NDN Blog

The Potential Cost of Political Paralysis: The Lesson of Japan

A political earthquake hit Japan this week, one which could hold important lessons for America's current political stalemates.  After a half-century of one-party rule, the Liberal Democratic Party (LDP) was buried in parliamentary elections by the Democratic Party of Japan (DPJ), a loose coalition of generally left-of-center opposition parties.  The elections were less a matter of partisan competition than an explosion of pent-up disgust with an utterly failed political system personified by the LDP's long rule.  Ask yourself, what powerful popular forces could be unleashed here, if yet another presidency cannot manage to reform our dysfunctional health care system, restore rising wages for most American workers, and take steps to preserve the climate?

One striking aspect of this week's events in Japan is how long they took to happen.  For two decades, Japanese have lived with the consequences of economic stagnation and a feeble financial system, including declining incomes and wealth, as well as deflation.   Japan's private sector didn't lose its edge -- over the same years, for example, its auto companies became the world's best, and Japanese companies adopted information technologies at a prodigious rate.  The problem was consistently wrong-headed policies by a succession of LDP governments unwilling to enact any reforms that might impose costs on the entrenched interests - big banks, construction companies, small farmers, and more - vital to the LDP.  Sound familiar?

Junichiro Koizumi's prime ministership from 2001 to 2006 was a hiatus of sorts, but also a fluke and ultimately a failure: Following a series of scandals involving LDP leaders, the party gave ordinary LDP members a new role in choosing the next party leader - and was shocked when those members chose the outsider Mr. Koizumi.  But he was a maverick sitting atop a corrupt parliamentary party determined to resist new policies to address the country's deepening economic problems, and he finally left with little changed. 

Our own outsider president has much more support within his own party in Congress than Koizumi did in Japan's LDP-dominated Diet.  Yet, Democrats in Congress are not immune from the corrosive politics of entrenched interests, pulling them in many directions that together could fatally weaken new policy directions for our long-festering problems with health care, wages and climate change.  And if the current economic policies do not produce a strong recovery - and they might fail to do so - the pull of those interests and the push of rabid Republican opposition could produce a decade of stagnation here as well. 

For now, President Obama may have the same advantage with the public that the LDP enjoyed for a generation  - a discredited opposition.  Republican leaders from Sarah Palin and Dick Cheney to Dick Armey and even John McCain thus far have offered the public little beyond emotion-laden grievances bound up in outlandish attacks on the President as a Marxist, an appeaser, and even a budding Hitler.  They know better, but the attacks appease the far-right interests that now constitute much of the GOP's diminished base.  Moreover, the Republicans' growing resistance to talk seriously with the White House and the majority party, about the serious challenges facing average Americans, comes from entrenched economic interests as determined to avoid any of the costs of change as those that hobbled the LDP for a generation.  

Unlike Koizumi, President Obama won his office, in part, by putting together a financial as well as popular organization organized through the Internet, and so much less dependent on established interests.  One way to break the stalemate might be to direct that organization to help fund congressional candidates relatively independent of those interests.  But that would force the President to take on members of his own party, a risky and confrontational course at odds with his moderate and pragmatic temperament and political views.  Mr. Obama has one other course open to him: Exercise the mobilizing leadership that won him the nomination, targeted this time to members of Congress rather than the millennial generation and independent voters.  It will require knocking more heads together than he might like.  He can do that - just ask Hillary - and our ability to avoid a decade of decline may lie in the balance.

Statement on Today's Deficit Numbers and the Bernanke Reappointment

Below, please find my comments today on the reappointment of Federal Reserve Chairman Ben Bernanke and the new OMB report estimating that the deficit will reach $9 trillion over the next decade.

On the new OMB estimates:

The new numbers today from the Office of Management and Budget remind us that short term and long term deficit projections are very uncertain. What is equally certain is that the economy needs stimulus today, whatever the short term cost to the deficit, as well as sharp reductions in long term deficits. Those long-term reductions have to form the basis for the other reforms in health care, energy, education and training which our economy and nation need. Addressing both of these tasks remains the administration’s most important domestic challenge.

On Chairman Bernanke's reappointment:

Chairman Bernanke did not see this crisis coming, but he steered the economy well once it arrived. The country still needs his wisdom, because this crisis is not over. Our large financial institutions remain fragile, as they continue to hold most of the toxic assets which brought down other financial giants. The economy remains vulnerable to additional shocks from the financial system, including the deteriorating commercial real estate markets. Foreclosures continue to rise, which in turn drain more of the value of the mortgage-backed securities still held by financial institutions. The only reason we haven’t seen greater effects is that we suspended their mark to market accounting. But underneath the bookkeeping, these problems remain serious. All of this portends a very challenging economic environment and the prospect of a difficult recovery. The President was right to opt for continuity in the face of this large and critical agenda, which we hope Chairman Bernanke will help resolve.

