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Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Quarterly Economic Letter

Wednesday, October 31, 2012


The more rapid increase in U.S. GDP than the GDPs in most other industrial economies is one of the most intriguing aspects of the global economic developments, especially after the damage to U.S. financial system during and after the 2008 crisis. Unemployment is high in most countries, except Switzerland. Many countries including the United States have large trade deficits, and most of them also have large fiscal deficits.
Typically countries with high unemployment and large trade deficits want lower values for their currencies as a way to increase exports and provide more jobs. The member countries of the European Monetary Union as a group have a modest trade surplus; however, France, Italy, and Spain have large trade deficits while Germany and the Netherlands have large trade surpluses. China’s trade surplus is $200 billion, those of Taiwan and of Singapore are $44 billion and $51 billion. The trade surpluses of Norway and other oil producing countries with surpluses are in the ballpark of $450 billion.
Interest rates in the United States, Britain, and Japan are low, and real — or inflation — adjusted rates often are negative. Fiscal policy is constrained by the large deficits and high ratios for government debt to GDP.
One key policy question is why the trade imbalances are so large, and another is why the policy choices are so constrained.
The first section of this catechism looks at the global imbalances. The second section discusses recent developments in the U.S. economy. The third section evaluates some of the statements in the presidential political campaign. The last section considers the investment of the lottery prize.
Q. Why are there so many weak economies?
A. Five major reasons. The United States, Britain, Spain, and Ireland had housing booms, and are still recovering from the decline in real estate prices and their negative impact on the capital of banks and their willingness to lend. Construction of new homes has been much below trend because of the excess supply that developed during the bubble years. Costs and prices in some countries increased during economic expansions that were financed with money borrowed from foreign banks; after the spigot of readily available money was cut off, these countries — including Greece, Ireland, and Spain — were left with high levels of costs and prices. Households in some Asian countries have extraordinarily high savings rates. Foreign money continues to flow to the United States and Britain, which has led to higher prices for their currencies and to larger trade deficits than they otherwise would have had. Finally the surpluses of the oil exporting countries are a massive tax on global spending.
Figure 1













































































































































































































































































































UNEM=Unemployment rate, in percent
TRBA=Current Account Balance, in Billions of Dollars
GDPGR=GDP Growth Rate Annualized, 2012
TRBA/GDP=Ratio of Current Account Balance to GDP
FSBA/GDP= Ratio of Fiscal Balance to GDP
Abbreviations — US United States; UK Great Britain; CH China; JP, Japan; EMU, European Monetary Area; GM, Germany; NT, Netherlands; AU Austria, FR, France; IT, Italy, GR, Greece; NO, Norway; RU, Russia, SW, Switzerland, SI, Singapore.
Source: The Economist
Q. What conclusions should we take from the data in Figure 1?
A. Focus on the countries with trade deficits and those with trade surpluses. The intuition is that on a global basis, the sum of the trade deficits should approximate the sum of the trade surpluses. (In fact this statement is not quite correct since exports are valued FOB (free-on-board, the prices when the goods leave the ports) while imports are valued at CIF (the prices of the goods when they arrive at the ports, which is the sum of FOB and the costs of cargo insurance and freight — but this difference is not large enough to distort the major issues).
 Many countries have trade deficits, a few have trade surpluses. Do Germany and China have trade surpluses because the United States, Britain, Spain, and Greece have trade deficits, or do these countries have trade deficits because China and Germany have trade surpluses?
