NDN Blog

A Lesson in Economics for the National Deficit Commission

The French statesman Georges Clemenceau famously called war "too serious a matter to entrust to military men;" and in the same spirit, national budgets in a democracy are too important to leave to economists.  But no sensible government would wage war without listening to general and admirals, and the National Commission on Fiscal Responsibility and Reform - aka the National Deficit Commission -- would be equally well served to consider basic economics more carefully.  This week's leaks from the Commission include reports that its members are leaning towards cutting back the deductions for mortgage interest and employer health insurance payments.  This approach could certainly raise a lot of money in the short-run.  But for an economy suffering as ours is from weak demand, a fragile housing market, and a decade of slow hiring and income gains, these proposals are economically illiterate.

Listen up, members of the National Deficit Commission.  This is the wrong time - maybe the worst time - to target the mortgage deduction.  Falling housing values have been the single largest force holding down consumer demand, and with it investment and growth, because their decline leaves the 70 percent of Americans who own their homes poorer.  That has created a classical, negative wealth effect which dampens spending.  And on top of that, these falling housing values sharply raise the ratio of most people's debts to their assets, moving most people to reduce their debt.  And that has meant fewer large purchases and less credit-card buying.

Cutting the mortgage interest deduction would only intensify these dynamics, because the value of that deduction is incorporated or "capitalized" in housing prices.  When prospective home buyers try to figure out whether they can afford the monthly payments on a particular house, they naturally factor in the value of the deduction.  Buyers are willing to pay more than they would without the deduction - and sellers demand more than they could without it.  Reduce the deduction, and buyers will be able to afford less, sellers will have to accept less, and housing values will fall further.

There are reasonable arguments for paring back this deduction, since it channels so much investment into housing.  Of course, that's its explicit intention, so home ownership can be part of the American dream.  And yes, a smaller deduction would raise considerable revenues.  But doing it would inescapably further drive down housing values, and doing it now could lock in years more of slow economic growth.

This is an equally ill-timed moment to cut back the deduction for employer-provided healthcare insurance.  Once again, there are reasonable arguments for rethinking this deduction, but shrinking the deficit under current conditions isn't one of them.  Limit this deduction for employers, and hiring costs will go up at a time when job creation is already historically weak.  Worse, the change would raise the cost of retaining people working today, creating new pressures for more layoffs.  The Commission may be talking about taxing workers, not businesses, on some share of the value of their employer-provided health insurance.  That seems no more sensible economically at this time, since it would reduce most people's after-tax incomes at a time when their consumer spending is historically weak. 

The truth is, this is not the time for any short-term deficit reduction.  We tried fiscal tightening in 1937, at the early signs of recovery from the Great Depression, and it bought us four more years of slow or negative growth.  Japan tried it too in the mid-1990s, during the early stages of their recovery from a financial meltdown, and it set off another half-decade of economic stagnation.  Now Britain's new conservative-coalition government is trying budget austerity, and the results almost certainly will be similar. 

Yet, it also would be foolish for the Commission to squander this rare public support for deficit reduction, so long as its members focus on the long-term and consider the economic fallout from their various brainstorms.  The place to begin is with the two forces driving the long-term deficits - prospective, fast-rising entitlement spending, and taxes that raise sufficient revenues only when the economy booms.  On the spending side, Social Security could be the relatively easy part, because its budget gap remains comparatively small for many years - if Americans are prepared to accept smaller benefits down the line.  Experts figure, for example, that we could close one-third of that gap by using the CPI for the elderly, rather than the higher overall CPI, to calculate future cost-of-living adjustments.  And much of the rest of the problem would fade away if we tied the annual increase in people's initial benefit to a combination of wage gains and inflation, rather than just wage gains.   

The harder part involves Medicare and Medicaid costs.  As with Social Security, the main difficulty lies not in figuring out how one could slow annual cost increases in health care, but rather in marshalling majority support for such measures.  In fact, the President's health care reform already included a catalogue of approaches to slow the growth of medical costs, albeit on a limited scale or in weak form.  The Commission could urge Congress to scale up and strengthen those measures.  If those reforms work, they not only would generate large budget savings down the line.  The same approaches also would support jobs and incomes, since fast-rising health care costs have significantly slowed job creation and wage progress.

The Commission purportedly has agreed to use additional revenues to close one-third of the long-term deficit.  Assuming that additional taxes would go into effect only once the economy fully recovers, higher taxes for wealthy Americans would raise revenues without severely damaging demand, since they don't spend nearly all that they earn.  The same idea could even be applied to industries which, by economy-wide standards, earn abnormally high profits.  By this measure, the leading candidate is finance.  A small tax on financial transactions, for example, would raise substantial revenues for the deficit with little adverse effect on the overall economy if other advanced countries follow suit - and Germany, France and the United Kingdom all have indicated interest.

And if the Commission wants to tackle broader tax reform, the top candidate should be a carbon-based fee on energy.  A tax on greenhouse gas emissions not only would restore U.S. leadership on climate change.  It also could turbo-charge the development and deployment of green fuels and technologies, a potential source of exports, and reduce our dependence on foreign oil and the consequent distortions in our foreign policy.  And if Congress set a carbon tax high enough to sharply reduce CO2 emissions, good a share of the revenues could go to reduce payroll taxes, spurring job creation and income gains. 