The Conundrums in Health Care Reform

The political furor over health care reform, and especially the media coverage, may be triggered by right-wing agitprop; but the cynical distortions – death panels! – fed by hard Republican partisans are not responsible for eroding public support. Health care reform will always be a tough sale. Three-quarters of Americans believe we need serious reform; yet two-thirds of those who voted in 2008 have insurance and say they’re satisfied with it. If the President is going to win this fight, he and his people have to unravel this conundrum – and economic logic can help.

People have plenty of complaints about their health care. They don’t like the waits they face to see their doctors, they really don’t like paying the world’s highest insurance premiums and co-payments, and they’re not insensitive to the plight of 50 million uninsured -- and the possibility they someday might join them. Yet most of us are deeply risk-adverse about real changes in these arrangements, and the reasons are as basic as they get: We naturally place infinite value on recovering from some terrible, future illness or injury, and so far the current arrangements have kept most of us and our children alive and even reasonably well. So, if the critics’ outlandish claims contain even a small kernel of truth, many of us can (and will) imagine that under the right circumstances, it could cost us the care we might desperately need.

There’s another, equally powerful factor at work here. Health care places most people in the uncomfortable position that economists call “radical information asymmetry,” which means that one party knows much more than the other about something important to both. We feel sick but we don’t know what’s causing it or what to do about it – so we go to a doctor or hospital staffed with people who do have the precious knowledge and skills necessary to make us well again. This genuine sense of ignorance about a matter of potentially life and death importance greatly intensifies our risk adverseness about changing the arrangements under which those all-knowing doctors and hospitals now take care of us. And since we all know that some illness or injury will eventually threaten or end our lives, it’s not a hypothetical concern.

This information asymmetry complicates health care reform in other ways. We can’t shop for the best medical deal or make independent judgments about whether we need one procedure or two, so we have to depend on doctors we know, who have obvious incentives to “sell” us as many expensive services as their Hippocratic oath allows. That’s why proposals to end the tax deductibility of employer-provided insurance probably wouldn’t much affect rising costs: Even with greater incentives to shop for less expensive care, we still lack the knowledge to make intelligent choices.

The policy conundrum for the President is that unless he can reform these arrangements, the pressures that have been driving up health care costs for decades will end up denying care for many more of us. But there’s little reason for most people to support cutting health-care costs, since people know that cutting costs in most areas usually means getting less – and in this case, getting less could cost them their health.

That’s why the action has been shifting from health care reform to insurance reform, by which Washington means new guarantees that insurers must maintain coverage for any serious condition any of us might face, and set premiums without reference to people’s current or past health. Most insurers are willing to go along, so long as Washington also requires all of us to buy their coverage. But their caveat presents another political obstacle ripe for demagoguery, since somebody would have to pay for the subsidies that tens of millions of us will need to afford that coverage.

Insurance reform may be the only change that almost everyone would welcome. But it also will increase costs further, which will eat away at coverage. Moreover, it does nothing about the major forces most responsible for driving up costs – the inexorable aging of the boomers, and the proliferation of new, very costly medical technologies to treat the common conditions that mostly befall older people, especially cancers and heart disease.

It’s obvious by now that there just aren’t any easy answers. The “public option” would probably force insurers to squeeze more efficiencies out of the ways they conduct their business, as could private, non-profit insurance cooperatives. But those efficiency savings would be one-shot deals that can only give us a few years of breathing room – like the shifts to HMOs and PPOs did in the 1990s – before the same problems reemerge.

As to the larger forces, we can’t do anything about the aging of the population, and the only way to control the costs of new technologies is to limit people’s access to them or slow down their advances. And no one is prepared to suggest that, since we all can imagine someday needing a recent breakthrough to preserve our health.

There is another option: Accept that we place unlimited value on gold-plated health care and be prepared to pay for it. Eventually, that will drive us to new, broad-based taxes to finance gold-plated care for everybody. Since that’s not a topic which our politics can handle today, it looks like we all should prepare ourselves for many more years of debates over health care reform.

Why, Yes, We Do Have to Regulate Some Executive Pay

The House of Representatives has committed some fumbles this year, but the legislation passed last week to regulate executive compensation in large public companies is sorely overdue. By any plausible standard, compensation for the very upper reaches of American business has been out of control for a long time. In 1991, candidate Bill Clinton scolded corporate America for rewarding the average CEO 80 to 90 times what their average worker earned -- compared to a pay gap of just 10 times in Japan. Today, the gap here is 250 to 300 times, and it has indirectly contributed to the economic turmoil affecting us all.