A country can have a trade deficit only if it can pay for the excess of imports over exports. Greece developed a trade deficit because the banks in Northern Europe provided the Government of Greece with the money to helped finance its fiscal deficit, which provided Greece the country with the Euros to finance a larger trade deficit. Now Greece has a trade deficit because the politicians in Northern Europe are frightened that they will be tagged as villains if Greece leaves the Euro. The North Europeans insist that the Government of Greece reduce its fiscal deficit which would require a reduction in its trade deficit — and lead to a reduction in their trade surpluses. The United States has automatic financing for its trade deficit because China and Saudi Arabia want trade surpluses.
Q. What is the relation between the trade surpluses of China, Norway, Japan, and Germany, and the U.S. trade deficit?
A. Sure, first focus on the arithmetic. Assume that U.S. GDP is twenty per cent of global GDP, and that there are twenty other countries and that each of the other twenty other countries accounts for four percent of global GDP. Moreover assume that each of these countries manages its economy to have a trade surplus of two percent of its GDP. The implication of these assumptions is that the ratio of the U.S. trade deficit to U.S. GDP would be eight percent, much too high to be sustainable because U.S. net international indebtedness would be increasing too rapidly relative to U.S. GDP. Thus one shortcoming of current international financial arrangements is that there is a potential inconsistency between the trade surpluses that some countries want and the trade deficits that others find acceptable.
The United States provides global consistency for the trade balances of all countries as group. The trade surpluses of the oil-producing countries are like “rainy day saving”, the countries will spend this money when the oil price is lower or as their annual production declines and they develop trade deficits.
Some countries — China, Japan, Malaysia — maintain low values for their currencies so they can have trade surpluses because they want to provide employment opportunities for workers moving off the farms. Singapore and Malaysia follow “beggar-thy-neighbor” trade policies.
If the oil exporting countries have a large trade surplus, then the oil importing countries have the counterpart large trade deficits. But some of the oil importing countries have large trade surpluses, which means that they either have surpluses in their trade with the oil exporters, or in their trade with other oil importers. The trade deficits of some oil importing countries are smaller than their oil importing bills, which means that they have trade surpluses with other oil importing countries. The trade surpluses of China and Germany with other oil importers are larger than their deficits with the oil exporting counties.
Return to the question; “Do these countries have trade surpluses because the United States has a trade deficit, or does the United States have a trade deficit because these countries want trade surpluses?” The United States has a trade deficit because those countries with trade surpluses want to increase manufacturing employment. Many oil importing countries use the dollars they earn from selling manufactured goods to the United States to pay for their oil imports.
The chatter in this political campaign that the United States borrows from China confuses an observation and causation. China has acquired $3,000 billion of international reserve assets, mostly securities denominated in the U.S. dollar. The United States has not borrowed from China, instead the Peoples Bank of Chinese has taken the initiative to buy U.S. dollar securities because they are more attractive than the securities denominated in most other currencies. If China stopped buying U.S. dollar securities, the U.S. trade deficit would decline by $200 billion.
Q. What would happen to unemployment in each country if its exports more or less corresponded with its imports?
A. The unemployment rate would decline in the countries with the trade deficits.
Q. Would each country then be fully employed?
A. No, while unemployment would decline in the countries with the trade deficits, it is unlikely that that these declines would be large enough for a significant number to move to full employment.
Each decline of one percent in the ratio of the U.S. trade deficit to U.S. GDP as a result of a reduction in U.S. imports of manufactures or an increase in U.S. exports of manufactures would result in a direct increase of employment in U.S. manufacturing of nearly two million workers; the implicit assumption is the value added per worker in manufacturing is $80,000. These newly employed workers would spend a large part of the increase in their incomes on domestically produced goods and services.
Q. But why wouldn’t each country be at full employment?
A. At the global level — that is, for all countries as a group, saving is too high and investment is too low.
Q. Okay, what does it mean to say “there is too much saving”?
A. Remember the cliché “Saving is a private virtue and a public vice.” The idea is that if households increase their saving, initially the decline in spending leads to higher unemployment. Eventually, the invisible hands will go to work; investment spending may increase in response to the decline in interest rates. But that adjustment may take years.
Now let’s go from these general principles to some examples. The amounts that individuals wish to save varies with their wealth, when household wealth surged as real estate prices increased sharply in the 2005 and 2006, household spending increased — -households financed the spending with the money obtained from home equity loans. Then when the real estate prices declined sharply and household wealth plummeted, the saving rate spiked upward, and spending slumped.
