Deficits Matter — But Right Now, Not So Much as Stimulus

Deficits Matter — But Right Now, Not So Much as Stimulus

February 23, 2011

The conventional Washington wisdom is that the key to economic policy today is deficit reduction for 2011, and battles over spending cuts almost certainly will dominate our politics for the next several months. This so-called wisdom is the economic-policy equivalent of snake oil.  Britain and Germany both tried it, and now both are struggling with significant slowdowns. The U.S. recovery remains modest, and the tax stimulus passed last December is the main reason why our economy should be able to take the fiscal drag from spending cuts without stumbling — and might well pick up if we forgo significant reductions. Don’t take my word for it — just look at recent economic data.

 The most important signals are coming from finance and housing, the two areas that ignited the financial meltdown of 2008–2009 and the deep recession that followed. The Federal Reserve knows the real story, which is why it pumped another $200 billion into the long end of the bond market early this year. The Fed’s goal is to keep long-term interest rates low so housing and business investment can pick up. Well, it’s not working, at least not yet. John Mason, a Penn State economist, has sifted through the latest banking data and found, as expected, that the cash assets at commercial banks increased by some $280 billion since early January. Here’s the rub: Only one-third of that increase shows up on the balance sheets of American banks, while two-thirds are logged to the accounts of foreign-owned banks operating here.

The second round of the Fed’s “quantitative easing” program has made foreign banks here cash flush, but they aren’t serious lenders to American businesses or consumers. The main business of these foreign-owned banks is to keep credit flowing for the American operations of their big corporate customers from back home. As for our own banks, loans and leases generated by the 25 largest U.S.-chartered banks dropped by $50 billion since the New Year, mostly in shrinking consumer lending. The loan portfolios of the rest of the U.S. banking system expanded a little, but not in residential lending or commercial real estate, which each declined by more than $20 billion. More important, overall commercial bank lending is contracting. The big banks also dumped $67 billion in Treasury securities since the first of the year, while smaller U.S. banks expanded their Treasury holdings nearly as much. The big banks know what they’re doing: They sold to take their profits as Treasury rates inched up. 

The data on business investment since January 1, 2011, aren’t out yet, but the trend isn’t very bullish. Business investments (not including inventories) grew throughout 2010. But their rate of growth has slowed since mid-year, from gains of over 17 percent in the second quarter of 2010 down to 10 percent in the third quarter and down again to 4.4 percent in the fourth quarter. That trend closely tracks the winding down of the 2009–2010 stimulus, which was largely spent out by mid-year. Consumer spending has been rising since the end of 2009 — again, thanks largely to the stimulus — but the increases have been too modest to drive strong gains in business investment or jobs.

The main reason why consumer spending remains pretty weak, even with the big stimulus, is housing. Once again, you can take the Fed’s word for that. The primary asset of most Americans is their homes — the bottom 80 percent of U.S. households hold 40 percent of the total value of all U.S. residential assets, compared to just 7 percent of the total value of all U.S. financial assets. And the value of those residential assets continues to fall. According to the latest data, housing prices fell another 0.5 percent last December and stood 2.4 percent below their levels a year earlier. That’s why 27 percent of all single family homes with mortgages today are worth less than their outstanding mortgage loans. And the most powerful force driving down those home values are the home foreclosures which have been rising steadily since 2008 — and are expected to increase another 20 percent this year. The Fed’s latest $200 billion quantitative easing was designed to revive housing and business investment. But that can’t happen when two-thirds of it is taken up by foreign-owned banks to meet the weekly credit needs of foreign-owned companies here.

There is another cloud forming on the economy’s horizon, and that’s rising energy prices. The uprisings in the Middle East have rattled oil markets, and oil prices are up 25 percent since Thanksgiving. Four of the last six U.S. downturns were triggered by oil price shocks, including the first phase of the 2007–2009 recession. If the revolutions stop at Libya, they shouldn’t have any major economic effects on our economy.  But if they spread to the really big producers like Iran and Saudi Arabia, an economy still beset by weak business investment, falling housing prices, and fragile consumer demand could take a big hit. The most positive news is that last December’s tax stimulus — which, by the way, doesn’t include the Bush tax cuts, since they were already in place — should bolster consumer and business spending later this year. The only reasonable conclusion is that the last thing the American economy needs right now is more spending cuts.