There's an untold story here that shows how genuinely hard it is to regulate how wealthy institutions and their executives conduct themselves, especially when it goes directly to their personal interest. Back in the fall of 1991, the young and still largely unknown Bill Clinton agreed to deliver three major policy addresses at Georgetown University, designed to dispel any doubts in the press about the depth of his knowledge and the breadth of his intellect. (It succeeded brilliantly: By December, the media had anointed him as the frontrunner.) The first address was on the economy; and on the appointed day, George Stephanopoulos (then Clinton's new top personal aide), Bruce Reed (the campaign issues director) and myself (the chief economic advisor) met to go over last minute changes. Clinton wanted to add a new section on executive pay and offered up his solution: Limit a company's right to deduct salary expenses to, say, $1 million for each individual. The economist in me warned that this approach probably wouldn't work: Most companies would find ways to reward their executives outside the limit, and most companies wouldn't care how much of it was deductible. So, I ventured an alternative: Require a shareholder vote to approve the annual compensation of executives earning more than, say, $1 million (it was 1991). After all, the shareholders are a company's actual owners. If the owners were okay with a $200 million payday for a successful executive or $20 million for another who drove the company into the ground, who are we to complain - especially since the pay packages ultimately came out of the owner's own dividends. In practice, the prospect of annual shareholder votes could effectively constrain executive pay, since most companies wouldn't dare to award their senior people pay packages that their shareholders would publicly reject.

My idea was overruled by the political gurus, who concluded it would be too subtle for the public. So the candidate stuck with limited deductibility, which we now know had no effect on out-of-control executive compensation.

The financial crisis could change all that. Barney Frank -- who has truly come into his own as chair of the House Financial Services Committee during this crisis - last week convinced the House to require a "shareholder advisory vote" on executive compensation. The proposal is weaker than it could be - the vote should settle the matter, not be merely advisory -- but the basic idea is right: Let a firm's owners decide how much its executives are worth.

The current arrangements have two glaring defects. The first involves self-dealing or what might be called "crony compensation." In the cozy arrangement of most large public companies, the pay packages for top executives are set by a firm's compensation committee, whose members are drawn from the board of directors. As it happens, most of those directors are also chosen by the executives whose pay they then determine; and to top off this mutual back-scratching, the committees often set compensation for the directors, including themselves. The results leave everyone involved a lot richer - except the shareholders -- and may account for as much as one-third to one-half of the current cavernous gap between executive and workers' pay. That's why it makes eminent sense to have shareholders review these self-interested decisions. Frank's legislation, which also directs that compensation committees be comprised entirely of "independent" directors (those who are not also executives of the company), would be at least a step forward.

The second defect goes to the particular ways that many executives, in effect, reward themselves: Their compensation arrangements pay them handsomely for short-term gains, with no adjustment or recourse if the same decisions end up producing large losses down the line. The obvious losers, once again, are the shareholders, who pay the dealmakers princely sums for decisions that may end up costing the company dearly. But as the financial crisis has shown, these arrangements can deeply distort these managers' incentives, focusing them on investments and other decisions that produce a quick payday but also involve large long-term risks.  When reckless risk-taking becomes endemic - for example, creating trillions of dollars in unsound securities and trillions more in their derivatives, as Wall Street has done in recent years - the fallout can pull down the entire economy. That makes it all of our business, and the Frank legislation also directs federal regulators to define and ban "inappropriate or imprudently risky compensation practices."  It's a beginning.

There may not be much time, because the old practices that got us into this mess still go on. Goldman Sachs and other financial titans which a few months ago happily took tens of billions of dollars in direct and indirect taxpayer bailouts are already preparing to dole out billions of dollars in new bonuses to their executives and top traders, based on new deals which have generated large, short-term profits but also are said to involve large, long-term risks. It's no surprise: The compensation committees and their practices haven't changed, and now they also know that whatever happens, they'll be bailed out. Ironically, the bailouts that saved us from a second Great Depression may also bolster some of the distortions that threaten to produce it. If we want to avert another, even worse crisis, basic economics tells us that these compensation practices have to go.

The Fault Lines in the U.S.-China Relationship

The fault lines in this week's "strategic dialogue" between American and Chinese leaders remained largely unseen, like a low-grade infection that can flare up without warning. Those fault lines matter mightily, however, because the United States and China are the critical players in the globalization process shaping every economy in the world.And despite America's insecurities about China's rising power, the fact is, we retain most of the advantages in a complicated relationship best described by the Financial Times this week as "adversarial symbiosis."

