to decline significantly unless China, Japan, et al. accept reductions in their trade surpluses. And the United States cannot reduce both its output gap and the fiscal deficit as long as the U.S trade deficit is $500 billion. The U.S. policy problem is to secure an adjustment in these global imbalances without appearing protectionist.



Q. How well is the U.S. economy doing?

A. The traditional approach is to compare the pace of this recovery with those after recessions in the previous 50 years, which leads to the conclusion that the recovery is faltering. Spending is increasing by three to four percent a year, although the second-quarter growth rate was clobbered by a modest increase in imports relative to exports that was then annualized, and reduced the growth rate by 1.5 percent. Still, the recovery has been less robust than I had suggested three and six months ago because I had underestimated the extent to which previous recoveries had depended on increases in housing starts.

The competing approach is to assess the recovery in terms of the steepness and the depth of the hole that the U.S. economy developed following the Lehman panic and crash in mid-September 2008. Previous recessions generally resulted when the Federal Reserve raised interest rates and curtailed the growth of credit in an effort to restrain inflationary pressures—six or nine months later the Fed eased after the inflationary pressures had been contained. There were three exceptional features of the 2008 recession. One was the massive oversupply of housing, maybe 2.5 million units; the second was the sharp reduction in housing and personal wealth as home prices and stock prices plummeted; and the third was the de-capitalization of many large financial institutions. Most of the investment banks—Bear Stearns, Merrill Lynch, Lehman—failed, and Morgan Stanley survived only after a large capital injection from Mitsubishi. Wachovia Bank failed. Bank of America and Citicorp needed government financial assistance. GM and Chrysler went bankrupt. AIG, the largest insurance company in the world, had to be bailed out by the U.S. government. Several hundred relatively small banks failed.

The good news is that one million more people are at work than were a year ago. Auto sales are up, even though August sales seemed sluggish in comparison with those of a year ago, which were exceptionally large because of the “cash for clunkers” program. Home prices appear to have stabilized in most markets or are increasing, despite the large sales of properties that were taken over by banks. Corporate earnings are up. Airplanes are full—and airlines are hiring pilots.

The recoveries from previous recessions were led by increases in housing starts as developers responded to the decline in interest rates. In contrast, the recession that began in 2008 was a response to the decline in housing starts as both developers and lenders adjusted to the massive oversupply. The conventional assumption is that the demographic demand is 1.5 million units a year, which includes purchases of first homes by newly formed families and purchases of second homes and the replacement of the 300,000 units that have been lost to fire, floods, widening of highways and expansion of school playgrounds. During the bubble years between 2002 and 2006, housing starts exceeded the demographic demand by an average of 500,000 units a year, and the excess supply increased to 2.5 million units, which were owned by speculators and developers. House prices peaked at the end of 2006. Housing starts have been in the range of 700,000 to 800,000 units a year in the last several years.

The estimate for demographic demand is long-run averages; actual demand varies from one year to the next depending on labor market tightness, interest rates, and whether the mood of the country is upbeat or downbeat. (The intuition is that because the replacement of the 300,000 units lost to attrition is relatively constant, the cyclical variation in demand around the long-run trend is much greater.) The housing starts are a measured number, although completions lag starts, especially in a down market—some large condominium projects in Las Vegas and Snowmass/Aspen have been mothballed because the developers tanked. If the excess supply peaked at 2.5 million in mid-2007, then most of the excess supply has been worked off, and it’s a safe bet that most of the remaining excess supply is in Florida, Nevada, Arizona, and parts of California. A New York Times story indicates that there are 300,000 unoccupied units in Florida. The rental rate of return has increased sharply with the 30 percent decline in house prices. Mortgage interest rates are exceptionally low. (We refinanced three months ago, a 15-year conforming loan at 4.375 percent, and we will refinance in the next week or two at 3.75 percent. The annual interest savings will be $625 per $100,000 of mortgage. The one-time refinancing costs will absorb the first year’s saving from the lower interest rate. The present value of the savings for the subsequent 14 years is $12,000.)

Sometime in the future—perhaps the very near future—housing starts will increase. Each increase in housing starts of 100,000 will lead to an increase in the growth rate of 0.20 percent. An increase in starts means more demand for refrigerators, landscaping, window treatments, insurance, the whole smear.

The press harps on the 14 million people who are unemployed. In the best of times, the unemployment rate is five percent, so the excess unemployment is seven million. Moreover, there is continuous churning in the labor market; each month more than two million people find new jobs—but about two million plus or minus lose jobs. When the economy is at full employment, two million people lose their jobs each month, remain unemployed for 12 or 13 weeks, and then find work again.

Because of the churning in the labor market, a 10 percent unemployment rate means that, on average, each individual is without work for 25 weeks. But it’s not that straightforward—there are two to three million people who are in the wrong neighborhoods with the wrong set of job skills. The incomes of many of these people will decline when they find new jobs, so they will not look for work until their unemployment compensation is exhausted. (Their marginal tax rate when they again are employed is high. Assume that someone had been earning $750 a week before losing a job and that the weekly unemployment compensation payment is $300. If this person finds work again at $600 a week, the incremental income is $300, which works out to the minimum wage, $7.50 an hour before taxes. The “marginal income tax rate” for returning to work is 50 percent—as long as unemployment checks continue, the incentive to return to work is small.)

