Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Fascinating Times

Tuesday, August 16, 2011


A fascinating last several months. The parallel between the problems in Athens and those in Washington centers on the arithmetic of government debt and the ratio of government debt to GDP. Greece surrendered its ability to manage the competitiveness of its economy when it decided to join the European Monetary System, while the United States long ago surrendered its ability to maintain its competitiveness when it implicitly did not contest the policies of currency undervaluation of Japan, Malaysia, Singapore, and China. Greece won’t be able to get out of its fiscal bind as long as it adheres to the euro, and the United States won’t be able to get on a sustainable fiscal trajectory until it adopts measures to counter the beggar-thy-neighbor policies of its major trading partners in Asia.

Now for the catechism. When the issues are many and related, the Q and A format is useful.


Q. Is it a coincidence, or is there a connection between the crisis involving Greece and the euro, and the debt crisis in Washington?

A. More than a coincidence, even though the two crises are very different. Greece has a severe credit crisis, evidenced by the very high interest rates on Greek IOUs. In contrast, the United States has a political crisis that has constrained the U.S. Treasury from selling more of its IOUs. Both crises are the aftermath of an extended period when credit was readily available and governments could readily finance increases in spending because the “money was there.” The crises in Greece, Portugal, Ireland, and Spain follow three or four years when the borrowers in these countries were engaged in Ponzi finance—they obtained the money to pay the interest on their indebtedness from the borrowers in the form of new loans. Then in 2009 the European bank lenders woke up to the combination of a fiscal deficit in Greece that was 12 percent of its GDP and government indebtedness that was 125 percent of its GDP. They concluded that Greece was insolvent; since then Athens has been on life support from the European Central Bank (ECB) while the European officials figure out who will take the “haircuts” on Greek government debt. In contrast, the U.S. crisis was precipitated by the combination of a debt ceiling, a Congress divided among Republicans and Democrats and hard-nosed Tea Party types, and lame White House leadership. The inference from the low interest rates on U.S Treasury securities—short term, medium term, and long term—is that there is no credit crisis in the United States.


Greece is Bankrupt

Q. You say Greece is broke. But the government of Greece hasn’t yet defaulted, has it?

A. You might want to talk to the German, French, and other banks that own the bonds of the Greek government. They have been arm-twisted to accept new bonds in an exchange, and the present value of the debt service payments they will receive has been reduced by 20 percent. The owners of Greek government debt inevitably will take more “haircuts”—probably a series of small haircuts rather than a large one.


Q. Will the ECB take a haircut on its loans to Greece?

A. Great question. The ECB probably has priority in securing repayment, which

means that the private lenders will be at the back of the queue—a 50 percent haircut of total debt of the Greece would mean that the private lenders would lose two-thirds or more of their money. Note that some of these private lenders are Greek banks and pension funds. Ugly, very ugly.


Q. What is the current financial situation in Greece?

A. Greece has a primary fiscal deficit of five percent of its GDP, which means that government payments exclusive of interest payments on the debt exceed government receipts by five percent of GDP. (The secondary fiscal balance includes interest payments on the government debt, and is probably 13 percent of GDP.) The government of Greece is much better at making promises about how it will reduce its primary deficit than it is at delivering on these promises. In the absence of money from the ECB, the Greek government would not be able to meet the payroll, pay the firms that sell pharmaceuticals to the government-owned hospitals, and pay for the gasoline used by the army and the tear gas used by the police.


Q. What will happen if the ECB stops providing more money to Greece while the Greek government still has a primary fiscal deficit?

A. For a while the Greek government would issue “scrip” to pay various venders; scrip is a piece of paper that would say, “The Government of Greece promises to pay 100 euros to the bearer of this paper in three months.” Some of those who receive scrip in payments from the government would in turn use the scrip in payments or they might sell the scrip to buy euros, because of the fear that in three months they would receive another piece of paper that would say, “The government of Greece promises to pay 100 euros to the bearer of this paper in three months.” Subsequently Greece would declare a “bank holiday,” the banks would be closed for a week, and then the government of Greece would legislate that all bank deposits and all other financial contracts within the legal jurisdiction of Greece that had been denominated in the euro be redenominated in terms of the euro drachma—think euro-lite. Greece would then have two monies (or three if scrip is considered a money), euro coins and currency notes, and euro drachma deposits. The price of euro currency notes in terms of the euro drachma deposits would increase.