The convergent interests of the United States and China are obvious and a cause for satisfaction at this week's talks. Most important, each is an enormous purchaser of the other's goods, so that domestic demand in one is a source of employment in the other. Nevertheless, the trade relationship will continue to have a sharp political edge so long as China sits on the other side of America's largest bilateral trade deficit. Yet, it really shouldn't be. We import more from China than from anywhere else, because China is both the world's largest producer of many cheap goods that Americans hardly make at all anymore - tee shirts and toys, for example - and a favored place for U.S. multinationals to assemble more complex products for the U.S. and other markets. In fact, nearly half of the high-tech products imported from China - computers, televisions, cell phones, and so on - are goods that U.S. producers merely finish or assemble there, sometimes using advanced parts made in America.And so long as the American economy is three to four times the size of China's, and much more weighted to consumption, no one should be surprised at our importing four to five times as much from China as China imports from us.

The economic truth is that America runs huge trade deficits with the world, because for years we have insisted on consuming much more than we produce, and imports are the only way to make up the difference. The flip side of this high consumption has been our low savings - at least until the current recession decimated so many people's savings and wealth - creating another fault line in the U.S.-Sino relationship. That low savings forces us to borrow abroad to finance some of our consumption, along with our budget deficits and business investment; and China with the largest surplus savings in the world has become our largest creditor. No one thinks of their creditors as their buddies - or the other way around - producing an unfamiliar and unpleasant dependency on an autocratic regime we don't trust. We cannot ignore that if China were to decide to abruptly reduce its lending to us, we would quickly find ourselves in deep economic trouble. But China needs us just as much economically, and not just to keep on buying Chinese goods.Just as important, China has to rely on the U.S. following economic and currency policies that will preserve the value of all the American assets - Treasury securities, stocks, real estate, and companies -- that China buys with the dollars we pay her for her goods.

China is dependent on the United States in other critical ways as well.American companies have been and remain a major source of Chinese modernization, through U.S. foreign direct investments (FDI) that transfer many of the world's most advanced technologies, equipment, and ways of doing business from here to there.China depends on these transfers as the ultimate source of much of its growth, and sustaining strong growth is a central factor for the legitimacy for its leaders' authoritarian regime.

China's reliance on the U.S. is also geopolitical. Chinese leaders desperately want and need peace, especially in Asia and the Middle East, so they can continue to direct most of the country's resources to their gargantuan modernization project. These leaders have long recognized - and said so - that American superpower has become the only force in the world capable of projecting the military and economic might required to contain local conflicts and terrorist threats that could threaten regional or global stability. That's why the last U.S.-Sino military confrontation occurred 13 years ago, when President Clinton sent the Independence carrier battle group into the Taiwan Straits and the Nimitz to the South China Sea, and why we rarely hear Chinese criticism anymore about "American imperialism" or "U.S. warmongering."

In no area is China's dependence on American superpower more important to China than the U.S. Navy's guarantee of the world's sea lanes. These are the routes not only for most of China's exports to the rest of the world, but also for the oil shipments from the Middle East, Africa and Latin America that fuel much of China's economy. Yet, energy also is an increasingly important fault line in the U.S.-Sino relationship. For the last decade, China has aggressively pursued long-term supply relationships with state oil companies across much of the world, including joint ventures, extended leases, and other arrangements. In some cases, China develops another country's oil fields in exchange for sole or heavily-favored access to whatever is found. (In Iran's case, China also sweetened the development deal by building a new Tehran subway system.) China's emerging global network of oil-supply relationships could become a point of conflict in the next global oil crisis.Beyond such a crisis, China's rising economic influence in countries that the United States sees as vital to its own geopolitical plans and interests will almost certainly create new fault lines in future U.S.-Sino relations. But it also could foreshadow a time when China will constructively engage in a number of serious global matters, from climate change and terrorism to intellectual property rights and currency adjustments, where the United States and most of the rest of the world would welcome their contribution.

Noticing and Solving the Problem with Jobs and Wages

America's vaunted job-creating machine has been breaking down, and the administration is finally noticing. 

It was 2003 when I first asked myself whether the dynamics that normally produce lots of new jobs when the economy expands were changing in some fundamental way.  I had noticed that job losses during the mild 2001 recession were five to six times as great as expected, given the modest drop in GDP.   Then we saw that in 2004, two years after the recession ended, the number of employed Americans was still falling, compared to the two months it took for job creation to turn around after the 1981-82 recession and the 12 months it took after the 1990-1991 downturn.  The evidence that America's labor markets were undergoing structural changes of a nasty sort continued to accumulate.  Just as employment had fallen several times faster than GDP during the 2001 recession, so once job creation finally picked up in 2004, private employment gains remained weak.  Over the same period that saw 14 million new jobs created in the 1980s expansion and 17 million new jobs created in the 1990s expansion, U.S. businesses in the last expansion added just 6 million new jobs.   Manufacturing was hit especially hard:  From 2001 to 2004, manufacturing lost more jobs than during the entire "deindustrialization" years from the late 1970s through the 1980s, and those losses continued throughout the entire 2002-2007 expansion.  

