Forget about Spending and Get Serious about the Economy

Forget about Spending and Get Serious about the Economy

March 31, 2011

Washington today, especially the Congress, has a textbook case of cognitive dissonance. A confluence of black swan developments may well threaten the American and global recoveries. There’s the civil war in Libya and unrest across much of the Middle East that could disrupt world energy supplies, the natural catastrophes in Japan may upend the world’s third largest economy, and several European governments are flirting with junk-bond status. On top of all this, recent data on housing, investment, and consumer spending all point to a still-fragile U.S. expansion. Yet, with all of this, Congress spends its time bickering over funds the federal government needs week to week just to keep operating.

This debate has become almost willfully wrong-headed. An economy not yet recovered fully from a historic financial meltdown and deep recession, and now facing possible major shocks from three directions, is no candidate for budget cuts. In fact, a new National Journal survey of 44 Washington economists and “economic insiders,” Democratic and Republican, found only one of the 44 who sees immediate spending cuts as the highest priority. (Full disclosure: I am one of the 44 surveyed.) If there are still any doubts about what happens when governments ignore this basic economics, consider Great Britain and Germany. Both embraced the austerity snake oil and plowed ahead with sharp spending cuts and tax increases. Two quarters later, the recoveries in both countries are stumbling badly.

Of course, these debates are not about economics at all. Here and in Europe, they’re driven by anti-government factions inside the base of each country’s conservative party. Congressional Republicans might take note, however, that this approach no better politics than it is economics. After enacting their programs, the governments of David Cameron and Angela Merkel find themselves hemorrhaging public support.

There is a time for serious debate about the role of American government in our economy and daily lives. The 2012 elections could provide a platform for real public deliberation about how much the government should do in the future to provide health care for elderly and poor people, ensure access to higher education for young people unlucky enough not to be born into affluence, or support the weapon systems, manpower and womanpower needed to wage multiple wars. At a minimum, the campaign should include some serious talk about whether the Obama administration did the right thing in driving health care coverage for most Americans.

Right now, however, is the time to focus on the clear and present dangers to the jobs and incomes of average Americans. The President made a good start this week with proposals to make the U.S. economy less energy intensive and especially less dependent on imported oil. Dealing with the continuing problems in Japan and Europe will be tougher. As we outlined last week, if the crisis in Japan persists for another month or longer, it will disrupt production here of everything that uses parts or elements made-in-Japan, from automobiles and electronics to medical equipment and even pharmaceuticals. Congress should take this time to consider steps that will help our manufacturers keep their U.S. workforces intact through such supply chain disruptions — for example, a temporary tax break on foreign earnings brought back home by manufacturers who expand their U.S. jobs. If Japan’s crisis deepens, it also will absorb all of Japanese saving, and then some. That development would likely drive sales of U.S. stocks by Japanese investors and sales of U.S. government securities by the Japanese government, creating new downward pressures on U.S. stock prices and new upward pressures on our interest rates. All of this means that the Federal Reserve and Treasury should take this time to prepare for another round of quantitative easing.  

A new debt crisis in Europe would threaten the balance sheets of our large financial institutions, yet one more time. They don’t have large holdings of Greek, Irish, Portuguese, Belgian or Spanish government debt, all of which now hang in the balance. But our big banks do have hundreds of billions of dollars in normal business with the large European banks that do carry huge portfolios of those bonds — and which might find themselves unable to carry out their contracts with our banks if another crisis hit. That’s what happened, in reverse, in September 2008, when American banks couldn’t honor their contracts with many European banks in the post-Lehman panic. Today, instead of arguing about PBS funding, congressional leaders should be quietly talking with the administration about ways to contain another financial crisis without bailouts which the public would never support again.

If the Congress and administration could refocus their current debate around these real and pressing issues, perhaps they could then move on to the longer-term problems that matter to most Americans outside the Tea Party. To begin, what can Washington do to help American businesses create new jobs at the vigorous rates we all considered merely normal, until the last decade?  There might even come a time for a serious public discussion about what steps might help reverse the corrosive income patterns of the last 30 years, which have seen a small minority of very rich and very highly-skilled Americans capture nearly all of the nation’s income gains, while middle class people stagnated and poor people lost ground.