Q. What about the austerity measures that the Greek government has been adopting at the behest of the ECB and the IMF? And what about the money that Greece would receive when it privatizes more of the phone company and other government firms?

A. Let’s deal with the second question first. The government of Greece can only sell these firms if there are willing buyers. These government-owned firms operate at a loss; no sane foreign firm is going to pay more than a nickel for the right to deal with the Greek unions that effectively are the “owners” of these firms. The Papandreou government doesn’t have enough political clout to transform these firms so they are profitable. Greece has a bloated public sector and many pockets of protection—limits on entry into a large number of economic activities.


Q. What will happen if the money from the ECB runs out before Greece eliminates the primary fiscal deficit?

A. That would depend on how large the primary fiscal deficit would be—if Greece is close to a primary fiscal balance, then it might scrape by. Possible, but unlikely. Greece has had very little success in reducing its primary fiscal deficit.


Q. What about the sale of assets owned by the Greek government?

A. Any money from debt sales might finance some of the primary deficit, but the

money would not reduce the primary deficit (except as the government-owned firms had been operating at a loss).


Q. What would happen after Greece achieves a primary fiscal surplus?

A. Assume Greece has a primary fiscal balance of zero—neither a primary surplus nor a primary deficit. The debt of the Greek government then would increase at the interest rate; to keep the arithmetic easy, assume that the debt of the Greek government is 150 percent of its full employment GDP. Assume that the interest rate is four percent—a heroic assumption, because the interest rate is likely to be higher. Assume that the Greek economy grows at three percent, another heroic assumption; the growth rate is likely to be lower. Then the ratio of government debt to GDP would increase by three percent a year. The implication is that Greece cannot outgrow its debt, unless it can achieve a primary fiscal surplus of at least three percent. That would require a decline in household consumption of eight percent without any reduction in the ratio of government debt to GDP. The miracle that would have to happen for the lenders to Greece to avoid a massive decline in the value of their Greek government bonds is that the government of Greece would be able to achieve a shift in the primary fiscal balance from a deficit of five percent of GDP to a surplus of five percent of GDP.


Q. How did Greece get into this mess?

A. There are two elements to the story. One is that sometime around 2000, perhaps a year or two earlier, the government of Greece began to fudge the data about its deficits and its debt so it would satisfy the Maastricht criteria for joining the euro. The second is that there were a large number of European banks that were happy to buy the bonds of the Greek government because the interest rates were attractive and they believed that Greece had satisfied the Maastricht criteria. Did any of these lenders know that the data on the finances of the Greek government had been fudged? Who knows?


Q. How would Greece leave the euro, since there are no provisions in the Maastricht Treaty for a separation?

A. Put the issue the other way around: how could Greece stay in the Eurozone if it runs out of money to pay the government workers? Greece would have to leave the euro so that its central bank would be able to print the money to finance the fiscal deficit. The euro drachma would depreciate sharply, and the price level would increase—but by less than the depreciation in percentage terms, so that there would be a real depreciation of 20 to 30 percent. Both measures would lead to a decline in living standards in Greece, especially the consumption levels of those in the government sector. After the separation of Greece from the euro, the lawyers will be brought in to deal with the damages, etc.


Q. Why have the Germans and the French been so accommodating in providing more money to the government of Greece?

A. The answer involves a complex economic and political rationale. My guess is that these government bureaucrats haven’t done the arithmetic on Greece’s primary deficit and the scope of depreciation necessary for Greece to become competitive. They are waiting for a “Hail Mary” pass. Moreover, they think that Greece has a fiscal problem, whereas the underlying problem is that costs and prices in Greece are too high by 20 or 30 percent. Some want to help the Greek government make the changes that will enhance the competitiveness of its economy. Some are worried about the contagion effect, and the impact of the separation of Greece from the euro on Portugal, Spain, Ireland, and Italy—which might have been news a year or so ago. Some are using the crisis as a way to enhance and strengthen European institutions.