These approaches may not satisfy the balance-the-budget-at-all-costs crowd.  But sound deficit reduction requires a larger economic frame.  At a time of serious economic stress and frustration, the National Deficit Commission should embrace real economic thinking.

Are We Better Off Now than We Were Two Years Ago?


To borrow a construction from the Sherlock Holmes mysteries, there’s a dog that hasn’t barked in this election.  In a campaign dominated by the economy, Republicans have never invoked some version of Ronald Reagan’s devastating query from 1980, “Are you better now than you were four years ago?”  It turns out, there’s good reason for their reticence:  By every basic economic measure – GDP growth, corporate profits, business investment, the stock market, incomes, wages, and jobs – Americans actually are quite a bit better off now.  That’s the inescapable conclusion after comparing the economy’s performance over the first six-to-seven quarters of Barack Obama’s presidency with its performance during the last six-to-seven quarters under George W. Bush.  

Let’s start with overall growth.  The Bureau of Economic Analysis (BEA) tells us that from January 2009 through June 2010, the first six quarters of the Obama presidency, the country’s real GDP grew by more than 2.8 percent.  That may not be strong growth by the standards of the Clinton or Reagan eras.   But it leaves Americans considerably better off compared to the last six quarters of George W. Bush’s term, when the economy’s output shrank by 2.1 percent. 

Business leaders complain a lot that President Obama unfairly bashes them.  Yet, the data suggest that they should thank him, because American business is clearly a lot better off under Obama.  The BEA reports that corporate profits grew 62 percent in the first six quarters of his term, rising from an annual rate of $995 billion in the first quarter of 2009 to $1,425 billion in the second quarter of 2010.  That’s a complete turnaround from the last six quarters of Bush’s term, when the annual rate of corporate profits fell 34 percent, from $1,501 billion to $995 billion.  It’s the same story for gross domestic investment by American businesses, which fell at an annual rate of 14.2 percent over the last six quarters of the Bush presidency, but has turned around under Obama to increase by 17.5 percent over his first six quarters. 

Given this record, it’s no wonder that American investors also are much better off today.   Standard & Poors reports that over the first 21 months of the Obama presidency, their benchmark index, the S&P 500, rose more than 46 percent, from 805.22 to 1,176.19.  The healthy gains under Obama have wiped out the miserable record of the last 21 months of the Bush presidency, when the S&P 500 sank 43 percent, from 1,495.4 to 850.1.

Political scientists say that the most powerful economic measure, for affecting elections, is what happens to people’s incomes.  The BEA has issued six quarters of personal income data since Obama took office.  Again, the contrast is clear.  From January 2009 through June 2010, the real per capita income of Americans rose 0.7 percent, from $32,780 to $33,009.  That’s not much, but it’s nearly twice the gains seen over the last six quarters of the Bush presidency, when real per capita income rose 0.4 percent, from $32,681 to $32,810. The hourly wage data from the Bureau of Labor Statistics (BLS) tell the same story.   Adjusted to 2010 dollars, hourly wages over the first 19 months under Obama increased 1.0 percent, from $22.45 to $22.67.  Again, that’s not great progress, but it’s considerably stronger than the wage gains over the last 19 months of the Bush presidency, when the real hourly wage grew 0.7 percent, from $22.18 to $22.33.

Finally, we come to jobs. A few months ago, I calculated that 92 percent of all private-sector job losses in this period occurred under Bush or during the first six month of Obama’s term, before his policies took effect.   Even if we don’t draw that fine distinction and compare the jobs record of the President’s first 19 months in office with the last 19 months under his predecessor, Americans again are clearly better off under Obama. BLS reports that total non-farm employment in September of this year was 130.2 million or 2.0 percent lower than the level in January 2009.  That’s a marked improvement from the much sharper job losses over the last 19 months under George W. Bush, when total non-farm employment shrank 3.5 percent from 137.7 million to 132.8 million jobs.

There is no doubt that Americans are disappointed and angry that the jobs and incomes picture hasn’t improved more.  But elections involve choices.  How the early-term Obama economy stacks up against the late-term Bush economy may help explain why, as my NDN colleague Simon Rosenberg has acutely argued, we may not be headed for a GOP wave this November.  At least, it’s now obvious why Republicans aren’t asking Americans if they’re better off now than they used to be.  The mystery is why more Democrats aren’t using Ronald Reagan’s famous question to frame their own campaigns.


The Disquieting View from the IMF Meetings, and the Need for U.S. Leadership

The International Monetary Fund held its annual Washington meeting last weekend, so I spent a balmy Sunday discussing the potential pitfalls for the U.S. and world economies.  I attended as one of two American representatives on the IMF’s advisory board for the Western Hemisphere; and in that group and beyond, almost no one could see a clear path to worldwide prosperity.  Yet, few delegates seemed open to their own countries accepting any costs to enhance the prospects of global growth or even to protect the world from another meltdown.  

The weekend’s favorite topic was the slow growth unfolding in the United States, Europe and Japan – too slow, that is, for the large developing countries that depend on us to buy their exports and so support their employment.  The upshot is new concerns about a “currency war” breaking out in the developing world, and perhaps beyond.  Already, many countries are intervening to keep their currencies relatively cheap and so make their exports more price-competitive than their neighbors.  Of course, the only certain way for a country to keep its exports competitive is to produce better goods and services than its rivals.  But that can involve reforms in investment, education and business-formation policies, all much harder to pull off politically than temporarily managing an exchange rate.  The catch is that when everyone tries to keep their currencies cheap at the same time, no one ends up better off – and the next step is protectionism.  If that sounds far-fetched, consider that one of the first orders of business in the new Congress will be legislation to punish Beijing for its cheap currency by slapping new tariffs on Chinese imports. 