With job losses in the current recession already two to four times greater than seen in the downturns of the early 1980s, 1990s and 2001, these dynamics are finally getting broader attention.  Late last week, Larry Summers, the President's chief economic advisor, acknowledged publically that what's known as Okun's Law has broken down.  Arthur Okun, JFK's economic advisor, observed in the 1960s that employment during recessions regularly fell by about half as much as GDP, in percentage terms, which he attributed to the costs employers bear when they fire workers and then have to hire and train again once the downturn ends.   Nobel laureate Paul Krugman also weighed in last week, positing that recessions triggered by bursting bubbles - that would be 2001 and this one -- affect jobs much more than those triggered by tight monetary policies to fight inflation (the 1974-1975 and 1981-82 recessions, for example).  It's an intriguing thought, but it doesn't appear to really jive with the evidence.  The IT-Internet bubble that burst in 2000 certainly helped trigger the 2001 recession, but the downturn's job losses and the subsequent delayed and slow job creation swamped the direct and indirect declines in demand that followed from the implosion of so many Internet and IT companies. 

It's much more complicated than that -- and consequently will be much harder to address.  To begin, the changes in the way our labor markets work also have affected everyone's wages.  During the 1990s expansion, productivity increased by about 2.5 percent per-year, and average wages rose accordingly by nearly 2.0 percent per-year.  That's the way free labor markets are supposed to work: As workers become more productive, employers become willing to pay them more (and which competition forces them to do).   But in the 2002-2007 expansion, even as productivity grew 3 percent per-year - the best record since the 1960s - the average wage of American workers stagnated.  And the most popular political explanation, blaming U.S. multinationals for outsourcing jobs abroad, doesn't hold up here:  Over this period, the number of workers abroad employed by those multinationals hardly rose at all.

This change is also getting more official attention.   Last week, President Obama reminded everyone that economic expansion isn't enough - and we're still quite a way from any real expansion - since most middle-class Americans weren't doing well even before the crisis hit and the economy tanked. 

The administration's agenda could go a long way to addressing these structural changes, if it's done right.   The most plausible explanation is that American jobs and wages are being squeezed by a combination of fierce competition created by globalization and our own failures to control health care and energy costs, two big fixed cost items for most businesses.  The competition has made it much harder for businesses to pass along these higher costs in higher prices - an important reason why inflation has been so low for more than a decade, here and around the world.  But that also means that when companies face higher health care and energy costs that they can't pass along, they have little choice but to cut other costs.   And the costs they've been cutting are jobs and wages.

The only way to ensure that the next expansion won't be like the last one, but instead will create more jobs and bring higher wages, is to make medical cost containment the center of health care reform and make the development and broad use of alternative fuels, from biomass to nuclear, the center of energy and climate policy.  That's not where Congress seems headed.  The House-passed climate bill will do little to drive alternative fuels for at least another decade, when a simple, refundable carbon tax could do the trick.  And the most promising aspects of health care reform for cost-containment - a public insurance option and performance-based reimbursement -- are both under serious congressional attack.   If the President hopes to see more job creation and wage gains than under George W. Bush, these are the places where he should take his stand.

Politicians Who Ignore the Problem with Jobs Could Lose Their Own

While public debate about jobs usually focuses on the unemployment rate, what matters more are the changes in the number of people still working and how many hours they're working, since that determines how much wealth and income the economy produces. On these matters, major developments are unfolding which could play decisive roles in determining not only the economic prospects of millions of households, but also the results of the 2010 and 2012 elections. As it now stands, Democrats in 2010 will have to explain why the jobs numbers are still deteriorating, and President Obama will likely go into his reelection campaign with fewer Americans working than when he took office.

What's been happening with jobs already has broken past records. Since this recession began – the National Bureau of Economic Research pegs the start at December 2007 – the number of Americans employed has fallen by 6.5 million or 4.7 percent. That's far worse than the entire, deep 1981-1982 recession, when the number of people at work fell by 2.8 million or a little over 3 percent. The current jobs numbers also are in an entirely different league from those seen in the recessions of 1990-1991 and 2001, when total employment fell by just a little more than 1 percent.

The number of Americans on the job will also continue to worsen even after this recession finally ends. After the 1990-1991 recession, jobs didn't begin to come back for 13 months – and it took four more years for manufacturing jobs to increase. The pattern was even worse after the 2001 downturn, when the number of Americans working kept on falling for two more years – and for nearly five more years for manufacturing jobs. All told, we may be looking at as many as 9 million fewer Americans working than before this all began. In addition, the number of hours worked by those who have jobs also is falling more sharply than it used to. During the big 1981-1982 downturn, an American worker's average number of hours shrank 1.7 percent, and the recessions of 1990-1991 and 2001 produced declines in average hours of less than 1 percent. This time, average hours on the job are down 2.4 percent already – and it will get worse before this recession ends.