Q. What about the chatter that the U.S. economy is in another depression?

A. The polite response is that this view is mistaken, and the less polite one is that it is stupid. The downturn in the U.S. economy in the early 1930s lasted 17 quarters; the downturn that began in 2008 lasted six quarters. The excess unemployment rate is five percent now; it was 20 percent during the Great Depression. The U.S. price level declined by 35 percent in the first several years of the 1930s, while today the U.S. inflation rate is about one percent. Corporate profits were negative in the early 1930s, whereas corporate profits now are seven percent of GDP—exceptionally high. And the likelihood of a double dip is very small.

Q. Has the Obama administration’s stimulus program been successful?

A. Yes, an unequivocal yes. The federal government wrote hundreds of billions of dollars of checks. Each of those checks increased the income of the recipients. To suggest that the program didn’t work implies that the individuals who received the money saved 50, 60, or 70 percent of the increase in their incomes—and that seems highly unlikely. The individuals who were working on highway improvements funded by the American Stimulus Act spent most of their incomes. The schoolteachers who were not laid off spent most of their incomes. Yes, the household savings rate increased, but this increase was the traditional response to the decline in personal wealth following the collapse of real estate prices and stock prices. Hence the spending financed by the stimulus prevented an increase in the unemployment rate of 1.5 percentage points.

Q. Could you expand on the income and spending cycle?

A. Most people spend 90 or 95 percent of their incomes—and a lot spend every dollar they receive. Every time they spend, they provide income to the sellers and the employees of the sellers.

Q. Okay, but why aren’t we at full employment if most of the population spends most of its income?

A. There are three major leakages in the income-spending circle. One leakage is the U.S. trade deficit of $500 billion; Americans spend more on foreign goods than foreigners spend on American goods. The second leakage—perhaps $200 billion—is in the business sector—profits are high relative to new investment spending because firms are reluctant to spend. The third leakage—probably $600 billion—is household saving; personal wealth declined massively with the fall in house prices, and many millions of families are hanging on to their money in an effort to rebuild their wealth. (Remember that the U.S. household savings rate declined as the trade deficit increased. That was not an accident or a coincidence—the increase in the U.S. trade deficit resulted from an increase in the foreign demand for U.S. dollar securities, which contributed significantly to the bubble in U.S. real estate.)

Q. What is the counterpart of the $1.3 trillion noted in the previous response, which is the sum of the savings of the foreign, business, and household sectors?

A. The iron law of double-entry bookkeeping is that for every surplus there must be a corresponding deficit. If households increase their saving, the fiscal deficit will increase as spending declines, and as income and tax revenues decline. Hence it isn’t a coincidence that the U.S. fiscal deficit is $1.2 trillion—the fiscal balance of the U.S. government has adjusted to absorb all of that saving.

Q. Why is it that the U.S. economy grew at a respectable rate between 2002 and 2007, despite the large flow of foreign saving to the United States

A. Yes, but remember that household saving declined sharply from 2004 to 2007 in response to the surge in home prices and household wealth, and Americans went on a consumption binge. Now they are rebuilding their financial wealth in response to the decline in home prices—the mirror of the consumption binge.

Q. The press says that Americans are borrowing from the Chinese. Is that correct?

A. Yes and no. Yes, there is a flow of money from China to the United States. But the initiative for that flow is entirely on the part of the Chinese. The more accurate statement is that the Chinese are forcing their money on Americans. And—more on this later—Americans would be better off if there were a steady reduction in Chinese purchases of U.S. dollar securities.

Q. But how can the United States reduce and close the output gap?

A. Closing the output gap requires a massive increase in spending; if the output gap is $1.3 trillion, then spending must increase by $1.3 trillion. Part of this increase will be primary spending, and the rest will be induced by this increase in primary spending.

Q. What must happen if there is to be a significant decline in U.S. unemployment?

A. One of the four major sectors must increase its spending—that is, reduce its saving relative to its income. Households want to rebuild their wealth and are likely to increase the fraction of their incomes that they save. Still the surge in the household saving rate is past—the rate may continue to increase, but much less rapidly. Business firms must spend more of their profits—but they don’t want to invest more because they are not confident that these new investments will be profitable until the growth rate picks up; then they will invest more. The U.S. government must spend more—but most of the public believe that the fiscal deficit already is too large. If the U.S. government reduces its spending relative to its income, then the output gap will increase unless there is a reduction in saving by one of the other sectors.

Q. And which sector is most likely to increase its spending?

A. Households might increase their spending, but they are confused because they are being told to save more and to spend more. The business sector could increase its spending, but its spending tends to piggy-back on household spending. The government sector could increase its spending because it seemingly has unlimited credit, but political factors point to smaller fiscal deficits. Which leaves the foreign sector—and the focus is on the large trade imbalance with China.



Q. What would be the impact of a reduction in the U.S. trade deficit on the U.S. output gap?

A. Most of the reduction in the U.S. trade deficit would represent an increase in exports of manufactures relative to imports of manufactures (or a reduction of imports of manufactures relative to exports of manufactures). Assume initially that the value added per worker in U.S. manufacturing is $100,000; then each reduction of the U.S trade deficit by $1 million means 10 more manufacturing jobs. A reduction in the U.S. trade deficit of $1 billion means an increase of 10,000 jobs—and a $100 billion reduction means one million more manufacturing jobs. A reduction in the U.S. trade deficit of $400 billion would be associated with an increase in domestic employment of four million.

