NDN Blog

The Cost of Playing Games with the Full Faith and Credit of the United States

I spent last week in Rio attending a meeting of the IMF’s advisory board for the Western Hemisphere — and returned this week to Washington for the latest round of threats and charges over raising the U.S. debt limit. The contrast was, at once, disturbing and farcical. At the IMF meeting, former finance ministers, prime ministers and other ex-economic policy officials tried to unravel the grim implications for all of us if (when) Greece, Portugal or, in the worst case, Spain is forced to default on their sovereign debts. Back in Washington, congressional Republicans laid out their terms for not driving the United States into a voluntary default on its sovereign debt. Perhaps holding onto a child-like faith that bad things don’t happen to the United States, under God, they spelled out terms which everyone knows will never be accepted by President Obama and a Democratic Senate. The irony is that the GOP gambit of holding out a potential debt default if they don’t get their way could, in itself, make long-term control over deficits much harder.

The reason lies in the powerful influence of worldwide investors on our interest rates. Thankfully, global capital markets still have confidence that our two political parties can settle this dispute on reasonable terms, and that in time the United States will regain control over its deficits and debt. We know that confidence is still there, because the interest rates and yields on U.S. Treasury bills, notes and bonds all remain near historic lows. If there were real doubts about our capacity to control long-term deficits, those interest rates would be rising as investors demanded higher returns to offset the risk that we’ll fail. This confidence makes sense, because we succeeded at the same task twice before, in the 1980s and again in the 1990s. It took several years of squabbling and compromise, but President Reagan and a Democratic House agreed to raise taxes, cut defense and reduce Medicare and Medicaid spending in the 1980s — and the same pattern played out again a decade later with President Clinton and, first, a Democratic House and then a GOP one. That combination of revenues, defense and health care was, and remains today, inevitable, since those are the only pieces of fiscal policy big enough for cuts and reforms that can make a significant difference for deficits.

But neither Reagan nor Clinton faced opponents prepared to hold the full faith and credit of the United States hostage to their own partisan approach to the deficit. To make this gambit appear respectable, House Majority Leader Cantor even claimed last week that major players on Wall Street had assured him that a U.S. default would be a matter of economic indifference. The only explanation is that Mr. Cantor, without realizing it, was talking to short-sellers getting ready to bet billions that U.S. stocks and bonds might crash — as they will if we actually do default.

Happily, worldwide investors are probably correct that the likelihood of a U.S. debt default is still very, very small. If it ever came close to that, the real players on Wall Street would face down the U.S. Congress. But cutting it close may turn out to be very expensive, too.

Let’s perform a small thought experiment. A Tea-Party infused GOP takes us to the edge of default and then pulls back. A really close call, however, would almost certainly make worldwide investors nervous. They would begin to question whether our politics truly are up to the task of dealing with our deficits, so they add a small risk premium to our interest rates. Let’s say — and this would be optimistic in this scenario — that short-term rates on Treasury bills go up one-half of a percentage-point; medium-term rates on Treasury notes rise three-quarters of a percentage-point, and long-term rates on U.S. bonds increase by 1.25 percentage-points.

Now, let’s be optimistic again and assume that Congress and the President eventually agree to cut the 2012 deficit by 10 percent — $108 billion off of the current projection of $1.081 trillion. That will leave a 2012 deficit of $973 billion to be financed. The small increases to interest rates would add about $7 billion just to the first-year interest costs of the 2012 deficit. And that’s just the beginning: All publicly-held Treasury bills also have to be refinanced in 2012 — nearly $2 trillion worth at last count. The tiny 0.50 percentage-point increase in those rates would add another $10 billion to next year’s interest costs. That comes to $17 billion in extra interest costs in just the first year, and just on publically-held debt. Those premiums would become embedded in those interest rates, adding much more to our interest costs, year after year, as additional deficits have to be financed and some $7 trillion in publicly-held Treasury notes and bonds come due for refinancing. A single refinancing of that current stock of publicly-held Treasury notes and bonds, with the new risk premiums, would add more than $50 billion, per-year, to interest costs. And the actual risk premiums demanded by global investors could be significantly higher than we assume here, and so that much more expensive.

These incremental increases in interest rates also wouldn’t be confined to U.S. Treasury rates; they would be transmitted immediately to other interest rates, from mortgages to credit cards. That means the expansion would further slow, American incomes and the government’s revenues would grow less, and, lo and behold, the deficits would be even bigger.