Households in some countries are “natural” savers; savings rates in China, Taiwan, and Singapore are very high. (Singapore is fascinating, because there is high compulsory saving by the government, and then high household savings rate.) The oil exporting countries, especially those with small populations, are large savers when the oil price is high. Argentina and Greece seem to want to spend as much of their own money and other people’s money as they can. Some of the Asian saving flows abroad in search of higher rates of return.
Q. Thanks, what is the relation between the trade deficits and the fiscal deficits of individual countries — say Greece, Britain, and the United States?
A. Complicated, because trade deficits and fiscal deficits are mutually determined; an increase in a country’s trade deficit may result from an increase in domestic demand or from an increase in foreign supply. Assume a government increases expenditures or reduces taxes to stimulate domestic demand, then the increase in the fiscal deficit will be associated with an increase in its trade deficit. Assume instead, purchases of foreign goods increase, in this case the increase in the trade deficit leads to an increase in the fiscal deficit.
Q. What are the implications of a decrease of $1.00 a barrel in the price of oil?
A. The revenues of the oil exporting countries would decline, their imports would decline although by much less than the decline in their export earnings, and their holdings of international reserve assets would increase less rapidly or in some cases decline. The U.S. trade deficit would decline, in part because of the decrease in the U.S. energy import payments.
Q. What is the significance of the chatter about U.S. energy independence?
A. The United States produces ninety percent of the energy that it consumes. As the U.S. dependence on energy imports decline, domestic spending on domestic goods will increase, and the oil price will fall, which means global spending will increase.
Q. Okay, what are the domestic economic implications of the U.S. trade deficit?
A. Thanks, my favorite question. The United States has a trade deficit with the oil exporting countries; American payments to oil exporting countries means smaller spending for domestic goods and services, and a higher level of domestic unemployment. The United States also has trade deficits with other manufacturing countries, which has led to a higher level of domestic unemployment. If Americans spent more for domestically produced goods and less on imports, U.S. income and employment would increase. Similarly if foreign residents spend more on U.S. goods and services, domestic income and employment also would increase. The total impact on employment depends on whether the labor component of the particular goods is high, as in textiles or low as in pharmaceuticals.  
Q. What about some of your earlier concerns, including the puncture of the housing bubble in China and fiscal debacle in Greece?
A. The slowdown in China’s economy appears to have stalled. But the massive imbalances in China remain, property prices are much too high relative to household incomes and the ghost cities are still ghosts. The massive infrastructure spending on railroads, toll roads, airports, etc. has been financed with borrowed money, and many of these projects do not earn enough to cover their interest costs, even though they pay low interest rates. The pattern is one of evergreen finance, the banks lend the borrowers more money so they can pay the interest. This pattern can continue as long as the growth rate of the country is higher than the interest rate. These losses will have to be absorbed. In a western economy, the indebtedness might be floated off in an inflation, and that may happen in China, but then the legitimacy of the government would be challenged because of the country’s earlier experiences with hyperinflation. If banks were to “mark to market” their loans, the value of bank assets would be much smaller than the value of their liabilities. That would invite a run on the banks, but the banks would not close; the banks would be bailed out by the government. The powder keg is that household holdings of money in China are extraordinarily large, and if households were to reduce their money holdings significantly, there would be a goods market inflation. Some households would seek other stores of values — gold, Hong Kong dollars, jewelry, etc. As the Chinese growth rate slows further, the trade surplus will increase.
The central Chinese problem is that the amount that households wish to save remains much larger than the amount that can be invested at positive returns on capital. If the value of these investment assets were set on the basis of their earning power, the growth rate would be three or four percentage points lower than the reported growth rates. A metaphor — assume that the Chinese decide to mimic the Egyptians and build pyramids, the growth rate would be high because the value of the pyramids is based on their costs of production. But the economic value of the pyramids is much less than their costs of production. China has been very successful in raising the living standards of four or five hundred million people, but real income and the growth rate are lower than the reported values.
Greece is a tragedy, unnecessary hardship because the politicians understand the problem and are reluctant to adopt the policies to fix it.
Q. Assume that the good fairy gave you the magic wand to fix the global economy; what would you fix and why?
A. Thanks, a marvelous gift. Note that the fixing involves some adjustments in prices and some adjustments in quantities
First, Greece should take a holiday from the Euro and allow the decline in the price of its new currency to effect a fall in its price level relative to the price levels in the other countries in the Euro area; otherwise it will take eight or ten years for prices in Greece to decline before its GDP begins to increase. The politicians y imagine horrible consequences if Greece leaves the Euro. The sun will rise the next day, just as it did after the U.S. Treasury closed the gold window. When the politicians are no longer distracted by this minor sideshow, they can focus on strengthening the institutions of the monetary union.