Wait, there’s more. Value added per worker in manufacturing is $80,000 rather than $100,000, so the metric is that each reduction in the U.S. trade deficit of $1 million leads to 12.5 more jobs. Hence the reduction in the trade deficit of $400 billion would mean five million more jobs. Moreover, these newly employed workers will increase their spending on domestic goods and services as well as on imports, and there will be a further increase in domestic employment (this is the secondary effect noted earlier). If the multiplier is two, then the reduction in the trade deficit of $400 billion would be associated with an increase in U.S. GDP of $800 billion. Moreover, there currently is not enough excess capacity in the U.S. manufacturing industry to increase production by $400 billion, so there would be a significant increase in business investment to increase capacity. It’s hard to estimate this impact, but the increase in spending could easily be $200 billion, and again there would be a secondary impact. The increase in spending of $1,000 billion reduces the output gap to $300 billion, say to two percent of GDP—the unemployment rate would decline significantly.

Q. Okay, so why doesn’t the Obama administration do something to reduce the trade deficit?

A. The Obama administration, like the Bush administration, has been leaning on China to allow its currency to appreciate in the belief that the trade surplus would decline as the currency appreciates. Earlier I have written that both the Bush administration and the Obama administration have confused “targets” and “instruments”; the target for U.S. policy should be a significant reduction in China’s trade surplus with the United States, and the increase in the value of the Chinese yuan is one—but only one—of the instruments that might achieve this target. A reduction in Chinese import barriers is another instrument. An increase in the value of the yuan by 10 or 20 percent will have only a modest impact in reducing the large trade imbalance; the Chinese export firms will sweat costs to maintain their market share.

The basic problem is the “design” of the international monetary arrangements. The International Monetary Fund was established to reduce the prevalence of “beggar-thy-neighbor” policies, but the Fund has lost its way—many of its members are “free riders” and manage their currencies to increase the numbers employed in manufacturing exports. Few Asian countries allow market forces to determine the market value of their currencies; most maintain low values for their currencies. The U.S. trade balance is the “stub entry” and changes to take on the value necessary to ensure global consistency for all trade balances as a group. If the sum of the intended trade surpluses that China, Japan, Norway, et al. want is larger than the sum of the trade deficits that other countries as a group can finance, the invisible hands go to work to ensure that the U.S. trade deficit increases.



Q. How severe is the U.S. fiscal problem?

A. Which of the four U.S. fiscal problems are you concerned about? The immediate problem is whether to continue with the Bush tax cuts of 2001 and 2003, or to allow some or all tax rates to return to their 2000 level. The next problem is to start on the path to a satisfactory budget balance over the next four years, which leads to the third problem of determining the appropriate fiscal balance when the U.S. economy is fully employed. And the fourth problem is to design a more efficient tax system.

Q. How much of the surge in the U.S. fiscal deficit since 2006 can be attributed to shortfall of revenues and how much to the increase in spending due to the stimulus and other government programs?

A. At the beginning of 2007 the U.S. economy was at full employment; fiscal revenues were $2.6 trillion, expenditures were $2.7 trillion—leaving a deficit of $162 billion, or slightly more than one percent of GDP. (If we agree that the U.S. government should have a modest surplus when at full employment, then revenues should have been higher relative to expenditures by two percent of GDP—say, $300 billion.) Revenues now are $2,100 billion, a decline of $450 billion from the 2007 baseline. Expenditures are $3,500 billion, $770 billion higher than the baseline. The U.S. fiscal deficit is $1,400 billion. Assume that the U.S. output gap of $1,300 billion disappears and that the marginal tax rate is 25 percent. Then U.S. fiscal revenues would increase by $325 billion. Government payments for unemployment compensation would decline and the stimulus program would have ended—assume another $300 billion reduction in spending. The return to the tax rates of 2001 would reduce the fiscal deficit by $220 billion. The U.S. fiscal deficit when the economy is at full employment would be $535 billion, or nearly four percent of full employment GDP. There has been massive expenditure creep.

Q. How did we get into this mess?

A. A flip answer is that the Republicans like to cut taxes and the Democrats like to increase expenditures. The Bush tax cuts of 2001 and 2003 were based on a view—a mistaken view—that there was a large budget surplus that reflected the fact that taxes were too high relative to expenditures. The strategy was to cut taxes quickly before the Democrats increased expenditures. The budget surplus of the last several years of the Clinton administration resulted from a surge in revenues due to the bubble in the stock market, which led to an increase in revenues of about 1.5 percent of U.S. GDP. The Bush tax cuts amounted to about two percent of U.S. GDP. The Obama administration’s 2009 stimulus program contained a tax reduction of $50 billion.

Q. Okay, what about the immediate problem?

A. Everyone acknowledges that the U.S. fiscal deficit is humongous and most agree the expenditures have surged—which means that government expenditures are too high as a share of U.S. GDP. One approach is to hold expenditures constant in nominal terms, and increase tax rates slowly and steadily to the 2000 level. For example, each of the marginal tax rates could be increased by one percentage point a year for each of the next four years; the top rate in 2011 would be 36 percent and the top rate in 2012 would be 37 percent, etc., until there is a return to 2000 rates.