That’s the math. Even if congressional Republicans don’t mean it, the political games they’re playing today with a U.S. debt default, purportedly in the name of fiscal responsibility, could make U.S. deficits and debt even more unmanageable, and U.S. prosperity more problematic.

Running on Empty: The Economics and Politics of Gasoline Prices

Mother Nature is intervening again in U.S. energy markets.  Just as falling oil prices are puncturing upward pressures on gasoline prices, prospects of serious flooding in areas of the Gulf states where refineries are concentrated has sent gas future prices soaring again.  With the economy sputtering a bit again, it’s not welcome news for the President, or for the rest of us.  But it shines a light on what actually drives the gasoline market in the United States and, by the way, refutes the energy policies of the President’s critics. And the reason it matters so much politically lies not so much in the actual price of gas, which Washington can do little to affect, as in the economy’s underlying problems with jobs and incomes.  

While speculators place bets that Mississippi Valley flooding will interrupt gasoline supplies, those supplies have played no role at all in rising gas prices over the last several months. Partisans can cry, “drill, baby, drill” all they want, but Energy Department data show that the United States has been a net exporter of gasoline since the beginning of 2010.  In short, America produces more gasoline than it consumes. From January of last year through this past February – the most current data on energy trade -- the United States exported an average of 5.5 million more barrels per-month than it imported.  And from last November through February, as prices at the pump marched up from $2.86 per-gallon to $3.20, the net trade surplus in gasoline jumped to an average of 9.8 million barrels per-month.

U.S. demand for the oil that goes into making gasoline also can’t explain rising gas prices, since our oil consumption is still about 2 million barrels per-day below the levels in late-2007, just before the onset of the 2008-2009 recession.  Yet, gasoline prices in April averaged $3.42 per-gallon, 22 percent above the 2007 average of $2.80 per-gallon.

The answer to this painful riddle does not lie in supply and demand.  Rather, most of the explanation lies in the Saudi Arabian’s government’s dogged determination to keep worldwide oil prices high even as worldwide demand eases, as it has with the recent stumbles in the American, European and Japanese economies.  And the rest of the answer can be traced to the increasing ability of large financial institutions to wield enormous leverage in order to dominate futures markets in oil and gas.  

The consequent high prices are understandably frustrating to Americans who have taken steps to reduce their energy demand, assuming like all good free marketeers that lower demand will translate into lower prices.  The share of U.S. vehicle sales going to light cars is up to nearly 60 percent, and hybrids’ share has doubled in the last five years (to about 6 percent).  But for most drivers, the recent increases in gasoline prices swamp any gains in miles-per-gallon. The administration’s critics whine all of this could have been avoided, if the Administration approved more permits for offshore drilling in deep water.  But permits for shallow-water drilling are up; and in any case, the Energy Information Agency says that opening up the outer continental shelf would probably reduce gas prices by no more than 3-cents per-gallon twenty years from now. 

In the long-run, technology will have a much larger impact on future oil and gasoline prices than today’s squabbles over drilling rights or tax breaks for U.S. energy companies – that is, so long as prices remain near their current levels.  For example, the United States has enormous natural reserves in oil shale and tar sands.  If oil prices stay near where they are today, oil from shale and sands will compete quite nicely with Saudi crude – and leave little room for the rulers in Riyadh to push up prices much further.  And with another five to ten years of development, the Administration’s favored clean-energy alternatives also will likely become competitive, again if current oil prices stick.

None of this can affect the current U.S. politics of high oil and gas prices.  But what matters most politically about those prices is actually not their level at all, but how much those prices crimp spending by Americans on everything else.  In short, the politics of oil and gasoline prices depends in the end on whether people’s incomes are going up or down.  The 1990s saw a happy convergence of rising incomes and falling energy prices, underwriting a boom in both consumption and business investments to meet the increased demand.  But the Saudi dictatorship swore that they would never let that happen again, which is why we now have to live with high energy prices in the face of weakening demand.

In an industry that doesn’t much follow the laws of supply and demand, a genuine fix for gasoline prices is simply beyond the power of the President and Congress.  The only course left is the harder work of getting incomes moving up again.  And that will require, just to begin, some serious steps to stabilize housing prices, jumpstart business and job creation, and provide opportunities for adult Americans to upgrade their skills with information technologies.