Q. Okay, so what is the end game for Greece?

A. At some stage in the next few months, there will be a run on the Greek banks at the retail level. There already has been a run at the wholesale level; few corporate firms hold significant amounts of money as deposits in banks in Greece, both banks chartered in Greece and foreign banks. Greek households will move money from deposits in Greek banks and foreign banks in Athens and Thessalonika to German and Swiss banks in Rome and Frankfurt. The liabilities of the Greek banks will decline, and they would normally sell assets or borrow from the central bank. But few are likely to buy any of the assets that the Greek banks would want to sell, and the Greek banks cannot borrow from the country’s central bank. Greece will leave the euro, at least temporarily. A separation, not a divorce. The separation and subsequent deprecation will enable Greece to become more competitive. Greece now has a large fiscal deficit because it has a large trade deficit, and it has a large trade deficit because its prices and costs are too high.


Q. What are the implications of Greece’s departure for other members of the Eurozone?

A. At least three. The impacts on other members of the Eurozone with troubled finances have been noted. The surge in the indebtedness of the governments of Ireland and Spain resulted from the bailouts of failing financial institutions, and not because their costs and prices were too high—both countries have a broad range of exports. Italy has a primary fiscal surplus and has had a very high level of government indebtedness to GDP since the early 1990s. The fiscal institutions at the supranational level are being strengthened. The euro will appreciate. The idea that the crisis in Greece means the end of the euro is nonsense.

Q. What is the take-away from the Greek crisis?

A. One take-away is that countries cross the “date of no return” on the trajectory to a crisis long before they realize they have made that transition. The Greek crisis hit the newspapers at the end of 2009, but this date of no return may have been in 2005 or 2006. There was then a large primary fiscal deficit, and no attention to how Greece would move to a sustainable fiscal trajectory.



Q. Okay, enough on Greece already. What is your understanding of the current fiscal deficit situation of the U.S. government?

A. The take-away from the very low level of interest rates on short-term U.S. Treasury securities, and especially on securities with maturities of 10 years and 30 years, is that the prospect of a credit crisis even in the distant future seems low. If the prospect for a crisis in 10 or 15 years seemed high, the interest-rate yield curve on U.S. dollar securities would be much more positively sloped. The connection between the posturing and political theater in Washington and the bond markets in New York is slight. There is a large supply of saving in the United States and the world, and a shortage of attractive outlets for the money—hence the interest rates on U.S. dollar bonds are very low.


Q. But what if Moody’s and Standard and Poor’s had reduced the credit rating of the U.S. government?

A. Yes, what if? Typically credit rating agencies rank the risk of default of various corporate bonds relative to the benchmark of U.S. Treasuries. The U.S. Treasury will NEVER default in the traditional sense; instead, the debt burden would be inflated away. Assume the debt of the U.S. government is downgraded. Where are those with large holdings of liquid short-term wealth going to park their money? Are the Chinese likely to increase their purchases of euros? Maybe slightly on the margin. There are no attractive alternatives to the U.S. dollar at this time. (To the readers—this paragraph was written three days before the Standard and Poor downgrade of U.S. Treasury debt. Greece has defaulted because its central bank is impotent, and cannot buy Greek government debt. In contrast, the Fed can always buy the U.S, Treasury debt. If the Fed refused, the Administration would “pack” the Fed. Of course there is a currency risk, but there is no credit risk.)


Q. Why are interest rates on U.S. Treasury debt so low?

A. Assume that you won a gigantic lottery. Interest rates are low in all stable areas because at the global level there is an excess supply of saving and inflation is virtually zero. And the Fed has followed a super-expansive monetary policy.


Q. Would the U.S. government have defaulted if the debt ceiling had not been increased on August 2, 2011?

A. The chatter about default on the U.S. Treasury debt was hocus pocus, a smoke screen, a henny-penny alarm that the sky was falling. The U.S. government would not have defaulted; it would have continued to pay interest on due dates. Interest payments on the U.S. Treasury debt are $300 billion a year or $25 billion a month (remember, most of this debt is short term, and short-term interest rates are very low). The U.S Treasury takes in nearly $200 billion a month—more in some months, less in others. The Treasury will always have enough cash to make the interest payments. Moreover, the U.S. Treasury would be able to roll over maturing debt without violating the debt ceiling. It would be able to sell $1 million of new debt for each $1 million of maturing debt. But there wouldn’t be enough cash to pay all the salaries and all the vendors to the government and to make the large transfer payments to the states, so some of these payments would be delayed. Vermont, for example, is scheduled to receive $50 million from Washington in August; that payment would have been delayed.