Q. What about President Obama’s statements that he won’t tax the middle class?

A. Demagoguery. Look, I am all for raising taxes on the wealthy and super-wealthy, but the rich and superrich don’t have enough taxable income to make a significant dent in the fiscal deficit. Taxes on the middle class must be raised.

Q. But wouldn’t increases in tax rates delay the recovery?

A. The U.S. economy has been in a recovery mode for 15 months, and the recovery is likely to pick up momentum. Eventually tax rates must be increased. The gradual approach to increasing tax rates by one percentage point a year is much less disruptive than any of the other proposals.

Q. What should be the “target” for the U.S. fiscal balance?

A. Good question. The U.S. Treasury should have a fiscal surplus of one percent of U.S. GDP—say, $150 billion—when the U.S. economy is at full employment. The rationale is that a small surplus when the economy is buoyant will reduce the indebtedness, and then the country can have larger deficits when the economy is in recession or sluggish.

Q. What do you mean by the most efficient U.S. tax system?

A. Consider how the U.S. tax system has evolved. No one in Washington sat down and said, “What is an efficient tax system?” Rather, the politicians say, “We need more money. Where can it come from at the smallest political cost?” Tax systems evolve incrementally over generations—custom duties, estate taxes, sales taxes, personal income taxes, corporate income taxes, user fees, etc. An efficient tax system is one that raises the desired revenues with minimal distortions in the way people behave and with the lowest collection costs.

Q. How efficient is the U.S. tax system?

A. Consider a few of the distortions. The corporate income tax is a sales tax in drag, one that penalizes the most efficient firms. The differences in tax rates by source of incomes are a distortion; why should dividends be taxed at one rate and capital gains at another? Why should the deductibility of some payments depend on the level of income?


Q. What is likely to happen to the American standard of living in the next 10 to 25 years?

A. The key determinant of changes in the standard of living in the long run is productivity, which has averaged –about 1.5 percent a year. That means that the standard of living doubles every 48 years.

Q. What will be the impact of a reduction and elimination of the U.S. trade deficit on the U.S. standard of living?

A. True, the trade deficit reflects that Americans as a group are consuming more than
they are producing. But the U.S. trade deficit is about one-third of the U.S. output gap. The increase in the U.S. standard of living from closing the output gap would be several times larger than the decrease from the reduction of the trade surplus. Because of the output gap, seven million Americans are consuming but not producing.

Q. What would be the impact of reducing the fiscal deficit on the U.S. standard of living?

A. The supply of resources available to Americans is unchanged, so the standard of living for Americans as a group would be unaffected.

Q. What does this mean?

A. No reason to despair. Living standards for the next several generations of Americans will increase in response to productivity—resulting in a larger GDP with the same number of man hours. Consider that most amazing aspect of the financial revolution, the ATM machine—a marvelous substitution of dumb machines for tellers. E-mail is remarkable, as is the World Wide Web. But even if annual productivity remains unchanged, standards of living for the population as a whole will increase less rapidly because the number of retired individuals will increase relative to the number in the active labor force.


Q. What is your view on the Federal Reserve?

A. Great question. Remember that the Fed was established to enhance financial stability. Then its mandate was expanded to include price-level stability and high employment. Let’s grade each chair of the Fed on the basis of how well the economy performed under his leadership.

• Arthur Burns earns an F-..The inflation rate surged under his leadership because he began to manage the growth of the money supply in the summer of 1971 to enhance the election prospects of Richard Nixon in 1972.
• Inflation accelerated after William Miller became chair in 1977; nevertheless, charity suggests he merits a low C or a high D because he was unsuited for the task of managing a central bank.
• Paul Volcker became chair in the late summer of 1979, when the inflation rate was 12 percent, and he left (was asked to leave) in 1987, when it was evident that he was more interested in securing a further reduction in the inflation rate than in managing monetary policy to prep the country for the election of a Republican in 1988.
• Providing a grade for Alan Greenspan is difficult because the American economy prospered from 1987 to 2006 while he was chair; hence, he merits an A grade for most of the period and then a D after 2002, when the prosperity was based on a massive bubble in real estate credit..
• Bernanke merits a low grade prior to the collapse of Lehman, and a B+ subsequently. Bernanke’s role in merging Bear Stearns was commendable—but it took him too long to recognize that there was a housing bubble, and that the structure of credit that led to the sharp increase in house prices was extremely fragile.

Q. What is the problem with the Fed leadership?

A. One problem is two of the Fed chairs—Burns and Greenspan—have been too politically involved. Burns had been closely attached to Nixon for a long time. Greenspan wanted to be well liked and he strayed into commenting on fiscal policy in the 2001 debate.

Q. Anything else you want to add about the Fed?

A. The New York Times had a recent story, more or less a bio of Don Kohn, a career Fed employee who just retired as vice-chair of the Fed. Kohn believes that the decisions of the Bush administration about which firms to save (Bear, AIG, Freddie and Fannie) and which should be allowed to fail (Lehman) were appropriate. His apparent approval of the the decision to let Lehman fail is puzzling, since this was the single most costly financial decision in U.S. history. The increase in the debt of the U.S. Treasury was larger than the increase during the four years of World War II. Kohn’s assessment is indicates how out of touch with the markets the Fed was—or is.