Cutting Long-Term Deficits Alone Won’t Fix the Economy

Washington is mesmerized these days with the two parties’ various stratagems to turn the deficit debate to their own advantage.   But all this political maneuvering may carry a big cost for Americans, as it sidelines any serious action on our larger, more immediate economic problems.   The U.S. expansion is in some danger today, but not from the deficit projections for 2015 and 2020.   The economy continues to grapple with structural problems that have led to a decade now of weak job creation and stagnating incomes.  Beyond that, we also face strong economic undercurrents coming from rising energy prices, the prospect of another financial shock from Europe’s growing sovereign debt difficulties, and the gathering economic aftershocks from Japan’s terrible disasters.  And while the two parties in Congress scheme and struggle over deficit plans, the party (and person) most likely to win next year will be the one that uses the debate over spending and taxes to credibly address jobs and incomes.  

A deficit debate designed to do that would look and sound very different from today’s charges and countercharges.   For example, it would certainly include steps of some kind to stem home foreclosures and stabilize housing prices, because those are key factors for rebooting consumer spending and business investment.  With the bottom 80 percent of Americans owning just 7 percent of the country’s financial assets, home equity has long been the only significant asset held by the most Americans – and the sharp decline in the value of most people’s home equity has left average Americans poorer on top of their long-stagnating incomes.  Until home values turn up again, most people will continue to hold back on family spending, which in turn will continue to dampen business investment.  And without strong business investments in technologies and other capital, most workers’ incomes can’t rise. 

The deficit debate already includes a ready but very wrongheaded response to housing, namely cutting back on the mortgage interest deduction.   Yes, it would raise some revenues; but it also would further depress housing values.  Instead, we should figure out the best way to help people keep their homes out of foreclosure – for example, a temporary, two-year program of bridge loans to people facing foreclosures.   And if we do it right, it could even help us out with the long-term deficit:  For example, Washington could make itself the priority lender for repayment if a homeowner loses the house anyway or, if a later sale produces capital gains, taxpayers could claim a small share of those gains.

The President’s deficit plan does include gestures towards the country’s larger economic challenges, in his insistence on modest funding increases for education, infrastructure, and research and development.  But those increases aren’t enough to move the needle on jobs and incomes, and so they’re also not enough to inspire broad support for smart public investment.  To have a shot at doing both, these initiatives have to touch most Americans.  For example, for less than a few hundred million dollars – almost chump changes these days – Congress could provide grants to community colleges to open their computer labs on the weekends to any adult who wants free training in computer and Internet skills.   We also could ensure that this investment would more than pay for itself.  For example, those who use the service could be required to return the favor to taxpayers, by paying an extra one or two percent income tax on increases in their incomes in the following two or three years.

The economy’s crying need to upgrade its infrastructure – from roads and highways, to city-wide wifi and a smart energy grid – also could be used to jumpstart job creation, and not just with temporary jobs at large construction companies.  Since new and young businesses are the strongest engines of job growth, we could set aside 20 percent of the funding for these projects for newly-formed businesses that would then provide hundreds of goods and services for the projects.  This kind of provision could stimulate the formation of thousands of new businesses, and the taxes on their profits and on the incomes of their new workers would go to the deficit. 

We also could stimulate job creation more directly while raising revenues at the same time.  Multinationals today keep overseas some $1 trillion in profits from their foreign operations, in order to avoid high U.S. corporate taxes.  We could let them bring back those funds at a lower tax rate, if they expand their U.S. workforces.  For example, any multinational that increases its U.S. workforce by 5 percent could bring back 50 percent of their foreign earnings at the preferential rate – or bring back 60 percent of those earnings in exchange for a 6 percent increase in their U.S. employees.  And, yes, it should ease the deficit since otherwise, most of those earnings will remain abroad indefinitely, and so untaxed here.  And on top of that, the new jobs generate income that also will produce additional revenues.  

Whether or not you like these particular approaches, they provide a glimpse into how far off-target the current deficit debate has veered.  The only economic justification for reducing any deficit is that doing so will in some way produce better times; and in this time, that especially means more jobs and higher incomes.  Unhappily, any current debate about how to produce those better times has been hijacked by Paul Ryan’s radical plan to cut every program that Republicans have ever disliked, and by the tempting target it offers Democrats.  

Yes, huge, long-term deficits do matter economically.  If history is any guide – as it usually is in economics – we have two to three years to enact a credible glide path to more sustainable levels of federal borrowing for the following decade.  That’s what Washington did in the 1980s and again in the 1990s, and it helped create tens of millions of jobs and, especially in the 1990s, healthy income gains.  The task is harder today, because the economy in this period doesn’t deliver jobs and rising incomes the way it used to.  That calls for two steps.  First, protect existing jobs and incomes while the economy remains fragile and vulnerable to the outside shocks, by foregoing more cuts in this year’s deficit.  And second, use the deficit debate to advance initiatives that address what Americans truly and properly care about, namely their jobs and incomes. 