And one point should be very clear: Budget cuts are no more of an answer to these long-term issues than they are for the more immediate problems facing the American economy.

The Aftershocks for the U.S. Economy from the Disaster in Japan

March 24, 2011

As the damage to Japan and its economy from the recent natural disasters deepens, we can begin to see serious potential aftershocks for our own economy. In certain respects, the United States relies on our broad and intricate financial and trading relationships with Japan. China has surpassed Japan as the world’s largest buyer of U.S. Treasury securities. But Japan remains the world’s largest, diversified investor in the United States, counting its large holdings of U.S. stocks, corporate debt, real estate, and plants and factories, as well as government securities. Now, in an unanticipated downside to globalization, the aftereffects of the natural disasters are beginning to disrupt the two countries’ normal financial and trading relationships. And that will create new upward pressures on U.S. interest rates, put new downward pressures on U.S. stock prices, and cause unexpected losses for many U.S. companies.

These concerns reflect the prospect that the terrible earthquake and tsunami will prove to be unusually destructive for the Japanese economy. The damage to the country’s power grid may extend the economic costs far beyond the communities directly devastated by the disasters, slowing agriculture and industrial activity across up to one-third of the country. And with the frightening news that Tokyo’s water supply contain radioactive iodine dangerous to infants, the radiation from crippled nuclear power facilities could bring economic activity to a halt in much more of the country, and for some time to come.

If this comes to pass, the aftershocks for the U.S. economy could be quite serious. The disaster and its disruptions for the Japanese economy have already begun to cut into the earnings and incomes of Japanese companies and citizens. To cover rising debts and other unexpected expenses, Japanese investors have been converting some of their foreign assets to yen, and then bringing those yen back home. Most of these liquidations involve American assets: Japanese investors hold some $211 billion in U.S. stocks and another $134 billion in U.S. corporate debt. Moreover, if the earnings of Japanese companies and the incomes of Japanese investors continue to shrink with the crisis, private saving in Japan will fall — and that’s just as Japan’s budget deficit soars. The result will be that most of the savings that Japanese companies and individuals manage to accumulate will go to finance their own government’s deficits, not to buy our assets. And if the crisis deepens and persists, rising outflows of Japanese holdings will depress U.S. stock prices and raise the interest costs for U.S. corporate borrowers.

The largest Japanese investor in the United States, of course, is the government in Tokyo, which holds some $1 trillion in U.S. government securities. As a long crisis drives up government spending in Japan and drives down revenues, a budget deficit already equal to over 8 percent of the country’s GDP will rise sharply. At a minimum, Japanese government purchases of U.S. Treasury securities will dry up. And if the crisis worsens, Japan may become a major seller of U.S. government securities. This will put considerable pressure on U.S. interest rates, potentially increasing our own deficit (through higher interest costs), and almost certainly slowing our economy.

The potential problems are not limited to finance. Japan accounts for about 5 percent of U.S. exports; and major exporters will feel the pinch. Those likely to feel it first include makers of aircraft and their parts, medical equipment, pharmaceuticals, and computers. It’s not all bad news for U.S. exporters, because the current strong yen tied to Japanese investors cashing out some of their foreign financial assets will leave Japanese producers less competitive in other markets. More grimly, while U.S. exports of foodstuffs also are taking an early hit; U.S. food producers will step into the breach if more of Japan’s domestic food supply becomes contaminated.

The potential costs for the U.S. economy also include disruptions in U.S. supply chains that involve Japan. With holdings of $260 billion in U.S. industrial and commercial operations, Japan is the second largest foreign direct investor in the U.S. economy, just behind Britain. Sony, Toyota, Honda and other large Japanese enterprises operate here to serve the American market; but they still produce most of their most sophisticated parts in Japan. Japanese production of many of those parts already is disrupted. If conditions worsen, it will cost U.S. jobs as Japanese production and assembly here slows or even stops. And by the way, American companies are also the largest foreign direct investor in Japan, so a deepening crisis in Japan also will reduce the earnings of U.S. businesses operating there.

The United States is not the only economy exposed to economic aftershocks from the Japanese earthquake and tsunami. Japan is the largest foreign direct investor in China, having transferred a good part of its manufacturing base there over the last decade. Unlike U.S. companies which have invested in China mainly to serve the Chinese and third-country markets in Asia, Japanese enterprises in China produce mainly for the home, Japanese market. The sharp downturn already beginning to unfold in Japan, then, will cost China jobs and growth, especially in southern China.