Q. Does that mean that the U.S. government doesn’t have a financial problem?

A. Yes and no. There is no immediate financial problem, at least in the absence of the debt ceiling, but there is a long-run financial problem in that if and when the U.S. economy were to approach full employment, the U.S. Treasury would “crowd-out” private borrowers because the U.S. fiscal deficit then would be three or four percent of U.S. GDP.


Q. Okay, why is there a long-run U.S. fiscal problem?

A. The U.S. fiscal deficit now is nine percent of U.S. full-employment GDP. There have been four major contributing factors—one was the Bush tax cuts of 2001 and 2003, which increased the annual U.S. fiscal deficit by two percent of GDP. These reductions in tax rates were based on the belief that there was a structural fiscal surplus, which would lead to an increase in government spending. (One line in the Republican playbook is “starve the beast”—the government can’t spend the money that it doesn’t have. That line was falsified in the Reagan presidency; taxes were cut, and government expenditures were increased and financed by a sharp increase in borrowing. Similarly, the line was falsified in the Bush II presidency.) The second contributing factor was the increase in defense expenditures—wars are expensive, and two wars are more expensive than one—say another two percent of GDP. The third is the cyclical downturn that began in 2007, which increased the fiscal deficit by four percent of U.S. GDP; the U.S. output gap is also about 10 percent of GDP. The fourth is that the stimulus program adopted by the Obama administration added about two percent a year to the U.S. fiscal deficit. Two percent plus two percent plus four percent plus two percent equals 10 percent.


Q. Is a debt ceiling a “good thing”?

A. A debt ceiling is a form of “pre-commitment.” In the past, the debt ceiling was raised when it was reached, and without any fuss. I used to think that the debt ceiling was a silly idea, a childish construct. But I have flipped 180 degrees. The politicians need to be reminded that there are limits to the amount that the U.S. government can borrow. When the gods are unkind or mischievous and a government has a primary fiscal deficit, it needs to develop a plan to achieve a primary fiscal surplus. Better to have a self-imposed limit than encounter a limit like the one imposed on Greece. The debt limit is like a stop sign at a railroad crossing—stop, look around, and determine whether it is safe to go ahead. Consider what would have happened if Greece had had a debt limit. (Yes, I know that Greece had a debt limit, but it evaded that limit.)

The problem isn’t the debt limit, but rather that there is now a large ideological gulf between the Democrats and the Republicans on the limits of government spending, as well as a stubborn reluctance to compromise. The Tea Party has sprouted like mushrooms in a soggy forest because the Obama administration had such a cavalier attitude toward the increase in government indebtedness; for better or worse, many of the Tea Party aficionados were seriously concerned about the growth of government debt. There are about 60 Tea Party members in the Congress—about 15 percent of its membership—but they have used the debt ceiling to get strong commitments about reducing the growth of expenditures.


Q. What about the chatter about compromise between the Democrats and the Republicans?

A. You may remember President Obama’s statement that there would be $1 of revenue increases for each $3 of spending cuts. The revenue increases have been compromised away. Now Harry Reid indicates that the Senate will agree to a reduction in expenditures—primarily a reduction in the increase in expenditures—without any increase in fiscal revenues. The Republicans have won most of the contested space in the sense of a reduction in the growth of expenditures or an actual decline in expenditures without any commitment to increase taxes—although on January 1, 2013, tax rates are scheduled to return to 2000 levels.


Q. How large is the difference between the Democrats and the Republicans on the growth of expenditures?

A. That’s a difficult one to assess, because there is no accepted baseline for the growth of expenditures over the next ten years. Expenditures in 2012 will be reduced by $25 billion. This is not a misprint.


Q. What about the proposal for a constitutional amendment that the federal budget be in balance year by year. There’s a lot of rhetoric that families have to live within their means, and that state governments balance their budgets.