President Obama Wins the First Round with Paul Ryan

Yesterday’s presidential address on fiscal policy was a very striking scene.  The venue was a small auditorium at George Washington University.  Invitations went out just two days earlier; and with so little notice, GWU students made up more than half of the audience.  Another row was filled up by former Democratic economic policy officials – myself and perhaps 10 others – directors of Democratic-allied policy shops (led by our Simon Rosenberg), and a smattering of CEOs and senior Senate staffers.  Just before the President took the stage, his economic team filed in – Bill Daley, Tim Geithner, Gene Sperling, Jack Lew -- along with Vice President Biden and his new chief-of-staff, fresh from directing the Simpson-Bowles Deficit Commission.  Alan Simpson and Erskine Bowles were there too, along with other Commission members – and here’s what added drama to the scene – including Representative Paul Ryan, this year’s Republican guru on the budget sitting uncomfortably in the first row.  The moment the President finished – without exaggeration – Ryan bolted for the exit.  Perhaps he suspected, like the rest of us, that the President’s plan is smarter, fairer, more balanced and more credible than his own. 

Both blueprints would reduce deficits by $4 trillion over the next 10 (Ryan) or 12 (Obama) years, but the real difference lies in revenues.  The Congressman would give away another $1 trillion in new tax cuts to high-income Americans and business, while the President would collect an additional $1 trillion in revenues.  The consequent $2 trillion difference explains how the President, unlike Ryan, can stabilize federal debt as a share of GDP while preserving the basic guarantees of Medicare and Medicaid.  And there was one telling moment during the speech which demonstrated how new revenues change the choices that Americans now face with the debt: The President was interrupted by applause only once, when he said, “They [Republicans under Ryan’s plan] want to give people like me a $200,000 tax cut that's paid for by asking 33 seniors each to pay $6,000 more in health costs. That's not right. And it's not going to happen as long as I'm President.”  

Obama’s plan, then, recasts the issue from the GOP choice between spiraling debt and drastic cuts in Medicare, Medicaid and all domestic spending, to a new choice between higher taxes on the top one or two percent of Americans and preserving health care coverage for elderly and low-income people while also controlling the debt.  That choice can be cast even more starkly: Control the debt by forcing seniors to pick up two-thirds of their own health care costs by 2030 (CBO’s estimate of the impact of Ryan’s plan) or deny wealthy Americans their most recent and future tax cuts.  If you believe the polls, Americans today overwhelming favor President Obama’s priorities over Representative Ryan’s. 

With his additional revenues, the President still has to find $3 trillion in spending reductions.  One big chunk of cash would come from broadening and strengthening the cost-control measures in his signature health care reforms, including reimbursing hospitals and doctors based on results rather than volume and authorizing a new federal board to mandate rather than merely recommend the use of proven, cost-saving approaches to treating Medicare patients. He also calls for a new version of an old budget mechanism from the late-1980s, which would trigger automatic, across-the-board cuts in domestic spending whenever the deficit exceeds a certain level.  In the end, OMB number crunchers believe that these and other measures would shave $2 trillion from spending over 12 years, and the lower deficits would save another $1 trillion in interest payments on the debt.  

President Obama’s approach also allows him to preserve the substantial new public investments in education, infrastructure, clean energy and basic R&D which he called for in his latest budget.  By putting together a plan to control deficits while increasing public investments – the “cut-and-invest” approach championed by Bill Clinton in the 1990s – he assumes an optimistic, can-do attitude that recalls Ronald Reagan.  And the implicit contrast with the Republican “the sky is falling” recipe of large sacrifices may serve his reelection nearly as well as it did Reagan’s.  

These choices will not be resolved anytime soon.  GOP leaders immediately rejected the President’s blueprint.  Yet, they and their Democratic counterparts know full well that any resolution will require real compromises that include both additional revenues and some paring of entitlements.  Based on the deficit struggles of the 1980s and 1990s, they also know that it will likely take several years for both sides to find and comfortably claim some common ground.   Even so, the President’s speech will have more immediate consequences, because it may well make the GOP’s position on the debt limit politically untenable.  They no longer can argue credibly that they have to hold the full faith and credit of the United States hostage in order to force the President to get serious about the debt.  The country now has a choice, and the Republicans can no longer say, our way or no way, when it would risk pushing up U.S. interest rates and possibly shaking the global economy.  The current impasse over the debt limit will be resolved with some face-saving commitment by both sides to begin negotiating in good faith. 