Q. Why all this attention to the Fed?

A. Two reasons: Fed policies have a major impact on economic performance, and the Fed seems accident prone—the average grade over the last 35 years is in the C range. The Fed seems to have blinders on when it comes to its ability to read the future and to understand the economy.

Q. Anything else?

A. Sure. In 1913, the year the Fed was established, the U.S. price level was more or less the same as it had been in 1813. In 2013, the U.S. price level will be 20 times higher than in 1913. The Fed contributed significantly to the stock price bubble in the late 1920s, just as it contributed significantly to the bubble in U.S. credit markets after 2002. Volcker gets a high grade because he corrected the costly mistakes of his two predecessors. Bernanke gets a high grade after September 2008 because he corrected the inaction of his “two” predecessors, the Bernanke that chaired the Fed from February 2006, and the last three years of Greenspan’s tenure.


Q. What is your view of China’s economic performance?

A. A marvelous success story. Several hundred million people have moved out of poverty and now have a middle-class lifestyle. This year China will produce 13.5 million cars, several million more than the United States. China has a first-world infrastructure—the rail line to Tibet may be the only one that provides oxygen to its passengers. Great airports. Promising initiatives in nuclear energy and other advanced technologies. The Chinese have the capacity to throw an immense amount of money at a problem. They aren’t worried about permitting when it comes to nuclear issues or the safety of the subjects when testing new drugs.

Q. Why has China been able to achieve such a rapid growth rate for the last 30 years?

A. Review some of its inherent advantages: a very high savings rate, a strong entrepreneurial spirit, an immensely large excess supply of labor on the farms and in the villages, competition among the provinces for leading sector firms, no rule of law and no property rights, and a powerful state.

One of the most brilliant decisions of Deng Xiaoping in the early 1980s was to invite multinational firms to invest in China, to satisfy both the foreign and domestic markets. A major constraint on the ability of a country to achieve a rate of growth much higher than those of its trading partners is its need for foreign currencies to buy raw materials, capital equipment, and technical knowledge. If a country is to grow more rapidly than its trading partners, it must capture market share from them. (The Japanese and the South Koreans stiff-armed the foreign multinationals and kept them as far offshore as possible, although they wanted their technologies and their money.) Moreover, despite all the tensions with leadership in Taipei, Taiwanese firms were invited to China. Many of these firms already were sourcing in South Korea or Thailand or Malaysia, and they shifted to China to reduce the costs of supply.

Q. What is the impact of the rapid economic growth in China on the global economy?

A. One answer to this question involves arithmetic and the other economics. China is a big country—it has a massive population and is large geographically. China passed Japan as the second-largest economy in the world a few years ago; China’s share of world GDP has grown from two to 11-plus percent—and the arithmetic is that rapid growth in China has added to the world economic growth rate.

The economics involves the impact of China’s rapid growth on different groups of countries. Australia, Brazil, Canada, and other raw material exporters have had a bonanza of larger sales volumes at higher prices. Germany, Japan, and other countries that have exported capital goods have benefited. Great news for Boeing, American consumers, and the Wal-Mart clientele, and bad news for American producers of consumer goods. Overall the rapid growth of Chinese exports has depressed the profit rates in the United States and other countries that produce the types of goods that China exports. China has added more to global supply than to global demand, and the increasingly large Chinese trade surplus has had a deflationary impact on the United States.

Q. How much of the U.S. trade deficit can be attributed to the Chinese trade surplus?

A. That’s a hard one, at least to come up with a single number. China has a trade surplus of $250 billion; the United States has a trade deficit of $500 billion. China’s exports to the United States are five times larger than China’s imports from the United States, although many of these Chinese exports are largely embedded imports from Japan and South Korea and Taiwan, so Chinese value added is significantly smaller than its exports. Nevertheless, the Chinese trade surplus of $250 billion is all Chinese value added. If value added per worker in Chinese manufacturing is the equivalent of $5,000 a year, then the Chinese trade surplus provides employment for 50 million workers. (I have checked and rechecked—there is not an extra zero in the previous sentence.) Assume, just assume, that President Lou Dobbs tells the government of China, “We love free trade and we know you love free trade, and we will buy as much from you as you buy from us.” It is highly unlikely that any other country would be willing to incur a trade deficit so that China would continue to have a $250 billion trade surplus. China’s dependence on American consumers is enormous.

Q. What about the claims that China is financing the U.S. trade deficit and the U.S. fiscal deficit?

A. Forgive me, but these claims are ass-backwards. The flow of Chinese savings to the United States is the single biggest cause of the U.S. trade deficit. And, as noted earlier, if the U.S. trade deficit were smaller, then the U.S. fiscal deficit would be smaller.

Q. What are the unique aspects of China’s rapid growth compared with the growth in Japan and South Korea?

A. The rates of return and the profit rates on new investments are high in countries that grow very rapidly—eight to 10 percent a year. (Profit rates are several percentage points higher than growth rates.) Money flows to rapid-growth countries—think America in the 19th century—and they develop trade deficits. China, in contrast, is the only rapid-growth country that has had a large trade surplus—currently about four percent of its GDP. China has been exporting 10 percent of its savings. It has accumulated an immense amount of international reserve assets, now $2.8 trillion—it’s as if each of the 1.3 billion Chinese—the two-year-olds as well as those in their nineties—owns $2,500 of U.S. Treasury securities. In fact, these Chinese hold currency notes and deposits in their banks. The Chinese economy is very, very liquid, the money holdings per capita are extremely large.