Second, the European Central Bank should make an unlimited amount of funds available to the banks in the member countries on the basis of good collateral. Concerns about the quality of collateral can be alleviated by requiring that the banks post 150 Euros of collateral for each 100 Euros of loans from the ECB. Central banks are created to lend unlimited amounts to solvent borrowers.
Third, the planned increase in bank capital requirements in Europe should be rescinded or at least delayed.
Fourth, China and the other Asian countries should reduce the ratio of their trade surpluses to their GDPs by one percentage point a year until these ratios decline to no more than two percent of their GDPs. Similarly Germany and the other trade surplus countries in Europe should be induced to reduce their trade surpluses.
Fifth, the United States should adopt measures to reduce the ratio of its trade deficit to U.S. GDP by one-half of one percent a year
Sixth, the energy importing countries should adopt measures to reduce demand, which will lead to a decline in the global prices.
Q. How would you characterize the U.S. economy in the autumn of 2012?
A. The U.S. economy has been doing well, and all the signs are positive and mostly increasingly so, even though the unemployment rate is higher than everyone would like. The shock to the economy in 2008 was a mini-depression, after the sharp decline in property prices that began at the end of 2006. The solvency of many large financial firms was threatened; Merrill Lynch was rescued by Bank of America, which then was rescued by the U.S Government. Secretary of the Treasury Paulson’s decision not to “save Lehman” was the most costly in American history. Spending on real estate fell sharply. Credit for the purchase of used cars was scarce, which led to a sharp decline in their prices, and the increase in the spread between the prices of new cars led to a sharp decline in the demand for new cars.
Two factors explain why the U.S. rate of economic growth has bounced around two percent a year rather than around four percent a year. One is the sluggish level of housing starts; it was predictable that starts would be at a low level as long as prices were declining, and that prices would decline as long as there was a significant excess supply. The second is the large U.S. trade deficit; Americans are spending $600 billion more a year on foreign goods than foreigners are spending on U.S. goods. The arithmetic is that if Americans and foreigners spent $100 billion more on U.S. goods, then in the first instance, employment in U.S. manufacturing would increase by 1,250,000.
Q. What is the good news about the U.S. economy?
A. The housing market has turned the corner and is recovering, and the likelihood is high that there will be a strong resurgence because of the demographics. The excess supply has dwindled, and the inventory of unsold homes is very low. Prices have increased in virtually all of the twenty major housing markets. As long as mortgage interest rates remain low, housing starts will increase. In the 1980s and 1990s, housing starts averaged 1.5 million units a year, in the last month or so, the rate has been 800,000 units. The stocks of the home building firms are up ninety percent. Each increase of 100,000 housing starts in a year will add 0.25 percent to the annual growth rate and lead to a reduction in the unemployment rate of 0.3 percent.
Consumer confidence is up. The auto firms are doing well. Stock prices — despite the large daily swings — are almost twice as high as they were in the trough following the 2008 crisis. Corporate earnings projections for the next quarter are being revised downward, in part because producers of investment goods are experiencing slower sales in China.
Q. Okay, what is the bad news about the U.S. economy?
A. More than two million people are structurally unemployed; they have been without meaningful work for more than six months. Ninety to ninety five percent of Americans believe that the distribution of income and wealth has become too skewed. They do not understand the intricacies of “carried interest”, but they have a visceral reaction that the tax rates paid by the super-rich reflect that they have bought a large number of the members of Congress. The low tax rates paid by the super-rich are outrageous, and so is their ability to manage buy congressional support for their position.
Q. Are you concerned about the fiscal cliff?
A. Yes and no. There are three separate problems, and they are conflated. One problem is that the projected U.S. fiscal deficit of $1,000 billion is too large, that deficit needs to be reduced slowly and steadily. The projected return to the withholding tax rates of 2008 together with the increase in taxes for Medicare is enough of a tax increase for 2013. The second problem is the impact of the aging of the country on Social Security payments, and the third is the impact of the changes in the health care technologies on the costs of Medicare. Fixing social security is kid’s play — three nickel-and-dime changes at the margin — continued increases in the age before individuals can receive full retirement benefits, raising the ceiling on annual contributions, and changing the mix of annual adjustments in benefits for those in lower income groups and those in higher income groups so that the former benefit relatively more from the annual increases in productivity than the latter.