Forgotten in all these machinations is the supporting role that artificially cheap currencies played in the financial crisis.  The strong dollar, compared to almost everyone else’s currencies, made Americans outsized consumers of everyone else’s exports – in 2007, U.S. imports totaled $2.2 trillion, or more than the entire GDP of all but five countries.  But most of the dollars we spent on imports came back here, since the United States is the only place where dollars are the legal currency to buy stocks or companies.  Those dollars helped swell the liquidity that financed the reckless leveraging by mortgage lenders and Wall Street, which all came crashing down in 2008.  And when economists today say we have to redress “global imbalances” to avoid another crisis, they’re talking about the same dynamics.  Yet, today’s competitive currency devaluations put us right back on the same path.

 The weekend’s next favorite topic was the current political fashion for tight budgets, especially in the advanced countries.  Since those are the same countries with slow growth, the talk turned to technical moves by the Federal Reserve and perhaps other major central banks – so-called “quantitative easing” -- to expand credit even as interest rates already are near zero. This cheap new credit, of course, could someday be the kindling for the next bubble.  

Moreover, it was hard to find anyone at the meetings who believes that the financial reforms taken thus far, here and around the world, are enough to avoid another meltdown.  The good news is that the Financial Stability Board – that’s a rule-setting body for the major central banks – is set to issue another set of requirements for big finance, which will go well beyond what anyone else has done so far.

Of course, it’s unlikely that the world’s big banks will accept significant restrictions from the FSB, following their success in watering down new limits everywhere else.  And even if they did, those rules won’t help contain the current flash point in the global capital system, the sovereign debt problems of Greece, Spain, Portugal and Ireland.  A default by Spain, for example, would leave major French and German banks insolvent.  They also would be unable to meet their obligations to U.S. and British banks, setting the stage for another financial meltdown.   Now, even if Greece goes down, as most financial experts privately expect, Spain and the rest may still avoid the worst.  But if the worst does happen, the EU-IMF contingency bailout program might well not stem the tide.  At least, that’s the current judgment of global investors, who have bid down the prices for Greek, Spanish, Portuguese and Irish bonds to levels near those before the EU and IMF announced their program months ago. 

Behind all of these problems, the core issue remains the persistent slow demand and growth across much of Europe, Japan and the United States.  The unavoidable fact is that the financial crisis has left countless tens of millions of households in the advanced countries poorer, and therefore reluctant to spend like they used to.  The only recourse is to help people rebuild their incomes and wealth through direct measures to stabilize housing prices (the source of most people’s wealth) and to induce employers to hire more people.   As usual, the world’s dominant economy and its President will have to take the lead.  And that, I suspect, was the main topic of discussion this past weekend at the White House, just a few blocks down the street from the IMF meetings.

The New Fight Over Access to Higher Education

As President Obama focuses this week on education, criticism has escalated regarding the levels of government assistance for the fastest-growing segment of American higher education, the private for-profit colleges, universities and institutes. From 1995 to 2008, the student bodies of private for-profit institutions increased from 240,000 to 1.8 million, a jump of 750 percent. With my Sonecon colleague, Dr. Nam Pham, I just completed an extensive study of how much support government provides to the three major types of institutions – private for-profit, public, and private not-for-profit – and the results for students. Drawing on the database of the National Center for Education Statistics, we found that most of the current criticisms of private-for-profit higher education are misplaced. They actually receive much less taxpayer support, per-student; they provide greater access to higher education for students from low-income and minority backgrounds, and they often produce better results than traditional schools.  

For idea-based economies like our own or those in Western Europe and Japan, building a workforce comprised of people with advanced skills and education has become a critical factor in global competition. And for individual workers, access to higher education is their most important ticket to long-term prosperity. Americans with bachelor degrees, for example, currently earn 83 percent more than high school graduates. Such stark differences have spurred the recent, rapid increases in the numbers of young Americans pursuing higher education. Over the last two decades, the number of students attending post-secondary institutions soared from 14.3 million to 19.6 million; and the even more rapid expansion of private for-profit colleges and universities accommodated nearly 30 percent of that increase.  

This turbo-charged expansion of private for-profit higher education isn’t serendipitous. The share of post-secondary students attending private for-profits rose from less than 2 percent to nearly 10 percent, because these institutions established certain powerful advantages. To begin, they can finance their expansion through capital markets, a more secure channel than appealing to governments and alumni as public and private not-for-profit institutions have to do.  Furthermore, new rules from the Department of Education in 1994 required strict accreditation of institutions accepting students with federal loans and grants, and many private for-profits responded by upgrading their facilities, faculties and course offerings. As young upstarts, many private for-profit institutions also are more eager and willing to adopt new, cost-effective technologies, especially online learning to scale up their enterprises. Perhaps most important, private for-profit institutions moved to meet the burgeoning economically-driven demand for higher education by emphasizing career-track programs to prepare students for jobs in particular fields, rather than a more traditional liberal arts education.