A. Silly rhetoric, wrong on the facts and wrong on the logic of the role of the central government. Many families live beyond their means when they borrow to finance the purchase of homes, autos, college, etc. State governments do not balance their budgets every year; each has a rainy day fund and builds up its cash reserves in the fat years in anticipation of revenue shortfalls in lean years. Moreover, state governments have capital budgets to finance their infrastructure investments; these capital expenditures are between five and 10 percent of their total expenditures. Neither family budgets nor state government budgets are a useful analogy. The role of the federal government is that of a massive counterweight; in the fat years when the economy is prosperous, the federal government should have a fiscal surplus, and in the lean years a deficit. Moreover, federal debt can increase over time as long as the increase in debt is not exceptionally large relative to the increase in GDP. The issue is not the level of debt, but the ability to make the debt service payments.

Finally, there needs to be recognition that households want to save, and a significant part of their saving takes the form of purchases of government debt. If the U.S. government were to balance its budget every year, household saving would be much, much larger than business borrowing.


Q. Could you return to the idea of a balanced budget amendment? I think I’m lost.

A. Sure, I like the concept of a limit to the growth of government indebtedness in the long run, but it would be very costly to seek a balanced budget every year.

Assume—just assume—that the balanced budget amendment were passed next year. The sudden sharp decline in the fiscal deficit would trigger a massive depression. When the economy is strong and the unemployment rate is below six percent, the U.S. government should have a fiscal surplus. In contrast, when the unemployment rate is north of seven percent, the government should have a deficit. This is the concept of the automatic stabilizers, and results primarily because tax receipts rise relatively more rapidly than GDP.


Q. What’s your advice on the fiscal balance and deficit reduction?

A. Look, I am an analyst—I gave up policy advising a long time ago. There was too much competition, and it didn’t pay enough. Nevertheless, the place to start is to develop a trajectory for the growth of government debt in the hands of the public but at a declining rate—$800 billion next year, $600 billion the following year, $400 billion the third year. And then the parties can decide on the adjustments between revenues and expenditures within that constraint. The current expansion of the U.S. economy is fragile.


Q. What about the arguments of Paul Krugman and Joe Stiglitz that there is need for another stimulus program because of the jobs deficit?

A. Sympathetic in principle. Both Paul and Joe are Nobel prize winners for major contributions to economics. Joe seems to think that more spending is the solution to every problem. Perhaps he has written about the end game—when will the fiscal deficits decline to a sustainable level—but I am not aware that he has. Household savings is not the explanation for the large U.S. jobs deficit.


Q. What about the increases in tax rates that are scheduled for January 1, 2013?

A. My objective is to minimize the shocks to the economy from Washington. The return to the 2000 tax rates should be phased in over two years.


Q. What about limits on the growth of expenditures?

A. Sure, let’s hold expenditures constant in nominal dollars.


Q. While we are on the topic, how large is the jobs deficit?

A. The posted unemployment rate is just over nine percent, and the civilian labor force is 120 million, ball park; the product of the two numbers 10.8 million. The labor force participation rate is exceptionally low, because of drop outs from the labor force; add another two percentage points for a total of 13.2 million. But remember that full employment is associated with a five percent unemployment rate, so the “excess unemployment” is 7 million—a massive number.

The unemployed can be placed in two groups: the structurally unemployed and the cyclically employed. The structurally unemployed probably are in the range of three to four million, and have been without work for more than six months, which is very debilitating to family life, etc. Think auto workers in Detroit. But there is always a lot of churning in the labor market; more than two million people lose their jobs or change jobs every month. When the unemployment rate is five percent, the average period of unemployment is about 13 weeks. Now the average length of unemployed is about 22 weeks.


Q. What about the claim that government spending has increased too rapidly?

A. Yes and no. The ratio of government spending to GDP has increased by several percentage points relative to GDP, largely due to the stimulus program. President Obama loves new social spending programs, but together the dollar value of these programs is nickels and dimes in terms of spending by the Pentagon, Social Security, and Medicare. The single most important factor that explains the surge in the deficit has been the reduction in tax receipts as a result of the sluggish performance of the U.S. economy.


Q. You’ve mentioned the primary fiscal deficit of Greece some time ago, what about the primary fiscal deficit of the United States?

A. The U.S. primary fiscal deficit is about eight percent of GDP. Thus the target is to change the U.S. fiscal balance by eleven percent of GDP. Think of the problem in the following way. The U.S. Government should be on a long run sustainable trajectory that would be keyed to a fiscal surplus of $100 billon when the economy is fully employed. The rationale is that a fiscal surplus and a reduction in the government’s debt when the economy is fully employed will partially offset the deficits and the increase in the debt when the economic growth is below trend or average.