These developments are yet another reason why the next expansion, when it finally comes, will be relatively weak. The main element now available to prop up a coming expansion is the President's stimulus, which was designed to kick in mainly this fall and winter. (The only way to get stimulus out more quickly is tax cuts; but the evidence showed that Bush’s spring 2008 tax relief had little effect on this cycle, since most of it was saved.) But the stimulus is a single shot affair, and the emerging jobs picture suggests that it's time to design a second one.

It's also time to take more seriously mounting evidence that globalization and other developments are taking big bites out of America's long-vaunted capacity for creating jobs. We see this evidence throughout the last expansion (2002-2007), when we added new jobs at a rate barely one-third as great as during the expansions of the 1980s and 1990s. Yet, there are few signs that these developments matter much in the current political debate. For example, a central factor in our new problems creating jobs, even during expansions, has been fast-rising health care costs being borne by businesses. With those businesses facing intense global competition, as most large U.S. businesses do, they've found themselves unable to pass along their higher health care costs through higher prices. So instead, they cut other costs, starting with jobs.

Even so, the health care reforms being considered by Congress all involve even higher health care costs for most businesses, which will mean more job cuts even as the economy grows. No one questions that health care reform is an urgent, national priority -- as are efforts to contain the risks of climate change. But we gain little except a false sense of accomplishment by enacting health care reforms that also aggravate the new jobs problem, or climate legislation such as Waxman-Markey which cannot deliver significant reductions in greenhouse gases.

The right way to do this is to focus first on the underlying problems in the current downturn and the issues with jobs and incomes -- before we take on broad and urgent reforms in other areas. The politics, if nothing else, virtually dictate it, since a growing economy that creates large numbers of new jobs and pushes up incomes is always a prerequisite for the public’s support for reforms that, one way or another, end up imposing new costs on them.

The Lessons of LBJ and Robert McNamara for Barack Obama

Robert McNamara died this week, but his life holds lessons for Barack Obama's presidency.   Arguably the leading light of JFK's stable of the best and brightest, McNamara's work as an architect and chief executive of LBJ's Vietnam debacle is well remembered by tens of millions of boomers who came of age during Vietnam, as well as by the President.   The caution for Mr. Obama's advisors lies in the conundrum of how McNamara's brilliance expedited the implosion of the most progressive presidency since FDR -- and how the spectacular failure of the Vietnam policy and the deep domestic divisions it produced helped deliver a generation-long majority to Republican conservatives.  

Mr. Obama came to his presidency at a moment of great opportunity to reshape the nation, the greatest  since LBJ and FDR.   Fittingly, his agenda - economic revival, universal health care access, abating climate change, and restoring effective American power and influence in the world - is the most sweeping since LBJ and FDR.  The core challenge he and his advisors face, however, involves their character more than their intellects, because the potential for greatness imminent in such moments can distort the decisions of the most brilliant leaders and advisors.   The prospect of grabbing history's golden ring breeds a powerful disposition for best-case scenarios, an indulgence which brought down McNamara and LBJ and now may threaten their successors.

Vice President Biden confessed about it this weekend, acknowledging the now risibly-obvious optimism of the administration's economic forecast.   The Obama team is certainly smart enough to recognize that after a year of real-life, worst-case scenarios which ultimately brought on the first systemic, cascading economic meltdown in three generations, it would be foolhardy to base the President's program on a supposition of a quick, sharp recovery.   Yet, they did.  It may be merely human to want to believe in such a miracle, because it could make everything else possible.   The catch is that without that particular miracle, there will be little money for health care reform, at least without risking the nation's credit-worthiness, and little public willingness to accept the costs of a genuine climate change program.  Most important, without the real prospect of people's incomes growing again, the American public could withhold the political support the President will need, again and again, to successfully deal with untold foreign crises and new domestic problems.

The issue here is not pragmatism, but realism.  Here's a dose to consider.  The yet-unreported chatter among New York financial people these days is that commercial real estate could be on the edge of the kind of crash suffered last year from home mortgage-backed securities and derivatives.  To make matters more dismal, the volume of commercial real estate securities and derivatives dwarfs last year's home mortgage market.  Moreover, commercial real estate lending and securitization are the business of not only Wall Street, but thousands of regional and local banks.  So, if that market goes south, the economic carnage will begin on Main Street.  The New York analysts who talk among themselves about thousands of banks going under in the next year may be suffering from their own kind of post traumatic stress.   But if they're right and the President and his brilliant advisors haven't planned for it, the blame will fall on them; and the most progressive presidency since LBJ could be left in the sort of ruins that can drive a political party and its agenda from power for a long time. 