Private for-profit colleges and universities especially attract those who historically have had the least access to more traditional institutions, enrolling disproportionate numbers of students from low-income and minority families. Looking across all four-year institutions, we find that lower-income students make up nearly two-thirds of those attending private for-profit colleges and universities, compared to just over one-third of those at public and private not-for-profit institutions. Minorities also comprise more than half of the student bodies at private for-profits, compared to one-third at private not-for-profit and public institutions. This focus on those with traditionally little access to higher education appears to be quite successful: The graduation rates for four-year institutions with predominantly lower-income students are 55 percent for private not-for-profits, compared to 39 percent for private not-for-profits and 31 percent for such public institutions. Similarly, across four-year institutions with predominantly minority student bodies, graduation rates are 47 percent at the private for-profits, compared to 40 percent at their private not-for-profit counterparts and 33 percent for public institutions.

The current political fight, however, is not over results, but access to government support, with many critics charging that the private for-profits absorb disproportionate taxpayer assistance. It’s no coincidence that that these criticisms escalated recently, while tight government budgets squeeze many public institutions and a weak economy puts new pressure on the endowments and gift-giving for private not-for-profits. Once again, the data from the National Center for Education Statistics refute the critics. All three types of institutions get both direct support through government appropriations, grants and contracts, as well as indirect support through government student loans and grants. But across all four year institutions, private for-profits and their students receive an average of $2,394, per-student, in all forms of government support, compared to $7,065 per-student for the private not-for-profits and $15,540 per-student for public institutions. The same pattern holds across two-year institutions, though with smaller gaps. 

The biggest differences involve direct support through government appropriations, grants and contracts. Focusing again on four-year colleges and universities, private for-profits actually pay more in taxes than they receive in such direct support. By contrast, four-year private not-for-profit colleges and universities receive an average of $4,765 per-student in direct support, and public institutions collect $13,240 per-student.    

Government is more even-handed in its indirect support through student loans and grants.  Students attending four-year private for-profits receive an average of $2,416 in loans and grants from all levels of government, compared to $2,300 per-student for those attending four-year public or private not-for-profit institutions. Students at private for-profits, on average, do receive larger federal grants and loans than other students – and significantly smaller loans and grants from state and local governments. These differences reflect the historic mission of federal student loan and grant programs to help low-income students, who predominate at many private for-profits. It’s also true that students from private for-profits are more likely to default on these loans. That’s also not unexpected, since students from low-income families have fewer family resources to help pay them off, especially at first.

No one would blame traditional private and public institutions from trying to claim as much support as possible from taxpayers. Yet, on a strict per-student basis, private for-profit institutions already receive only a small share of what other institutions receive from government. And in less than a single generation, the private for-profits have created a new pathway to economic opportunity for millions of people with traditionally limited access to American higher education. At a time when what we know determines both what we earn and how effectively we compete in global markets, the United States can ill afford to shortchange the fastest-growing segment of American higher education. 

The Illogic of the Current Economic Debate

In early June of 1992, I sat in the living room of the Governor’s mansion in Little Rock with Bill and Hillary Clinton and a half dozen other advisors, hashing out the economic program he was preparing to take to the country. Clinton had just won the California primary and sealed the presidential nomination, but he was running third in the polls behind President Bush and Ross Perot. That afternoon was the only time I ever heard Bill Clinton doubt himself. Referring to Perot and his movement, he said quietly, “sometimes no matter what you do, a big wave just washes it all away.” President Obama and congressional Democrats face a comparable challenge today from the Republicans and their Tea Party allies, who together threaten to wash over the Democrats’ plans and hopes for themselves and the country. The critical question for Democrats is how they should respond. 

Bill Clinton offers the best example in modern times of how doing what’s right, especially on the economy, can produce very large political rewards. First, there’s the rule that political scientists have taken from decades of economic data and election results: Reality trumps marketing. So, that June day 18 years ago, I reminded the Clintons that average incomes were lower than when Bush had taken office in 1988, and no president in the 20th century won reelection under those conditions. The second rule was all Bill Clinton’s, and it presaged the economic successes of his presidency: He said he would stick with the economic plans developed for him, based on a serious reading of what was wrong with the economy and what modern economics could teach us to do about it.

Today, our real economic conditions have a political double edge. The economy is in much better shape than when President Obama took office, but these remain deeply frustrating and even desperate times for millions of Americans. The political reality is that the frustration has overwhelmed any sense of progress on the economy. The pundits can argue over how Republicans managed to pull off their political jujitsu, in somehow shifting the debate from their own culpability for the worst financial crisis and recession in our lifetimes to the legitimacy of the steps the administration has taken to bring back the economy. By this Orwellian illogic, people’s economic problems today are somehow tied to an orthodox stimulus program to bolster sinking demand and the TARP rescue of the financial system, approaches supported at the time by virtually every conservative as well as liberal economist. In the tradition of “Ignorance is Strength” and “Freedom is Slavery,” the Tea Party-purified opposition also now calls for permanent stimulus through tax cuts while ignoring the repayment of most TARP rescue funds. And their only concession to their own loudly-stated concerns about deficits are far-fetched proposals to cut deeply into the safety net created to protect people from the worst effects of a bad economy, including unemployment benefits, Social Security, Medicare, Medicaid, and the recently-enacted health insurance guarantees. 