Q. Fine, where is the U.S. economy now with respect to this sustainable trajectory?

A. Far below the trajectory. Assume full employment means an unemployment rate of five percent. The measured unemployment rate is nine percent but the “true” unemployment rate is 11 percent—the difference of two percentage points reflects that two-plus million people have dropped out of the labor force (some have taken “early retirement,” etc.). The output gap in the economy—the difference between the actual level of GDP and the potential output at full employment—is $1,000 billion. If U.S. GDP were $15,000 billion instead of $14,000 billion, fiscal revenues would be $300 billion higher, and expenditures would be lower. The fiscal deficit now is $1,200 billion. Subtract $300 billion and the result is $900 billion.


Q. That is helpful—does that mean that if the relationship between fiscal revenues and expenditures changes by $900 billion that we will have achieved our target?

A. Not quite. First remember that the objective is a fiscal surplus of $100 billion when the economy is at full employment. So bump the $800 billion change in the expenditure-revenue relationship up by $100 billion to $900 billion. One more adjustment; the first is the long-run target is a constant ratio of government debt In the hands of the public to GDP. If GDP increases by three percent a year, then debt in the hands of the public can increase by three percent a year. Debt in the hands of the public is now $9,500 billion, so the debt can increase by $285 billion in the next year without leading to an increase in the ratio of debt in the hands of the public to GDP. Subtract $285 billion from $900 billon and the result is $615 billion—about five percent of U.S. GDP at full employment. Helpful, I now understand the arithmetic—but the economy seems stuck in low gear, and the pickup in the expansion that you promised six months ago has faded.


Q. Why has economic growth been so sluggish?

A. The cryptic answer is that there hasn’t been enough spending. Government spending is declining as the stimulus money is spent. Households have been saving because they are trying to rebuild their net worth.


Q. Okay, what is your view of the spending deficit?

A. I was hoping you would ask. We know that Americans like to spend–it is not that Americans are not spending enough but rather that they are spending $700 billion more of their money on foreign goods than foreigners are spending on U.S.-produced goods. Petroleum is one of these foreign goods and bananas and brandy are others; most are manufactures—autos, electronics, shoes, apparel.


Q. What is the arithmetic of the relationship between a change in the U.S. trade deficit and a change in the U.S. output gap?

A. We’ve been over this before. Value added per worker in the tradable goods sector is $80,000 a year. Each reduction of $1 million in the trade deficit would mean an increase in U.S. employment of 12 ½ workers; each reduction of $1 billion in the trade deficit would mean an increase in U.S. employment of 12,500. Assume a reduction in the U.S. trade deficit of $700 billion; the increase in employment would be 8,750,000. Voila, the output gap would be closed, the jobs deficit would disappear, and there would be a super boom and inflationary pressures because of excess demand, especially if this happened in one year or two.


Q. Anything else??

A. Sure, assume that the U.S. trade deficit declines by $150 billion a year, more or less at the rate of $12.5 billion a month. U.S. employment in manufacturing would increase by nearly two million—that’s a big number, a very big number. Consider the impacts of the increase in spending by those who will be newly employed; each would spend more on food and clothing and other necessities. These workers had been spending money on food and various services even when unemployed, using the money from unemployment compensation payments and from their savings and from incomes of their significant others. Assume that each of the unemployed had been spending $25,000 a year. Then these newly employed would increase their spending by $55,000, but they would have to pay taxes and repay loans, and they will increase their saving. Assume each increases spending by $40,000. Most of this money will be spent on domestically produced goods and services, which will increase employment in U.S. factories and other business establishments—call this the second round. Similarly, there will be a third round, and a fourth round, etc. Moreover, as domestic employment increases, business firms will spend to expand productive capacity.


Q. What are the implications of these second order spending impacts and these third order spending impacts associated with the reduction of the U.S. trade deficit?

A. A reduction in the U.S. trade deficit of $300 billion to $400 billion would close the U.S. output gap. And closing the output gap would reduce the fiscal deficit by $300 billion in a very painless way. But that still leaves a shortfall of revenues relative to expenditures of $600 billion plus or minus. Reducing the U.S. trade deficit and closing the output gap is the single most important measure to reduce the U.S. fiscal deficit.