The Economics and Politics of Cutting Deficits

February 16, 2011

The 2011 battle over the budget brings to mind the U.S.-Soviet nuclear arms talks of the 1970s and 1980s. The issue is not whether the antagonists can settle everything at once, but whether each will accept modest concessions and keep on talking until the next round, when more incremental compromises can be reached, and so on into subsequent rounds.  The negotiations to contain deficits in the 1980s, early-1990s and latter-1990s all proceeded in just this way, one step at a time once the two sides had found a common frame of reference. This week shows that any meeting of partisan minds is still a long way off, since President Obama and congressional Republicans haven’t found common ground to begin the process.

Both sides agree that whacking away at deficits running at 10 percent of GDP is an economic necessity, but they remain far apart on what those economics actually portend. The President sees the effort as part of the larger challenge of bolstering the competitiveness of American businesses and workers. So, his administration’s case hinges on combining targeted public investments with targeted spending cuts and tax increases for upper-income Americans. This “cut-and-invest” approach with a side order of taxes comes directly from Bill Clinton’s 1992 campaign program, and it’s no coincidence that Obama’s top economic adviser, Gene Sperling, helped manage economic policy in that campaign.

The approach is drawn directly from mainstream economics: Invest in things that support growth across industries and regions — basic R&D, infrastructure, and education and training — while gradual deficit reduction frees up capital for private investment. As the public investments nudge up the returns on private investment, businesses will use the freed-up capital to develop new products and services, expand operations and hire more workers. Finally, the deficit cuts should come gradually so they don’t squelch the natural upswing in Americans’ demand for everything businesses produce.

The best argument for the President’s approach is that it worked last time. When Clinton followed this script, what followed included the longest expansion on record, as well as the strongest gains in business investment, jobs and incomes in 30 years. To be sure, Japan demonstrated in the 1990s that waves of infrastructure spending for a slow economy can be wasteful, especially when powerful interests determine where that spending goes. And the United States isn’t immune from that dynamic —  the 2009-2010 stimulus had less long-term benefits than it might have, once Congress substituted its own parochial priorities for the broad public investments that Obama had laid out in his original plan.

The Republican budget proposals are targeted very differently. Defense and entitlement programs are still off-limits; and since those two areas account for most federal spending, the GOP cuts for everything else are much deeper and don’t distinguish between public investments and other kinds of spending. Moreover, the GOP economic logic doesn’t accommodate either higher revenues or a gradual glide path to lower deficits. Much like David Cameron in Britain, they believe that without draconian cuts very soon, investors will give up on the United States and America could face a Greek-style default of its public debt.

The trouble with the conservatives’ case is that the markets don’t buy it. If investors believed that America’s credit worthiness is at any genuine risk, we would see sharp increases in the interest rate on long-term federal bonds as those investors demanded higher returns to offset that risk. That’s simply not happening — though not because those investors don’t take deficit projections seriously. Rather, based on the historic record, they still trust that the two parties will find a way to contain those deficits, just as they always did in the past.

Despite this week’s threats by both sides, the markets are probably right that the economic costs of ignoring huge, unending deficits will eventually nudge the antagonists to the negotiating table. The calendar suggests that Democrats may well blink first: The prospect that House Republicans may really refuse to raise the debt limit will likely extract larger spending cuts from the President and congressional Democrats, if only because they know that voters would probably hold the President responsible in 2012 for any economic cataclysm that might follow. After that, it will be the Republicans’ turn to swallow higher taxes, much as Ronald Reagan did in 1982, 1983 and again in 1984. The base will howl, but John Boehner and Mitch McConnell know that without more revenues, they’ll be forced to embrace program cuts that would make most Americans recoil. And broad tax reform may give them some welcome cover — for example, to bring down the corporate rate in exchange for measures to raise more revenues from the same high-income households that will benefit most from lower corporate taxes.

All of this would be the prelude to a later round of even more consequential discussions, when entitlement reform takes center stage. Serious talks on Medicare and Social Security almost certainly will require a foundation of trust absent today, built on prior agreements on other spending and taxes. And if that trust remains unattainable, there will be no deus ex machina of the sort that finally resolved the nuclear arms race —  the Soviet Union’s collapse under its own economic deadweight —  to bail out the American economy in the next generation.