For everyone not running for office this year or employed by those who are, the pressing question is how this sorry debate will affect how most Americans fare over the next two years. Political opposition in democracies is often irresponsible, but those who govern don’t have that luxury. Like Clinton in 1992 and throughout his presidency, they have to resist the temptation to respond with distortions of their own. Instead, the administration has to stick with policies that could successfully nudge the economy to a better place for most Americans – and then get credit for it in the next election. 

That’s a very hard strategy to pull off. Reigniting job creation, for example, is clearly a critical part of any serious effort to drive economic recovery. The opposition points to small businesses as the source of most new jobs, and claims that raising the top marginal tax rate would disproportionately harm those same businesses. It’s more Orwellian marketing. They define “small businesses” not by their size, but as any enterprise organized for tax purposes to pass its earnings through to its owners. That does take in nearly all small LLC’s, LLP’s and subchapter-S companies. But it also covers every partnership and private-equity- owned enterprise, from Bechtel and parts of the Koch brothers’ empire, to the accounting giant PriceWaterhouseCooper and many of the holdings of the Carlyle Group. What most Americans care about here is not whether a business is large or small, or how it’s organized for tax purposes, but whether it really creates jobs. Yet, the GOP rebranding of their high-end tax cuts as job creators has driven the Democrats to respond with  their own package of new tax breaks for so-called “small businesses,” alas triggered not by the new jobs they create but by investments they would undertake on their own anyway, as soon as the economy strengthens.  

There are serious ideas developed by real economists about how to stimulate new jobs. For example, we could suspend an employer’s payroll taxes on new hires for two years, and so directly reduce the cost to create new jobs. Or we could offer American multinationals a temporary tax break on the foreign earnings they now hold overseas, in exchange for increasing their domestic workforces by 5 or 10 percent. But serious ideas are always more complicated than political slogans. So, a payroll tax holiday for new hires would also require a real plan to make up the lost revenues, and a jobs policy geared to multinationals would force progressives to retire their outdated views about how the foreign operations of U.S. companies affect American jobs. 

The Tea Party wave being amplified now by most Republicans could well drown out genuine public consideration of new steps for the economy. But what would Democrats lose by trying? Even if they end up losing 35 to 45 seats in the House and seven to nine in the Senate, President Obama and the country still need a serious plan to restore people’s incomes. Without it, the President in 2012 could find himself in the same position as George Herbert Walker Bush in 1992.

Why We Learned So Little From the Collapse of Lehman Brothers

On the second anniversary this week of Lehman Brothers’ spectacular collapse, it’s instructive – okay, frustrating and dispiriting – to see what our policymakers learned from it. Based on what unfolded then and the trillions of dollars lost, you would expect that even conservatives could now acknowledge that unregulated financial markets are not always an optimal arrangement. But that’s not how it has worked out. By now, everyone also should recognize that when markets crack-up, government is the only game in town to contain the damage and head off a repetition. Yet as a rule, conservative Washington still doesn’t see that. And by now, when virtually everyone should appreciate the dangers of over-leveraging, policymakers across the political spectrum still don’t fully get that either.

It matters, because all of this leaves the U.S. and global economies exposed to another financial crisis and the truly terrible economic costs that would accompany it.  

This is a period, it seems, when simple-minded political ideology regularly trumps economics.  After a succession of gruesome financial meltdowns over 20 years – in Japan, Sweden, East Asia, Spain, and now America and Europe – the leading ideology still offers knee-jerk reverence for markets unfettered by public standards or rules. Those now poised to take over at least one house of Congress wouldn’t support even the tame financial regulation approved earlier this year. That’s despite the fact that the new law forgoes setting common standards, rules or other meaningful regulation of most trading in large blocks of asset-backed derivatives. Those are the precise transactions which proved to be so dangerous for Bear Stearns (RIP), Lehman Brothers (RIP), Merrill Lynch (RIP), AIG and the rest of us. Just as it was before Lehman and the rest imploded, most investors and regulators still won’t know which banks are carrying out those large trades, what those trades consist of, and how heavily they borrowed to complete them.

The still-reigning ideology also won’t tolerate regulation to stop flash trading, which allows a handful of giant institutions to see incoming orders a few milliseconds before ordinary investors, and repeatedly has triggered huge, sudden share price declines. It also won’t countenance regulation of so-called “dark pools” or private deals between firms to move large blocks of securities without anybody else knowing about it. As the world learned painfully two years ago, markets that aren’t transparent become vulnerable to devastating panics when an outside shock hits them. We haven’t even been willing to direct the big banks to divest themselves of the same risky assets that crushed Lehman two years ago.    

We’re not doing much better with international regulation. This week’s news from Basel was a new agreement among the major countries to “triple” the capital reserves that banks hold against future losses. But market insiders know that these standards, along with parallel ones in our own financial reforms, won’t hold off another crisis. As the always-rigorous Martin Wolf of the Financial Times put it, “tripling almost nothing does not give one much.” The punch line is that the lame new standards don’t even take full effect until 2019. It is little wonder that bank shares rallied when the “tough” new standards were announced.

So at least until the next global meltdown, risky derivative and dark pool transactions, as well as continuing rounds of flash trading, will continue to depend on out-sized leverage and unfold beyond the purview of most investors and regulators.

There’s a final irony. The only reason that investors let banks get away with such low capital reserves, high leverage and risky transactions is that the banks and everyone else knows that if the worst happens, governments will bail them out. At the same time, the same financial institutions and their ideological fellow-travelers in Washington won’t stand for new rules that would meaningfully reduce the likelihood of another eventual bailout. That’s as good an example as any of socializing risk for private gain, and a convincing demonstration that Wall Street and much of Washington learned little from the economy’s near-death experience two years ago, this week.