In the end, it’s the American economy that is most interconnected with Japan’s, so the United States is most exposed to collateral economic damage from the recent, terrible natural disasters.

The Economic After Shocks of the Disaster in Japan – Part 1

March 21, 2011

Natural disasters can strike anywhere, but the heart-wrenching tragedy unfolding in Japan may be unique for modern times, at least economically. In today’s post, we focus on what makes last week’s earthquake and tsunami so different from other natural disasters and why they have put Japan’s economy at real risk. Later this week, we will lay out the implications for the rest of us, especially the economic aftershocks poised to hit the United States and China.

As a rule, natural disasters in advanced countries, like terrorist attacks, inflict enormous economic costs on the specific places where they occur, but with little if any serious damage to the nation’s economy as a whole. When Katrina crippled New Orleans in August 2005 and exacted $81 billion in property damages on Louisiana and Mississippi, it didn’t puncture investment or growth in the rest of the country. For a natural disaster to upend an economy, the damage has to touch most of the nation and endure for a considerable time. Those conditions normally occur only in small countries, especially small developing nations that depend heavily on foreign investment. What makes the terrible Japanese earthquake and tsunami uniquely destructive to that country’s large, advanced economy is that they could result in disabling a significant part of the nation’s power grid for months and, even worse, spread dangerous radiation across many of the country’s agricultural, industrial and population centers.

To be sure, major natural disasters always have significant local and distributional effects. Katrina depressed parts of the Gulf state economies for several years, and tens of thousands of people fled Louisiana for nearby states, especially Texas. In addition, the temporary closure of the port at New Orleans reduced U.S. exports for several months. But the real losses were confined to the immediate region. And while the terrible human and property costs shook most Americans, their empathy didn’t dampen investment or household spending anywhere else in the country. In fact, two months after Katrina struck, the fourth quarter of 2005 saw the strongest GDP gains of the entire decade.

The same dynamics were evident after the 9/11 attacks, which hit lower Manhattan like an earthquake. There were large, temporary distributional effects. For example, the attacks devastated real estate prices and rents in downtown Manhattan, but they boosted the real estate market for midtown. The attacks certainly shook most Americans psychologically; and when millions of people canceled planned trips for the coming months, it depressed airlines, hotels and other travel services. But the money that people saved by skipping their vacations went instead to buy large screen TVs and SUVs. And the Federal Reserve responded to the attacks by cutting interest rates, boosting interest-sensitive industries from capital equipment to housing. Just like Katrina, then, 9/11 had no adverse effects on the national economy. In fact, investment and consumer spending in the quarter following the attacks, October-November-December of 2001, were stronger than any quarter for two years before and after.

Unlike such localized catastrophes, the recent earthquake and tsunami will likely inflict enormous damages across Japan, and for some time to come. The issue here is not the terrible, immediate losses of life and property in the country’s northern shoreline towns and cities. The damage done to the country’s power grid will extend the economic costs far beyond the communities directly devastated by the disasters, slowing agricultural and industrial activity across up to one-third of the country. And for these losses, there will be no offsetting gains from reconstruction. Even more frightening, the radiation released by the ongoing meltdowns at nuclear power facilities could bring economic activity to a halt in much more of the country.

Other national economic effects are beginning to be felt across Japan’s already fragile economy. Japanese investors are cashing out much of their large holdings of dollar and Euro-denominated financial assets, converting them to yen, and bringing those yen back home. The result has been a large boost for the yen’s value, dealing an additional blow to Japan’s export companies. Those same companies also are beginning to cut back their foreign production, because many of critical parts for Japanese automobiles and electronics are still made in factories closed down by the disaster and electricity problems.

The disaster and its aftermath also are quickly driving up Japan’s budget deficit and national debt, which already were at dangerous levels following a decade of economic stagnation punctuated by the 2008 – 2009 financial meltdown and subsequent deep recession. As Japan’s economic outlook deteriorates, and its domestic savings fall with incomes and earnings, international investors will likely pull back. All of this could raise serious doubts about the viability of Japanese sovereign debt, pushing up interest rates and possibly triggering a run on the yen and a dangerous downward spiral.