Q. Have China’s holdings of international reserve assets surged as a byproduct of its desire to maintain a low value for the currency, or has a low value for the currency been needed because China wants an “outlet” for its excess savings?

A. Great question. The engineers who manage the Chinese economy may or may not have identified this question—or maybe they disagree about whether the desire to acquire foreign wealth requires that they have a low value for the currency, or whether the desire for a low value for the currency to stimulate exports has meant that they end up acquiring a bundle of foreign assets.

Q. What is the problem of acquiring a large volume of foreign assets?

A. Compare the rate of return to the Chinese economy if on the margin one million yuan are used to buy U.S. dollar securities or if instead the same amount of money is invested in plants and equipment in China. The real rate of return on Chinese holdings of U.S. dollar securities is a nickel above zero in terms of the U.S. dollar, and almost certainly negative in nominal terms in the yuan because of the eventual appreciation of the yuan. It is very hard to imagine a scenario in which China actually spends a significant part of its holdings of foreign assets—and if that assumption is accepted then the investments are gifts to the United States. (One scenario would be a major disaster in food production in China that would require massive imports of grains—but the exporters would probably apply quotas to limit Chinese purchases.) If instead the one million yuan is invested in domestic plants and equipment, the rate of return would approximate the growth rate.

This comparison suggests that China has acquired the foreign currencies as the byproduct of the desire to grow its exports.

One unique feature of China is that its savings rate is much higher than the savings rate in the other Confucian countries in the region. Japan, South Korea, and even Malaysia have achieved 10 percent growth. The implication is that if (a big IF) the capital-output ratios in these different countries are similar, China would have to grow somewhat more rapidly—perhaps by 12 percent a year—to absorb its savings. And the higher growth rate would have led to greater shortages of electricity, clean water, etc.

Q. What is the implication of China’s exports of savings that amount to four or five percent of its GDP?

A. Consider the comparison in the answer to the previous question. One implication is that the “export lobby” in Beijing has captured control of the management of the economy—and this is the sector where fortunes are being made. Another implication is that China wants other countries to adjust to its very high savings rate.

Q. Okay, but why is the savings rate in China so high?

A. That’s a hard one. Households save, business firms save (since there is no tradition of paying dividends), and even governments save. One reason household savings are so large is that China has a one-child policy. Young Charlie Chan will need to support his own two elderly parents, and the elderly parents of his wife.

Q. But is that the only explanation?

A. No. Assume that the GDP growth rate in China is 10 percent a year (line 1 in Figure 3), and that the savings rate is 40 percent; line 2 shows the value of accumulated wealth. The ratio of wealth to income doubles every six years. That would mean that this ratio in 2010 is six times higher than in 1990. Wealth from the point of view of the Chans and other individual households is capital from the point of view of the Chinese economy. Because of the very high savings rate, the Chinese economy has become much more capital intensive. But the paradox is that the increase in capital intensity has not led to an increase in the rate of economic growth (although it probably offset a decline in the rate that would otherwise have occurred). The result is that China uses its capital stock very, very inefficiently.

Q. Okay thus far, but how do you reconcile the negative or low rate of return on investments as a group with the fortunes that are being made?

A. Obviously individual investments make a lot of money. But the economy as a whole features massive Ponzi finance—individuals borrow against the value of assets that are hugely inflated in terms of their earning power. Eventually interest rates will increase, and the bubble will pop.

Q. How much longer will China be able to grow at eight or 10 percent?

A. Remember Andy Warhol’s quip, “Every one is famous for fifteen minutes” My bastardized version is “Every country grows rapidly for 15 years—or 20.” It is as if there is a growth rate hit parade, and different countries assume the top position on the parade for a significant part of a generation. When a country is small, it can grow much more rapidly than countries that achieved high rates of growth in the previous decades. When a country is large, it is much more difficult to grow rapidly because of constraints on the supply and demand sides.

Q. What are the constraints on the supply side?

A. Eventually every country runs out of excess labor, which explains why there are three million Turkish people in Germany and lots of Thais in Israel. More than 50 percent of the labor force in China remains on farms and in villages, so China is not likely to run out of labor for several generations. But China could run out of clean water and air, although these resources can be recycled, at a cost.

Q. What are the constraints on the demand side?

A. There are two aspects of this question, a foreign aspect and a domestic aspect. It will be more and more difficult for Chinese goods to increase share in foreign markets. Vietnam, Indonesia, and the Philippines are replacing China as sources of supply. Moreover, the United States will lean on China to reduce the bilateral trade imbalance.
The domestic aspect is that China’s growth may decline because domestic investment declines relative to domestic saving. Domestic demand would increase less rapidly than potential supply, much as in Japan since its bubble imploded.