There is no good historic analogy to the U.S fiscal cliff — when a pressing domestic financial problem was not addressed in a timely way. The motive for developing a fiscal cliff was the sharp decline in spending would be so frightening that the stubborn and partisan knuckleheads would come to a satisfactory. We need to get on a trajectory for a gradual decline in the U.S. fiscal deficit, but the expansion is still too tentative to withstand a severe decline in expenditures or a sharp increase in tax rates.
Q. What else concerns you?
A. The continued slowdown in China will lead to an increase in its trade surplus partly because of the decline in its imports and the decline in commodity prices. The U.S. trade deficit will increase.
Q. Anything else?
A. Yes, one of the topics in third debate between President Obama and Governor Romney was the fit between the strength of the American economy and the U/S. foreign policy choices. The U.S. trade deficit is a major diversion of spending from goods and services produced in the United States to goods produced abroad. This diversion occurs not because the United States is not competitive, but because foreign governments maintain low prices for their currencies as a way to stimulate employment.
Q. Anything else?
A. Yes, the U.S. fiscal deficit, which now is seven percent of GDP, is too large by four percentage points -say $600 billion. Part of the reduction would occur more or less automatically as the U.S. output gap declines — assuming that the gap declines. Taxes have to be increased relative to government expenditures.
If taxes are increased suddenly relative to expenditures, the economy would slow, and the deficit might increase as in 2009.
Q. What is the relevance of the Japanese experience?
A. Japan had a modest government debt in relation to its GDP until its asset price bubble declined in the early 1990s. Since then its fiscal deficits have been large, and the ratio of government debt to GDP is approaching 200 percent, but all of this debt is to domestic residents. The Japanese economy is growing at an annual rate of two percent, so the ratio of debt to GDP continues to grow rapidly. Because interest rates on government debt are very low, the interest payments of the government are modest. But if interest rates were to increase, then the interest bill would surge and the financing problem would be immense.
Q. Can the United States continue to have fiscal deficits until the end of time?
A. Yes, but it cannot have large fiscal deficits. Since U.S. GDP is likely to grow, then the United States could continue to have fiscal deficits. If the U.S. economy grows at three percent a year, then the U.S. fiscal deficit might be three percent of U.S. GDP, or say $450 billion. Since the U.S. fiscal deficit is now about $1,000 billion, which means that the necessary minimal reduction in the fiscal deficit is $550 billion. As the U.S. output gap declines, tax revenues would automatically increase; each reduction in the output gap of $100 billion would lead to a reduction in the U.S. fiscal deficit of $25 billion. The output gap is now $800 billion, so the reduction in the output gap could lead to a reduction of $200 billion in the fiscal deficit. That means that the changes in the ratio of taxes to expenditures would have to bring in $350 billion — say a bit more than two percent of GDP.
These changes should be distinguished from the changes necessary to deal with the problems of social security and of financing Medicare.
Q. Any observations about statements about the economy that we’ve heard in the campaign?
A. Dreadful. Awful, mind-boggling. Both candidates are treating the voters as if they were idiots.
Q. What about Governor Romney’s proposal that everyone should receive a twenty percent tax cut?
A. The first impact of a reduction in tax rates is that households would spend more and there would be a quickening of the U.S. rate of economic growth. But the fiscal deficit would increase, Congressman Ryan said that the growth in the economy would mean that the fiscal receipts would increase and Governor Romney said that the increase in revenues obtained from tax simplification would generate enough revenues to offset the losses. Consider the intuition inherent in the arithmetic of the following example, if tax rates decline by twenty percent would lead to a decline in tax revenues by twenty percent if GDP did not increase, , then taxable incomes would have to increase by twenty percent if fiscal revenues were to remain unchanged. But the U.S. output gap is eight percent; if taxable incomes were to increase by twenty percent, there would be a surge in the U.S. inflation rate. The idea that tax cuts would pay for themselves was advanced in the early 1980s and used to rationalize the cuts in tax rates — but the deficit soared. Similarly George W Bush made the same promise in 2001
Tax simplification is a desirable objective, but the revenues gained would be smaller than those lost from the reduction in rates.
Q. What is your reaction to Governor Romney’s five point plan to increase jobs?
A. Any plan to increase jobs should be applauded. The objectives are clear but the means to get to these objectives remains hidden. His plan is a set of targets, like getting to the moon, but he hasn’t offered specific statements on the programs that will lead to the increase in spending.