As terrible as these dislocations will be for Japan, the world’s third largest economy, they’re not enough to derail the current global expansion. Even so, serious economic aftershocks will be felt soon beyond Japan, especially in the United States and China. Later this week, we will examine the potential damage to the American and Chinese economies from the horrific disaster in Japan.


The U.S. Economic Debate Gets a Failing Grade at the IMF

March 9, 2011

At the private conference this week convened by the International Monetary Fund (IMF), 30 world-class economists talked for two days about “Macro and Growth Policies in the Wake of the Crisis.” Their discussions provided a reality test for the current economic debate in Washington, and the last decade of U.S. policymaking flunked. Economic ideology not only blinded American policymakers to the seeds of a financial crisis that never had to happen; it also has led to wrong-headed responses for both the short-run and the long-term.

While the United States and other advanced countries embraced large-scale stimulus in 2008 and 2009 to avoid a global depression, the panelists pointed out that the world’s advanced economies are now moving in the opposite direction, without regard for the consequences. Across a group of economists who normally argue over every assumption and decimal point, a genuine consensus emerged that the American and European economies remain too fragile today to successfully absorb major deficit cuts.

While congressional Republicans wield a meat axe over the budget, and many Democrats would apply a scalpel, nearly all of the economic notables gathered at the IMF concluded that additional spending and tax breaks would be much more sensible. The 2009 and 2010 stimulus programs came in for plenty of criticisms, especially for their emphasis on tax breaks for households:  The financial meltdown and deep recession left most households with so much debt relative to their incomes that much of the stimulus just went to reducing their debt loads. Household debt today is considerably lower; but it hasn’t fallen as far as most people’s assets, because the value of their principal asset, their homes, has kept on declining month after month. This time, the experts agreed, any stimulus should be better targeted, for example through investment tax breaks and spending on education and infrastructure.

To be sure, there were repeated calls for a long-term “fiscal consolidation” program, which is how economists describe entitlement reforms and other measures that can limit a nation’s public debt to a reasonable share of its GDP. But they weren’t encouraged by what they’re hearing out of Congress, where politicians regularly conflate the need for long-term deficit reduction with a short-term opportunity to roll back the size of government. Nowhere is this confusion more obvious, several noted, than in a misguided focus on cutting current discretionary appropriations. And particular scorn was heaped on calls for cuts in education and infrastructure investments, which economists have long promoted as the best way to support future expansion and provide a lifetime of healthy social returns.

The most stinging critique, however, was reserved for the years of policy and business misjudgments which brought on the financial crisis and ultimately triggered the worst recession in 80 years. Starting with the opening remarks by Dominique Strauss-Kahn, the head of the IMF, a long line of economic luminaries laid out how policymakers here and in Europe misunderstand the very nature of modern financial capitalism. Again, there was rare unanimity for the view that markets today, which work so well in allocating resources, lack the means and the information to recognize bubbles and evaluate the economic risk of complex financial instruments.

Nor do policymakers have the excuse that this challenge represents something new. Hundreds of savings and loans went under in the 1980s, because financial markets couldn’t evaluate risk very well. Moreover, the 1990s saw three bubbles slowly take shape and then explode, first in Japan, then across much of East Asia, and finally in the Nasdaq tech sector. Yet, policymakers at the White House, the Federal Reserve, the Treasury and their counterparts across Europe sat by placidly, just a few years later, as leading financial institutions recklessly accumulated enormous leverage for financial instruments based on an obvious bubble and whose riskiness they couldn’t begin to assess.

Yet, these misjudgments weren’t universal: The financial meltdown was limited to the advanced economies, while much of the developing world learned the painful lessons of the 1997-1998 Asian financial crisis. So, their policymakers imposed new limits on leverage, and their financial institutions passed on investing in the toxic assets that brought down the U.S. and European economies. That’s why, at least for now, the developing economies have become the engine of global growth.

The Great Depression produced a large sheaf of institutional reforms which have helped the world avoid a repeat ever since. Yet, the Nobel Laureates and other experts gathered this week by the IMF also agreed that the United States and Europe have yet to undertake comparable reforms that would make another global financial crisis less likely. If we don’t, they warned, another financial crisis almost certainly will befall America and Europe in the foreseeable future.