Q. Why is there a bubble in housing in China?

A. The Chinese economy is all screwed up, as its centrally planned economy evolves into a market economy. It is as if Rube Goldberg had designed a system that would produce a series of asset price bubbles. (A lot of people in China have become very rich from these bubbles, especially in property.) The low value for the currency produces large trade surpluses, and the international reserve assets owned by the Peoples Bank of China and the reserves of the commercial banks increase rapidly. But the Peoples Bank doesn’t want the money supply to increase, so it sells its own IOUs to the commercial banks and then raises reserve requirements to ensure that the banks buy these IOUs. The authorities don’t want to yuan to appreciate, and they want to insulate the domestic economy from the large increases in reserves. There are interest rate ceilings on deposits, which are below the inflation rate, so individual Chinese households save a high proportion of their income to minimize the decline in the real value of their financial wealth. The demand for credit at the low interest rates is much greater than the supply, so there is some non-price rationing. The banks are told to lend to x and y, and they also lend to their cousins, brothers, sisters in-laws, outlaws, etc. A lot of people buy real estate, and they have profited enormously. (It is not a coincidence that this system is more or less like the one in Japan in the 1970s and 1980s, since the arrangement was imported from Tokyo after a visit by Deng Xiaoping in the early 1980s.) There is tremendous investment in industry, and a lot of overinvestment. But not to fear, the lenders are never asked to repay the loans, and the interest payments are added to their indebtedness.

The New York Times of Wednesday, October 19th has a front page story of a new modern city Kangbashi near Ordos, China, in the northern part of the country; Kangbashi was projected to have 300,000 residents at this time. The city is empty of residents. Real estate prices have increased from $15 a square foot in 2004 to $65 a square foot, on the basis of speculative purchases, more or less like Miami and Las Vegas in 2006. “So frenzied is the Ordos real estate market that some property developers have willingly taken out grey market loans with interest rates as high as thirty percent…….The spokesperson for one developer said “we could easily make a 300 percent return on a property development….If you think like that, paying 30 percent interest is really small.”

Q. How will the bubble in China end?

A. When a bubble is under way, virtually no one believes it will end. When the bubble in China ends, household wealth will decline sharply. Businesses will fail—or at least incur large losses. The losses that banks will incur on their loans will be immense. Households will curtail their spending—their savings will surge. Unemployment will increase sharply. The Chinese leadership will suddenly become much more humble.

Q. What are the implications of the implosion of the bubble in China for the United States?

A. The sharp slowdown in Chinese growth is bad news for the commodity producing countries and good news for consumers. The Chinese trade surplus with the United States will surge, which will mean a sharp increase in trade tensions.

Q. What about the value of the yuan?

A. That is a major uncertainty. Immediately before the June meeting of the G-20, the Chinese announced a change in their currency policy. That removed the heat that they would have anticipated at the meeting—and the yuan appreciated by 0.5 percent, and then retreated. The box is that the Chinese authorities do not want to appear to give in to foreign pressures, but they won’t budge in the absence of pressure.

Q. What should the U.S. government do?

A. The focus of the U.S. government should be to secure an agreement with the government of China on an orderly reduction in the bilateral trade imbalance. China should be free to choose how to secure this reduction. China is one of the most protectionist countries in the world; it could reduce its import barriers. If the government of China will not agree, then the United States should stipulate the targets.

Q. How would it work?

A. Lots of ways to make it work. One is that there would be a monthly quota on imports from China; quotas would be auctioned and the money used to reduce the U.S. fiscal deficit. When the quota is filled, no more imports could enter the United States until the beginning of the next month. Or U.S. exporters to China would earn vouchers that the could sell to those who want to import from China; every import from China would have to be accompanied by a voucher.

Q. Will a reduction in China’s trade surplus with the United States lead to an increase in the U.S. price level?

A. A trivial impact. U.S. imports from China are 20 percent of total U.S. imports. Imports are 15 percent of total U.S. consumption. Assume the price of U.S. imports from China increases by 25 percent. Remember that most of the prices that U.S. firms pay when they buy goods from China are like wholesale prices, a modest fraction of the U.S. selling prices.

Q. How would China respond to U.S. measures to reduce the trade imbalance?

A. Obviously much would depend on the measures chosen to reduce the large trade imbalance. Stability in the Chinese economy is very dependent on continued access to the U.S. market, China has a relatively weak bargaining position on narrow economic issues. U.S. imports from Thailand, Indonesia, Vietnam, et al. would replace U.S. imports from China—but the trade imbalance would diminish rapidly because the trade surpluses of these countries would be significantly smaller than the Chinese. The United States values cooperation with China on geopolitical issues, including stability on the Korean peninsula, weapons developments in Iran, and climate change.

Q. What about the Chinese threat that they would buy fewer U.S. dollar securities?

A. There are two possible responses. One is that China adopts measures to reduce its trade surplus with the United States. The other is that China seeks to maintain as large a trade surplus as possible, but China would then use the U.S. dollars that it earned from the trade surplus to buy the euro or the Japanese yen or the Canadian dollar. These currencies would appreciate, and the firms in these countries that produce exports and import competing goods would go bankrupt.

Q. What can the Chinese do with their holdings of U.S. dollar securities?

A. Not much, they are “locked in.” Assume they sold these U.S. Treasury securities and bought U.S. dollar deposits; these transactions would be reversed by the Federal Reserve. If the Chinese bought significant amounts of U.S. equities, the uproar would be immense. If instead the Chinese bought yen securities, the Japanese would go ballistic, and buy dollar securities to offset the Chinese purchases of the yen. If instead the Chinese sold dollars to buy the euro, the Europeans would complain. About the only transaction the Chinese might undertake that would lead to a reduction in their dollar holdings is to finance a large trade deficit that might have occurred because of a massive crop failure or some other natural disaster.