Time for a Mid-Course Correction in Economic Policy

The economic proposals unveiled this week by the Administration suggest that the President’s determination to target his policies for the long-term has led the White House to misread the economy today. Allowing firms to deduct their capital investments in the year they occur instead of slowly depreciating those costs, and expanding the R&D tax credit and making it permanent are measures that can help sustain growth once it returns, but they won’t lift the economy’s current faltering pace. To do that, they need a midcourse correction aimed directly at the economic distortions which brought down the economy and produced today’s abnormally slow and halting recovery. It’s time for presidential leadership and big initiatives, starting with the housing market.

Since 2009, when the White House famously forecast that strong growth would return this year and unemployment would top out at 8 percent, their program has relied on models and analyses that see the current period as part of a normal business cycle. If only that were so, because then the massive fiscal and monetary stimulus of the last 18 months would, indeed, have produced the robust V-shaped recovery they expected. But that isn’t the economic hand we’ve been dealt. Much like the sorry story of post-bubble Japan in the 1990s, the structural distortions in housing and finance which brought on our crisis remain largely unaffected by stimulus. While all that stimulus stopped our slide towards a depression, it was neither sufficiently large nor long-lasting to offset the structural problems.   

So, the banking system, still saddled with hundreds of billions of dollars in shaky mortgage-backed assets and fighting additional drag from falling values in commercial real estate and European debt, remains too weak and wary to resume normal lending to most businesses. The problems with housing have even more far-reaching effects for the recovery. With high unemployment dragging on – as it typically does following a financial crisis – housing foreclosures are stuck at three times normal levels, pulling down the value of most Americans’ homes. This continuing decline in housing values not only has left 23 percent of households with mortgages under water. It also continues to eat away at the net wealth of everyone who owns their own homes, producing a “negative wealth effect” that leaves most Americans, much like the banks, too financially weak and wary to resume normal spending.

Even if a second round of stimulus were possible politically, it wouldn’t cure these structural problems with any greater success than the first round. Until the administration and Congress tackle the forces holding down consumption spending and business lending – or wait another half-decade for this dismal cycle to run its course – the American economy will remain weak and unemployment high.  

A real opportunity here lies in a new approach to keep Americans in their homes and so help stabilize housing values. Subsidies for banks to rewrite troubled mortgages haven’t worked, because the approach glosses over the weakness of the banks and the way they conduct business. Even if these institutions were in better shape, very few bankers are willing to extend new credit to people who couldn’t keep up with their mortgages. Only a government can assume such risks.    

The best approach for this would be a new two part program aimed at housing and unemployment. The first part is a loan program, modeled on student loans, to help Americans with troubled mortgages. Those families could apply for five-to-ten year government loans to stave off foreclosures, with the repayment schedules linked to people’s incomes recovering. With many fewer foreclosures, housing values could stabilize and staunch the negative wealth effect now holding down consumption. The second part of the new program would reduce the cost to businesses of creating new jobs, by expanding and extending the administration’s modest cuts in an employer’s payroll taxes for new hires, the approach that CBO calls the most effective way to jumpstart job creation. Every new job will enable another family to earn the income needed to help keep up with their mortgage, further stabilizing housing values and so ultimately supporting consumption.

If the economy were poised to take off, the Administration’s proposals for another $50 billion in infrastructure spending and $200 billion in tax breaks for small businesses might help. Unhappily, that’s not the case. But the President has time to seize the opportunity to make a mid-course correction, and put in place the foundation for a strong recovery in, say, 2012.

Why the Value of Your House Moved Global Markets This Week

This week’s housing news was a primer on globalization. U.S. existing home sales fell 27 percent in July, twice as sharp a drop as Wall Street analysts said to expect. (Of course, they’re the same geniuses who didn’t see their own meltdown coming, didn’t expect the long, deep recession that followed, and couldn’t figure out that the recovery would be slow and halting.) Right away, our stock markets sank by one to two percent – no surprise there – but we weren’t alone. On Wednesday morning, the financial news led with “European Stocks Drop on Dismal U.S. Home Sales Data” and “Most (Asian) Stocks Fall Amid Speculation on U.S. Home Sales Report.”

Why does a bad report on American home sales rattle investors a half-world away? To be sure, housing is an important piece of every U.S. recovery. And the world pays close attention to ours, since we remain by far both the world’s largest market for imports and the place where most foreign multinationals maintain their subsidiaries. This time, however, there’s more at stake. Housing is both a lynchpin for a full recovery from the financial crisis that pushed most of the world to the brink of depression; and the key to something better than our current stumbling expansion.

The link to finance is straightforward. Everybody remembers how Wall Street’s largest institutions swooned or crashed when the end of the housing bubble brought down hundreds of billions of dollars in mortgage-backed securities and the credit default swaps that backed them up. But when Washington stepped in to rescue most of them, it took out its own risky bet that a housing recovery would quickly stop the bleeding. So we never seriously considered what Sweden did so successfully in the early 1990s – and what we did ourselves to resolve the S&L crisis: Take over an insolvent Bear Stearns, AIG or Merrill Lynch, pull out the weak and failed assets, and sell the still-healthy stuff to new investors who would promptly reopen the institution under a new name. And the bailouts didn’t even require that these institutions put their books back in order by getting rid of the most risky housing-based assets which they still held. 