Q. What is the judgment on the President Obama’s stimulus program?
A. This spending programs together with the aggressively expansive monetary policy prevented the economy from imploding in 2008. The statements that stimulus money was wasted are hogwash, but a different allocation might have led to an even more rapid increase in employment.
Q. What about President Obama’s proposal to return to the 2000 tax rates for those with annual incomes above $250K?
A. A useful proposal — but the increase in fiscal revenues will be modest. Look, America is largely a middle class country; the move to a sustainable fiscal balance will occur because the taxes on the middle class are increased or because the supply of middle class entitlements is reduced. Both candidates want to favor the middle class — but at whose expense.  
Q. Is the U.S. economy in better shape in September 2012 than it was in September 2008?
A. Yes, absolutely, beyond the shadow of a doubt. Fannie Mae and Freddie Mac the two large government sponsored mortgage giants were about to go bankrupt, although the term of the U.S. Treasury was that they were put into conservatorship. Lehman Brothers was about to fail, as was AIG; the economy was about to experience a massive credit crisis, unlike any seen since the early 1930s. House prices had fallen by about 15 percent since their late 2006 peak and were about to decline another 20 percent. Stock prices were about to decline by almost fifty percent.
Q. Is the average American better off?
A. How should we measure better off — by annual income, by annual consumption expenditures, by household wealth, or by some combination of these metrics? If the metric selected is household wealth, then the $8,000 billion decline in the market value of real estate means the median household wealth has declined. Millions of individuals have lost their homes to foreclosure, several million more have up-side down mortgages. Obviously these people are worse off. But real estate prices were on a non-sustainable trajectory, and these millions were caught in the froth of clichés like “property prices never decline.” Using 2003 or a subsequent year as a benchmark for household wealth biases the conclusion. Median income has not increased, but median income includes both the employed and the unemployed, and my bet is that the median income of the employed has increased, and that the median for the population has remained static because of the increase in share of the unemployed.
Q. What about the policies of the Obama Administration?
A. The Obama Administration was slow to recognize the severity of the economic crisis; its forecasts of the speed of the expansion and for the decline in the unemployment rate were too optimistic (as were mine.)
Q. Anything else on the shortcomings of the Obama Administration?
A. Lots, how much space do I have? Its policies to cope with hardship in housing market were too little, too late. It was inevitable that house prices would decline, and that the losses associated with the decline in the market value of the American housing stock would be about $8.000 billion. Initially these losses would fall on the homeowners, then the losses would fall on the banks and other lenders to these homeowners, and then the losses would fall on the Federal Government. Note that most of the decline in the market values of the U.S. housing stock would be borne by homeowners around the country; some did not have mortgages and others had mortgages that were modest relative to the market value of their properties. The three groups that were most vulnerable to being “wiped out” by the decline in prices were the recent buyers who had grossly overpaid and had modest equity-or they had traded up to more expensive homes as the equity in their first homes surged, and those who were continually or sporadically refinanced to take equity from their homes.
The policies of the Obama Administration slowed the price adjustment policies, and hence prolonged the adjustment. The Administration could not separate the hardship of the homeowners from the price adjustment.
The Obama Administration was slow to recognize that the job skills — the human capital — of those several million of those unemployed had become obsolete. They needed re-training. Re-training is much better done by private firms than by government agencies.
The Obama Administration was slow to recognize that millions of Americans are greatly concerned about the fiscal deficits and increase in government debt. They blithely ignored the need to present scenarios for an orderly reduce in the deficit.
The Obama Administration is “right on” in returning to the pre-Bush cut tax rates on those with annual incomes greater than $250,000 a year. But it has been irresponsible in avoiding the need to return to the tax rates that prevailed in 2000 for those with incomes less than $250,000. The revenues that might be raised by doubling or even tripling the tax rates on those with incomes above $250.000 will be a drop in the proverbial bucket relative to the needed reduction in the U.S. fiscal deficit.   
Q. What about the tax simplification as a way to generate the larger revenues?
A. Great question. I have just completed the preparation of my 2011 Federal Income Tax. Three large “tax expenditures.” — deductions for the payment of local and state taxes, interest payments on home mortgages, and charitable contributions. The housing industry benefits enormously from interest deductibility, and non-profit sector — churches, hospitals, and colleges and universities — benefit from the deductibility of charitable contributions. These tax expenditures are regressive, they benefit high income taxpayers much more than low income taxpayers. I like the spirit of Governor Romney’s suggestion that there be a cap on the deductibility of these types of expenditures in relation to taxable income; the cap might be twenty percent in 2013, 19 percent in 2014, 18 percent in 2015, etc.