Q. Can you sum up your views on China?

A. China’s growth rate will slow as its investment bubble implodes. China’s exports then will surge, its imports will decline, and its trade surplus will increase sharply. Tensions with China over trade issues will become more intense.



Q. What are the key economic parameters that are the background for investing the $10 million lottery prize?

A. Moderate but accelerating U.S. economic growth. The U.S. inflation rate will remain low, in the absence of a major international political shock that would disrupt oil supplies. Short-term interest rates will remain exceptionally low for at least two years. China’s growth will slow as its investment bubble implodes. China’s trade surplus will increase, and its central bank will increase the proportion of non-dollar securities in its holdings of international reserve assets.

Q. What are the implications for commodity prices?

A. The real rate of return on a portfolio of commodities has been close to zero in the long run—over many decades. Demand increases as more and more countries industrialize; when prices increase in booms, there is a surge of investment in supply, and eventually prices decline as new supply becomes available. A key factor that had led to higher commodity prices in the last several years has been rapid rate of growth in China. The slowdown in the growth in China suggests that commodity prices will decline, and the presumption is that all of this decline has not been priced into the market because China continues to wear the halo of rapid growth.

Q. What are some of the implications of these assumptions?

A. Assume—just assume—that short-term interest rates are as low in Tokyo and London and Frankfurt as in New York; then the “carry trade” is dead. Mrs. Watanabe in Tokyo no longer has an incentive to withdraw yen funds from her account at Mitsubishi Bank to get the money to buy U.S. dollar securities. The currencies of the countries that have exported short-term money—Japan, Singapore, Malaysia, Germany and the European monetary union—will appreciate unless the central banks become much more active in their purchases of U.S. dollars. The currencies of the countries that have received this money—Britain, Australia, India, South Africa, Brazil—will depreciate.

The best bet for the carry trade is to borrow U.S. dollars to buy the Asian currencies on the assumption that the Chinese yuan will appreciate, and the other Asian currencies will appreciate with the yuan.

Q. What will happen to the euro?

A. The U.S. dollar price of the euro declined from $1.50 to $1.15 during the Greek debt crisis. Greece had a credit crisis, although some investors shorted the euro as a play on the credit crisis. The euro area as a whole has a current account deficit of $50 billion—Germany and the Netherlands have large surpluses while Spain, Italy, and France have large deficits. The adjustments in Greece, Ireland, Spain, and other euro zone members to reduce their large fiscal deficits will lead to a decline in their current account deficits, and hence the current account deficit for the euro area will decline. The Chinese will increase the share of euro-denominated securities in their portfolios. Both arguments suggest that the euro will appreciate further.

Q. And what will happen to the British pound?

A. The Cameron-Clegg Government inherited a massive fiscal deficit and is slashing expenditures, which will lead to a significant increase in unemployment; the reduction in government borrowing will lead to lower interest rates. Monetary policy will be more expansive, as long as the inflation rate is not too high. Lower interest rates will reduce the incentive to buy British pound securities. I don’t have an explanation for why the pound has appreciated relative to recently, although it may have been pulled up by the stronger Euro; my bet is that the pound will depreciate relative to the U.S. dollar.

Q. What about the U.S. dollar price of gold, now over $1,300?

Remember the cliché, “Gold is a great inflation hedge.” Between 1700 and 2000, gold was a perfect inflation hedge; the real rate of return on gold differed from zero by less than a measurement error. The U.S. dollar price of gold now is five times higher than in 2000—a rate of return of about 20 percent a year. Why? One explanation is that the convention is to price gold in terms of the U.S dollar, even though the “price makers” are in euro. Since the euro was undervalued by 30 percent in 2000, about one-third of the increase in the U.S. dollar price—say, from $300 to $400—resulted from the appreciation of the euro. The euro price of gold is three times higher than in 2000. Why? The principal explanation is that risk-averse investors believed that it was wise to hold some of their wealth as a commodity because they were concerned that financial Armageddon was around the corner and that paper money including claims on banks and central banks would become worthless. Maybe it was wise to hold a small proportion of one’s wealth in gold during the crisis—but the crisis is over.

Q. What about U.S. dollar bonds?

A. As I said earlier, we refinanced our home mortgage in April/May and intend to do so again in the next several weeks. A marvelous time to be a borrower—which means it is an unattractive time to buy long-term bonds—unless you can find some bonds that have been beaten up because they were deemed too risky.

Q. What about the stocks?

A. An immense amount of noise in the stock market on a day-to-day basis, probably because of the high-frequency trading strategies. Still, corporate profits came through this severe downturn with less trauma than in the 1980-1982 period. And the brunt of the decline in profit share was borne by the financial and the energy firms. Real U.S. GDP is likely to be 10 to 15 percent higher in 2014 than in 2010. Corporate profits are likely to be 15 to 20 percent higher than in 2010. These assumptions suggest that the total return on stocks will approach ten percent.

Q. Is your U.S. growth assumption consistent with your interest rate assumption?

A. If potential output increases by three percent a year, and the output gap is nine percent of GDP, then output could increase by five percent a year for nearly five years before the economy returns to full employment. The Fed is likely to be accommodating until the price leve l begins to increase.

Q. You are remarkably upbeat, especially for someone in your age cohort. What worries you most?

A. Thanks, I was hoping that you would ask. Trade tension with China is a major uncertainty.