Q. Why does the United States have such a large trade deficit?

A. Great question. The United States has a unique role in the global economy; the U.S. trade deficit is the mirror image of the trade balances of all other countries as a group. A few oil-producing countries—Norway, Kuwait, the United Arab Emirates—have concluded that the rate of return on money in the bank is higher than the rate of return on oil in the ground, so they are transforming the composition of their wealth. Or maybe they want larger diversification. Some countries—China, Malaysia—want to increase employment in manufacturing, and so they want large trade surpluses. Germany wants a large trade surplus. There is an adding-up problem: the number of countries that want trade surpluses and the size of the trade surpluses they want is significantly larger than the number of countries that want trade deficits and can finance these deficits.


Q. Which countries want trade deficits?

A. Often the countries that want trade deficits are those with fiscal deficits. The money that Greece borrowed enabled it to finance its fiscal deficit as well as its trade deficit.


Q. You seem to be the only analyst—other than Donald Trump and Lou Dobbs—who makes a connection between the U.S. trade deficit and the U.S. output gap.

A. Yes, I’ve noticed that very few others make this connection. Trump may be a charlatan, but he is no fool.



Q. How well is the U.S. economy doing relative to your earlier upbeat forecasts?

A. An embarrassing question, at least for me. I was too upbeat earlier in the year. I greatly underestimated the handicap of the housing problem—the excess supply of completed and unoccupied homes as well as the impact of the several million homes in foreclosure on home prices. Housing starts are in the range of 500,000 to 600,000, whereas the demographic demand is 1,500,000. If housing starts were at the annual rate of 1,500,000, the annual U.S. growth rate would be more than two percentage points higher than it now is. At the beginning of 2007, the excess supply of homes was about two million; by now the excess supply would have been fully exhausted. But obviously that hasn’t happened—yet. Demand growth has been exceptionally slow. The would-be buyers are on the sidelines as the foreclosure process continues. The New York Times carried a story about a surge in demand for vacant properties in the South Florida area. Market by market, region by region, housing will come back. As it does, the growth rate will increase.


Q. Any other observations about the data on the economy?

A. Yes, there is a contrast between the anecdotes and the data. The anecdotes suggest a stronger economy than the data do. Auto sales are brisk. Harley Davidson reported that sales were up nine percent. The inference is that there has been an increase in the supply of credit. Yacht sales are up. Restaurants seem to be flourishing. Flights appear fully booked, and airline companies are ordering new aircraft. New claims for unemployment compensation have declined below 400,000. The financial crisis of state governments is history; their revenues from sales taxes and income taxes have increased significantly.


Q. Can you explain the contrast between the data and the anecdotes?

A. These burps suggest that the data for the next quarter will be above trend. Hence I am still bullish about the second half of 2011, with growth about 3.5 percent. Americans have been discomforted by the Washington circus, but the impact on their spending is likely to be modest.


Q. Okay assume that you won the $10 million lottery prize. How would you invest the money?

A. Thanks, I was hoping you would ask. First, we refinanced our home mortgage several months ago, a 10-year conforming mortgage at an interest rate of 3.75 percent. That’s almost free money on an after-tax basis. This may be the sixth or eighth time we have refinanced in the last 20 years—and it is probably the end of the bull market in bonds. Interest rates are exceptionally low because of the aggressive policies of the Federal Reserve. (The local mortgage broker is now offering 10-year conforming mortgages at 3.25 percent,) Those policies will end, and interest rates will increase. So it is risky to buy or hold bonds as long as the Federal Reserve continues to follow the policy of excessive monetary accommodation. The Fed thinks the “best of all possible worlds” would be an inflation rate of two percent a year.


Q. Okay, if you rule out bonds, then the choices are between cash and stocks.

A. That’s a statement, not a question. You’re right. And the only reason for not holding stocks is that one believes that there is a non-trivial likelihood that stock prices will decline by 10 or 15 percent or even more in the next year or two.


Q. What about foreign stocks?

A. Yes, but I am not a stock picker, and this Q. and A. is already much too long.


Q. What keeps you up at night?

A. China, China. It is inevitable that trade tensions will rise as China’s growth slows.

Enough, already.