Even if commercial real estate doesn't melt down - and sovereign debt defaults don't start springing up in Asia and Europe - a rosy forecast isn't the only economic trap waiting for the President and his indisputably brainy advisors.   During the last expansion, job creation fell by half even as GDP generally grew at healthy rates, and the strongest productivity gains since the 1960s didn't stop average real wages from falling.   President Bush and his less than brilliant economic advisors certainly mismanaged the run-up and onset of our current crisis, but we cannot also pin these new structural problems on their mistakes.

Yet, the administration agenda seems to depend on some faith that decent growth and productivity gains in the near future - which both remain problematic - will drive healthy job creation and income gains again as they did in the 1990s.   It's time to put aside that best-case scenario, too, and focus on reforms that might make a difference for these dynamics.  The President could get behind a proposal he supported as a senator, to make free computer and Internet training available to all American adults through community colleges.  He also could redirect the early stages of his energy and health care programs to restraining those costs for businesses.  For the last decade, intense competitive pressures from globalization have prevented businesses from passing along their higher costs in higher prices - the secret of our long, low inflation - but it also forces them to cut jobs and wages. 

If the President and his advisors can live with less than best-case scenarios, they can still achieve their agenda over time, as the economy and people's incomes come back.  In that way, they can escape the trap that snared LBJ and Robert McNamara. 

Will Higher Savings Help or Hurt the Economy?

What happens if Americans come out of the current downturn with a serious commitment to save more? There are many sound and obvious reasons for people to save -- to build up a cushion should they lose their jobs, for example, accumulate the down payment for a house, cover their children's college tuition, and be able to retire on more than their Social Security. Yet, over the last generation, the U.S. personal saving rate fell steadily and sharply, even reaching negative territory, as most Americans decided that the rising value of their homes or stocks could substitute for saving. And anyway, most of us simply preferred to consume more. The drawbacks became painfully clear as soon as the current crisis struck, and those home and stock values nosedived.

For now, personal saving is back, quickly turning positive and reaching 4.3 percent of people's post-tax incomes in the first quarter and nearly 7 percent in May. Businesses also are saving (i.e., they're retaining earnings) -- but not much, since hard times leave them less to save: The private saving rate, which includes businesses and households, was a little under 6 percent of national income in the first quarter. But the national saving rate is down in negative territory for the first time in generations, mainly because federal and state governments are running such big deficits -- i.e., "public dissaving." So households are rebuilding their resources, businesses are holding on, and government is using stimulus to support overall demand.

As there are risks to both families and the economy from under-saving -- our low national saving rate is what's forced us to borrow so much from China, Japan and Saudi Arabia -- high saving brings its own problems. As people save more, they have to consume relatively less, and ours is an economy run for a long-time largely on consumption. A saving rate substantially higher than we've been used to could mean slower growth and fewer new jobs, unless we maintain strong demand with large, permanent government deficits -- a bad idea for other reasons -- or much stronger business investment. Other nations also have some skin in this game of ours: More than $2 trillion of what we consumed last year came from abroad -- imports -- so weaker U.S. consumption means fewer exports and jobs in China, Germany, Japan and a lot of other places.

How we all fare with a higher saving rate will depend in part on how quickly it rises and how high it goes. Nouriel Roubini, the NYU economist who actually predicted the housing and financial market meltdowns, sees personal saving going to 10 or 11 percent, and worries especially about how a quick ascent to those levels could mean a deeper and longer recession. Most Wall Street economists, however, predict a relatively gradual increase which shouldn't impair an initial recovery -- especially since we still have most of the federal stimulus in the pipeline -- but would likely mean a slower expansion. But if the saving rate does continue to go up, it's likely to stay high for some time: Nobel economist Edmund Phelps calculates that it may take 15 years for American households to rebuild what they've lost in this meltdown. And that doesn't count the enormous debts which so many Americans carry today: In the seven years from 2000 to 2007, the debts of American households grew as much, relative to income, as they did during the previous 25 years. All of this helps explain why a majority of Americans now say they plan to keep their expenditures down after the recession ends.

The actual effect of higher saving on jobs, growth and most Americans' quality of life, however, will really depend on what happens to the incomes those savings come out of. If we return to the trends of the 2000-2007 expansion, when real wages declined and real incomes stalled, each percentage point increase in the saving rate will reduce spending by at least $100 billion. That's more than $1 trillion if we reach 10 percent and stay there (and assuming business investment doesn't soar). But if incomes rise 2 percent a year in the next expansion -- as they did through much of the 1990s -- we can save more without having to endure a long period of very slow growth.

It always comes back to incomes. It was, after all, the income slowdown since 2001 which drove up that household debt and pushed tens millions of families to spend down their home equity -- ultimately contributing to the current meltdown. And let's talk politics: Once the recession eases, what happens to wages and incomes will be the critical test of the economic success of Barack Obama's presidency and his large, Democratic majorities.