Q. What about the “disappearance or immersion” of the Great American Middle Class?
A. If the middle class disappears, where does it go? The middle class is can be identified by worker skills or by annual income. Some relatively unskilled workers who were in industries with a lot of monopoly power are experiencing declines in their real incomes. Fed Ex, UPS, and the internet mean that the number of employees of the U.S. Postal Service is declining. (Thetford, Vt. has six villages — East Thetford, North Thetford, Thetford Center, Thetford Hill, Post Mills, Union Village, and Rices Mills, five of these villages have post offices.) Consider the American auto industry, or rather the two American auto industries, the older unionized industry north of the Ohio River and the younger non-unionized industry south of the Ohio River. Many of the foreign- owned plants are south of the Ohio River. The older industry has been losing market share because of its higher costs. The annual incomes of the workers in the older industry were high relative to their labor skills.
Q. What about the statement that our grandchildren will be worse off than we are?
A. The changes in the living standard from one generation to the next depend on productivity, which has averaged a bit less the two percentage points a year — which means that living standards double every 36 years. But the improvement in living standards also depends on the changes in the proportion of the population that is in the active labor force. As the American population ages, the proportion of the population that is the labor force will decline and the increase in GDP will be spread over more people. That difference is likely to be slight, and in tenths of one percent a year.
Q. What about the claim that the surge in the debt outstanding in of the U.S. Treasury will be a burden on our grandchildren?
A. As the debt of the U.S. Treasury increase, its interest payments will increase, and the ratio of these interest payments to total government expenditures will increase. Remember that the liabilities of the U.S. Treasury are the assets of other participants in the economic system; some of these participants are non-Americans but most are Americans. (And there is a partial offset to foreign owned U.S. dollar securities because Americans own more foreign securities; there is greater international diversification of portfolios.)
Q. Are you upbeat about the U.S. economy?
A. Look, by now it should be obvious that I am always upbeat, (and at times excessively so; the economy has let me down by failing to live up to my forecast). The news on that the housing problem is behind us is marvelously good. Households are more upbeat than at any time in the last four years. But I am less confident than in the past because of the unwillingness of the Europeans to take the decisions to move their economies forward and because the slowing of Chinese economy will lead to more trade tensions
Q. If you won the lottery, how would you invest the proceeds?
A. First what not to buy? This is not the time to buy — or to continue to own — bonds; interest rates are about as low as they will ever go. Interest rates will increase as the economic growth quickens — the statement that interest rates will increase is the same as the statement that bond prices will decline. If bonds are out, the basic choice — at least among U.S. dollar denominated securities — is between cash and stocks. Or perhaps among cash, real estate, and stocks. The only reason for holding cash is the view that stock prices will decline by a non-trivial amount — say by at least fifteen percent. The combination of the very low interest rates and the recovery in real estate market suggests real estate oriented investments will do well. Americans need shelter; the demand for apartments appears to be increasing relative to demand for single family homes.
The slowdown in China is woeful news for commodities and for the countries that produce and for the countries that export commodities. Securities related to the Euro area are likely to do well as the crisis is resolved — and all crises are eventually resolved.
Q. Could U.S. stock prices decline?
A. Sure, stock prices can always decline. Stock prices probably decline on forty five percent of the trading days. Note that in the long run stock prices increase by about eight percent a year in real terms, slightly more in nominal terms. The variations around the trend are of two types — some are more or less noise, and on several occasions stocks declined by fifty percent in the early 1970s and again after the 2008 crisis. Stocks lost ninety percent of their value in the early 1930s, but there had been a bubble in the last several years of the 1920s. And stocks declined by forty percent from 2000 to 2003. These are large price declines; in two cases they resulted from the implosion of stock price bubbles, in one case the decline resulted from the surge in interest rates, and the fourth followed from shortage of liquidity.
Why might stock prices decline significantly in the next year or two? The price-earnings ratio is now seventeen, about its long run average value. Stock prices might decline because earnings decline or because interest rates increase. Earnings remained remarkably robust despite the sharp decline in economic activity in 2008 and 2009.
In the long run, corporate earnings increase as the economy grows; the share of profits to GDP has averaged about eight percent. There is significant variability in the share of profits to GDP and in the price earnings ratios. But in the long run, the average is the average is the average.
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Robert Z. Aliber