The Real Economic Implications of the Uprising in Egypt

February 9, 2011

Thanks to globalization, the uprising in Egypt raises serious questions about the impact on Western economies, including America, as well as Egypt’s political and economic development.   The precipitating event for the current unrest almost certainly was a facet of globalization — steadily rising worldwide food prices which hit record levels just before the unrest broke out.   An average household in Cairo has to spend 40 percent of its income on food, so price increases of more than 30 percent in recent months almost certainly helped fuel the volatile dissatisfaction.  Outside Egypt, the economic issue is, as usual, oil prices.  Egypt produces little of black stuff; but unlike Tunisia, it is an important transit country for crude.   Despite media doomsayers, however, the current unrest is very unlikely to take a serious toll on Western economies. 

A full-out civil war certainly could compromise the Suez Canal and the Sumed pipeline that links the Red Sea to the Mediterranean.   If that happens, tankers carrying more than 2 million barrels of oil a day will have to add another 6,000 miles to their journeys.   Such an interruption of shipments through the Canal and the Egyptian pipeline would shake up world oil markets and set the stage for speculators like Goldman Sachs and large hedge funds to gin up a short-term spike in prices, and profit nicely by it.  And yes, oil price increases can have huge effects on the American and world economies.  The recessions of 1974-1975, 1980, and 1990-1991 were triggered by big jumps in oil prices; and what became the Great Recession of 2007-2009 also was set off by oil price hikes.

But in order to threaten the U.S. and global recoveries, an oil price spike would have be both very large and persistent — for at least four-to-six months.    Before this year’s unrest gripped Tunisia and Egypt, oil prices in 2010 had risen by about 27 percent.  That cost the United States an additional $72 billion for oil imports, an extra $70 billion for the EU’s oil imports, and $27 billion more for Japan.  That’s not peanuts, but it was still just a ripple for economies of their size.  Saudi Arabia is the only country today with the capacity to engineer and maintain a price spike sufficient to wreck real economic havoc — and to prevent any other oil-producing country from trying to do the same.   

The real economic impact here threatens Egypt, not the United States; and once again, globalization is the key.  As China, Eastern Europe and parts of Latin America attest, globalization creates a new path for rapid economic development, based on vast foreign direct investments (FDI).  Over the last decade, the world’s leading multinational companies have transferred hundreds of billions of dollars in advanced technologies and business organizations directly to developing countries, including Egypt.  But FDI goes to countries whose economic and political stability those companies trust.  The political and economic conditions that emerge in Egypt once the uprising is resolved will determine whether FDI to Egypt continues, sustaining its path to modernization, or reverses itself and puts the country back on a path to economic stagnation.

These FDI transfers to Egypt swamp, for example, all U.S aid.  Over the last decade, American economic assistance to the country has averaged about $500 million per-year, and total economic and military assistance has run about $1.8 billion per-year.   Over the same period, FDI into Egypt has averaged $4.8 billion per-year, nearly three times all U.S. assistance and almost 10 times our economic aid.   Moreover, these FDI transfers increased sharply in recent years, averaging $9.4 billion per year since 2006 or 6.2 percent of Egypt’s GDP.  

There’s no doubt that the chief investment officers at the world’s largest companies have put on hold new investments in Northern Africa, at least until the outcome of the uprising becomes more clear.  Many factors go into the decisions about where to set up new foreign operations by companies like Coca Cola, General Electric, and Mitsubishi — or in Egypt’s case, by energy companies such as APA and BP, and financial service giants such as Citigroup and Metropolitan life.  The size and composition of a national or regional market count, as do a developing country’s infrastructure, the skills of the local labor force, the taxes multinationals will have to pay, and the soundness of a country’s currency.

Underlying all of these conditions is a country’s basic political stability and willingness to embrace Western businesses.   Sadly, multinational have no special preference for democracies over dictatorships, so long as both can guarantee stability and the rule of law.  To be sure, democracies tend to be a little more stable and lawful than many dictatorships, and sometimes they’re more prone to undertake the large public investments that Western companies look for.  But if the Muslim Brotherhood and its allies end up on top in Egypt, the modernizing investments now planned for there or many already in place will almost certainly go to other countries — along with many of the hopes for a better life that have fueled the uprising.