Why Big Banks Want Americans to Pay More for Everything

Once again, the nation’s big banks are working hard to have their own way with some of the most consequential issues before Congress. Tucked into the small print of Paul Ryan’s budget plan for 2012 and beyond are provisions to roll back the key regulatory steps taken to make another financial meltdown less likely, especially higher capital requirements tied to the riskiness of a bank’s investments. That’s not their only fight these days: They also are trying to roll back a critical debit-card reform enacted last year and just now about to go into effect. If they succeed — and the Washington airwaves are saturated with ominous ads calling for the rollback — it could cost many Americans nearly as much as what they have at stake in the ongoing squabbling over the 2011 budget.

The bipartisan debt and credit card reforms passed last year put the first real limits on how much the card networks and the large banks that issue nearly all cards can charge merchants when a consumer pays with a debit card. These charges are called “swipe fees,” and while they apply to all credit card as well as debit card transactions, the 2010 swipe-fee reforms apply only to debit card transactions. But if they save consumers as much as economists estimate, these reforms could well be extended to all credit card transactions too. And that could save the average American household some $230 per-year.

This is worth dwelling on, because it involves an ostensibly free market which, behind the curtain, a few huge companies actually manage to a significant degree — and now, behind the scenes, they’re also trying to manage the legislative process.

The facts, in a nutshell, are as follows. Merchants pay the three credit and debit card networks that account for some 80 percent of all charges a fee for every transaction using one of their cards that ranges from 1.5 percent to about 3.2 percent of the value of the transaction. A fee at some level makes perfect sense, since people buy more when they can charge or debit it, which benefits the merchants. But there’s no real economic basis for the actual levels of the fees. Less than 20 percent of the fees go to cover the actual costs of transaction for the banks and the credit card networks. Most of the rest goes to the four big banks that account for nearly 70 percent of all card transactions, with some going into higher profits and some for the advertising and rewards programs used to attract more customers.

We studied these fees last year. We found that in 2008, merchants paid swipe fees totaling some $48 billion. Those costs were tacked on to the price of everything they sold – clothing, computers, gasoline, restaurant meals, airline tickets, medications and so on. Moreover, the credit card networks forbid merchants from charging anyone using their cards a higher price to cover the fee, than those who pay cash. So, everyone pays for the swipe fees in higher prices every time they buy anything, whether or not they even use a credit or debit card.

We found that 56 percent of the swipe fees paid by merchants get passed along in higher prices, which in 2008 came to about $26 billion or $230 per-household. This year, it will be more, because we’re all charging more. And if the swipe fees were limited to the actual costs of processing debit and credit card transactions, plus normal profits, the lower prices for everything would expand real demand enough to create nearly 250,000 more American jobs.

In truth, the credit and debit card system operates more like a cartel than a genuine market. The fees are set by three companies that together account for 95 percent of consumer charges and two-thirds of business charges — Visa, MasterCard and American Express. Their actual customers are the banks that issue the cards, because the more cards are issued, the more swipe fees are generated. Moreover, four banks account for 70 percent of all cards and charges: JP Morgan Chase, Bank of America, Citigroup, and American Express (all of which, by the way, also collected taxpayer bailouts).

Since each of the networks and each of the banks account for a good slice of any merchant’s business, merchants have little option but to deal with them — again, much like a cartel. So, merchants can’t put normal market pressures on the networks and the banks to lower the fees by exiting the system. And since the networks forbid merchants from charging different prices based on whether a customer uses a card or cash, consumers have no incentive to pressure the networks and banks to lower their fees by using cash instead.

This not only produces higher prices, but higher prices that are applied in particularly unfair ways. More than half of all lower and moderate-income Americans don’t carry credit or debit cards at all. Yet they pay the higher prices along with everyone else. And most middle-class Americans with credit or debit cards pay higher prices to finance rewards programs largely restricted to more affluent card users.

So, last year, Congress gave the Federal Reserve authority to set rules for the swipe fees on debit card transactions. When Australia did much the same to cover both credit and debit cards, swipe fees there fell to 0.50 percent — and the system continued to work fine. The new rules are nearly ready to be issued here, and that’s what the banks and credit card networks are working so hard to stop. It will be another political test of whether big finance really can get anything it wants from Washington, regardless of the cost to everybody else.

Forget about Spending and Get Serious about the Economy

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

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

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

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 conflatethe 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.

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

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, each of which 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.  

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