The catch is that if the housing market continued to deteriorate – as it did – more of those assets would decline in value or fail outright. Those losses, current and prospective, leave finance much less willing to lend to most other companies. And that means that strong business investment, which is a critical part of all healthy expansions, this time will follow a housing recovery, not lead it.

There’s more at stake in the current housing market than the pace of business investment. Some 70 percent of U.S. households are homeowners, which makes housing values the most important piece, by far, of most Americans’ wealth and economic security. So, the sharp drop in those values has made most of Americans poorer than they had been, and, unsurprisingly, people who feel poorer tend to spend much less. The health of the housing market, in short, now directly affects both business investment and consumer spending, and with them the outlook for the entire U.S. recovery. 

It is little wonder that world markets reacted badly to this week’s dismal U.S. housing report.  Beyond the 27 percent drop in existing home sales – and one day later, sales of new homes also fell sharply – nearly one-third of the houses that did sell were “distressed” properties. That means they were either in foreclosure or sold for less than their outstanding mortgages. Average home prices did inch up a little bit, but the only reason was that the end of the temporary tax credit for first-time homebuyers led to a particularly sharp fall in their purchases, which normally involve lower-priced homes. 

Nor are there signs of a real housing recovery anytime soon.  Foreclosures are still running at four times their normal levels – and nothing drives down a neighborhood’s housing prices and slows down sales more than nearby homes in foreclosure. On top of that, supply continues to way outpace demand: At current rates of home sales, it would take over a year to clear all of the homes already on the market today.

If we don’t take serious steps to finally turn around these conditions, the United States and much of the rest of the world will be looking at a weak expansion, or worse, for several more years.  One measure that could have a powerful effect would be steps to bring foreclosure rates down to normal levels. For example, congressional Democrats could advance a new program modeled on student loans for homeowners with mortgages in trouble. Homeowners who qualify could borrow the funds they need to stay in their homes, at a low interest rate, with no interest due the first year so long as they stay in the homes for at least two more years.  

Most Republicans will denounce it as just another “big government program.” Yet, without a housing recovery, the alternative is not only smaller government but also a smaller economy, because businesses can’t find loans, people can’t find jobs, and most consumers  can’t spend like they used to.

How to Remain the Number One Economy as China Ascends to Number Two


The news that China’s GDP will surpass Japan’s this year, making China the world’s number two economy, raises important issues for the United States.   There’s no prospect of China taking over our number one slot anytime soon:  Even in our present shape, the American economy will produce at least $14.3 trillion in goods and services this year, compared to China’s $5.3 trillion.  But the Sino-Japanese shakeup in global economic rankings is a sign that we have to raise our game.

The lesson here comes less from China’s ascendance than from Japan’s decline.  Twenty years ago, Japan had racked up 30 years of extraordinarily rapid growth – just as China has today – and scaremongers predicted that Japan would soon overtake us.  Yet, Japan’s good times ended abruptly in 1991, ushering in two decades of economic stagnation.  The origins of Japan’s long downward slide should be all too familiar to Americans, since it began with the sudden collapse of a huge real estate and stock market bubble, which then triggered a banking crisis and deep recession.  

Sweden had a financial meltdown the same year as Japan; yet Sweden put together a new policy consensus around economic liberalization, and the Swedish economy came roaring back within three years.  On the other side of the world, Japan suffered year-after-year of policy mistakes and paralysis by the long-ruling Liberal Democratic Party, and the result was two decades of economic languish.  Moreover, the particulars of Japan’s decline should be an object lesson for our own public officials: Hemmed in by powerful interests and an irresponsible opposition, the LDP couldn’t bring itself to clean up Japanese banks or fix the country’s housing market, much less undertake deeper economic reforms to prepare Japanese businesses and workers for the intense competition of globalization.  So, Japan was left instead with years of financial-sector weakness that limited business investment – sound familiar? – especially for the new enterprises that drive technological innovation and job creation.

As Japan continued to falter economically, the LDP spent trillions of yen on new public projects – and invested almost nothing in reforming their economic policies or upgrading the skills of Japanese workers, especially millions of Japanese women consigned to positions with no future in a modern, idea-based economy.  The result has been the country’s prolonged economic stagnation, and faltering competitiveness even for its global companies.  From 1990 to 2005, for example, Japan’s share of the world market in producing high-tech goods collapsed from 24 percent to less than 15 percent.

The question for the United States is whether our own political system has the capacity to address the challenges here which echo Japan from a generation ago.  We may not face the prospect of a national economic reversal as severe as Japan’s, and our world-class corporations should continue to prosper.  Yet we face serious challenges of our own which, if left unaddressed by Washington, could consign a majority of ordinary Americans to economic stagnation for a long time.

At the top of this catalog of challenges are jobs, because the storied capacity of America’s companies to create new jobs has eroded badly.  In the Bush expansion of 2002-2007, our private sector generated less than half as many net new jobs, relative to growth, as it did in the Clinton expansion of the 1990s, the Reagan expansion of the 1980s, and even the Carter expansion of the mid-to-late-1970s.  The best policy response here is to reduce the cost to businesses of creating those new jobs.  And we know just how to do that – cut the employer’s payroll tax burden for net new hires, and slow future increases in the health care costs which employers have to pay.