Unhappily, nothing will be harder to achieve, because restoring the broad income gains we saw in the 1950s, 1970s and again in the 1990s will require, just to begin, slowing increases in the health care and energy costs that businesses bear, and, which in a period of intense global competition come out of jobs and wages. Fortunately, the Obama Administration is focused on both of these problems. The catch is that their programs, at best, will take a decade to produce a significant slowdown in those costs. That's a long time for people to wait while their wages stagnate. But if we don't start now, those benefits will be still further off, and prospects for broad upward mobility could fade for another generation.

Sensory Overload Produces Sloppy Policymaking

Washington policymaking is caught in its own version of sensory overload. All at once, there are too many problems that seem - and actually are -- urgent, mind-bogglingly complex, and politically ultra-sensitive, to handle well. The result now emerging could be waves of ill-considered decisions.

Exhibit A is climate change.Taking serious measures to protect the planet's climate and ecosystems by driving down greenhouse gas emissions comes as close to an imperative as exists in science-based policy. But a small group has used this imperative to try to force a decision quickly, without preparing the public or most representatives for how their cap-and-trade scheme would affect everybody - for example, by increasing the volatility of energy prices, and setting off frenetic Wall Street speculation in the emission permits created by cap-and-trade.That's just the start of the sloppiness: The process of corralling the support to pass the measure in the House of Representatives - the vote is expected this week - has become a frenzy of giveaways that have cost the program most of its teeth and all of its bite. The result is the worst of both worlds: A measure that most environmentalists agree (at least privately) would do little about climate change, while unnecessarily harming the economy. Thankfully, the Senate is unlikely to go along.Once it fails there, perhaps we can get on to more serious and public deliberations about what will be required from all of us to shift to a less carbon-based economy.

Financial regulation is Exhibit B. The minimum for sound policymaking here has to be a genuine recognition of how our capital markets came to melt down and what irreducible steps can prevent it from happening again. We now know, to start, that the most prominent institutions in our financial system have operated for years in ways that create unsupportable levels of risk. We also know that their risky behavior wasn't an accident, but the result of thousands of calculated responses to real incentives. The toxic combination here is what insiders refer to as limited liability plus leverage: The executives, managers, traders and deal makers at Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup, Bank of America, AIG, Merrill Lynch, Goldman Sachs and others could borrow unlimited amounts of money (the leverage) to enter into almost unlimited numbers of risky deals. For the deals that worked out, they pocketed enormous profits and additional compensation; and for those that went south, only the shareholders suffered. If the bottom fell out on thousands of deals at once, they also all believed that they would be both too big to fail and not too big to save - and but for the incompetence of the Bush Treasury in the Bear Stearns and Lehman Brothers cases, they were right.

Today, after $3 trillion to $4 trillion in federal bailouts and federal guarantees, these incentives to undertake risky deals are even greater than they were before. And if the latest OECD forecast is right, and we should expect at best a weak and fragile recovery next year, the incentives to go for a killing will be even greater still.

Yet, most current proposals for new regulation would do little to head this off. Part of the problem with the financial system comes from simple size - firms that are too big to fail - yet none of the proposals even approach this issue. For example, we could debate scaling up a firm's capital requirements with its size:The bigger it is, the less pure risk it can take on - an approach the Administration likes. And with the collapse of so many large institutions, the survivors are now even bigger. So here's another thought we haven't heard much about: Shouldn't the rules of antitrust apply to finance?

We also know that part of the problem is the nature of the risks taken by these huge institutions:Complex derivatives being traded outside regulated markets, and thus not subject to the normal capital and governance rules applied to those issuing them or to the normal disclosure and transparency requirements applied to all transactions in regulated markets. So, requiring that all derivative-like instruments henceforth be traded on regulated public markets seems like a no-brainer. Perhaps sensory overload can help explain why the leading reform proposal preserves the right of those undertaking "large private transactions" in these derivatives to operate outside the regulated markets.If this sloppy decision stands, another element for the next market meltdown will be in place.

We also know that part of the problem lies in compensation arrangements that reward executives, managers, deal makers and traders for the highly-leveraged risks that pan out, but exact no costs for those that don't.The issue here is not how big the bonuses are - that's their business - but rather a structure that actually drives decisions to take unreasonable risks because they carry no personal price.Yet, for all of this issue's urgency, addressing it among the hundreds of others demanding attention has apparently been too complex and politically-sensitive. Why can't we have a serious discussion of creating a new SEC rule that would require a shareholders' vote approving any compensation over, say, $1 million? Better still, how about a genuine debate about compensation arrangements that would claw back previous bonuses to reflect large losses by the same people?

Maybe everybody needs a break to clear their heads - and remember their principles. Let's hope it happens before the new regulatory reforms for climate change and finance become law.

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