The outstanding question is whether Washington can raise its game and enact these kinds of reforms.  Let’s frame the political challenge in the terms that have dogged economic reform in Japan for so long.  Can congressional Republicans accept a tax increase, even one designed to fund a corresponding payroll tax cut?  Optimally, the tax increase could contribute something on its own – for example, a carbon fee that also would help address issues of energy security and climate change.  For the other side of the aisle, can Democrats support a tax cut for business, even if it’s the most effective way to spur job creation?  Similarly, can Republicans swallow hard and support more regulation of our broken health care market, in order to reduce costs for business – and are Democrats prepared to trim federal outlays for powerful health-care interests if doing so will ultimately help create jobs and raise wages? 

Here’s another challenge we have to meet in order to avoid a version of Japan’s fate: Restore higher levels of domestic savings to support higher levels of both private investment and public investments, especially in education and training, and in 21st century infrastructure including universal broadband and a modern electricity grid.  We know, after two generations of trying, that tax breaks aren’t enough to convince most Americans to save more: Since the 1990s, we’ve provided generous tax breaks in various forms that cover 80 percent of all personal saving, to no avail.  The only certain way to raise national savings, it appears, is to reduce public dissaving by lowering budget deficits.

Facing a slow economy that could go on for a long time, can Republicans accept cuts in defense spending – even with Secretary Robert Gates’ blessing – and measures to expand revenues?  Ronald Reagan, of course, took the same two difficult steps a generation ago; but he was more willing to compromise, it seems, than many of his current-day followers.  Across the aisle, will Democrats vote for measures that expand revenues from those they don’t call “rich,” even gradually, along with initiatives to trim future Medicare and Medicaid costs in part by trimming benefits?  

Stating these challenges so directly exposes the political difficulties.  But we should know by now what can happen eventually when a wealthy country – one like Japan – loses the political will to raise its’ game.  


Who's Really to Blame for High Unemployment, and What to Do About It.

An economic slowdown is now here – one we repeatedly cautioned would come – so even the Federal Reserve is downgrading its forecast. Alas, the United States isn’t alone. The prospects for Europe look even worse, especially with their largest banks so heavily invested in the bonds of EU member countries still skirting the edge of sovereign debt defaults. And now China faces the cross pressures of trying to boost their weakening exports while letting some of the air out of their own housing and financial bubbles. That will spell serious problems for China’s four state megabanks, whose loans keep much of Chinese industry afloat. We’ll be lucky to come out of this dismal environment with just another year of slow growth and high unemployment. 

So, with the midterm elections coming on, most Americans have one question for their elected officials and those hoping to replace them: What decisive steps are they prepared to take to rescue this economy? Remarkably, the answer from much of the GOP opposition seems to be, repeal part of the 14th Amendment and stop Muslims from building a mosque in downtown Manhattan. Of course, there’s also lots of finger-pointing about the economy, including the audacious claim that the fault for the high unemployment lies in the Administration’s economic policies, especially the stimulus.    

Since that claim has some popular traction, and even support from a handful of muddled conservative economists, let’s test it with the hard data from the Bureau of Labor Statistics.  

From December 2007 to July 2009 – the last year of the Bush second term and the first six months of the Obama presidency, before his policies could affect the economy – private sector employment crashed from 115,574,000 jobs to 107,778,000 jobs. Employment continued to fall, however, for the next six months, reaching a low of 107,107,000 jobs in December of 2009. So, out of 8,467,000 private sector jobs lost in this dismal cycle, 7,796,000 of those jobs or 92 percent were lost on the Republicans’ watch or under the sway of their policies. Some 671,000 additional jobs were lost as the stimulus and other moves by the administration kicked in, but 630,000 jobs then came back in the following six months. The tally, to date: Mr. Obama can be held accountable for the net loss of 41,000 jobs (671,000 – 630,000), while the Republicans should be held responsible for the net losses of 7,796,000 jobs.  

So, when some of those GOP candidates change the subject from unemployment to treacherous immigrants, they actually may know precisely what they’re doing.

Some Democrats may take satisfaction from these data; but that won’t be enough for most voters, not while Democrats still control the White House and Congress. The opposition may get away with silence about what they would do to bring down unemployment – apart, of course, from the traditional GOP catechism of tax cuts. But Democrats will have to lay out a more serious program if they hope to convince America to keep them in power.  

So, here’s a four-part program for Democrats to take to the voters. First, create jobs by expanding an Administration initiative already in place: Deep cuts in the payroll tax for employers who expand their workforce. Second, shore-up the weak housing market and stabilize falling home prices with a long-overdue, new initiative: A loan program for homeowners with mortgages in trouble, modeled on federal student loans, to bring down foreclosure rates. Third, prepare tens of millions of Americans for the jobs the economy will begin to create once it’s back on track: Provide grants to community colleges to fund free computer training for any American adult who walks in and asks for it. And fourth, put in place some long-term deficit reduction to head off higher interest rates when the economy does begin to expand again.  Rolling back the Bush tax cuts for higher-income folks is a beginning, but it should be paired up with serious spending restraints. The best place to start is health care: Slow down Medicare and Medicaid cost increases with much stricter and more comprehensive versions of the cost-containment measures already enacted in the President’s health care reforms.  

That would be a real program that the parties could debate in the fall campaigns – and if the Democrats prevail, they could run on its results in 2012.

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