Economy

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

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

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

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

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

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

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

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

David Leonhardt points out that the world's poorest are enjoying dramatically improving standards of living:

In a new book called "Getting Better," Charles Kenny - a British development economist based in Washington - argues that the answer is absolutely not. Life in much of Africa and in most of the impoverished world has improved at an unprecedented clip in recent decades, even if economic growth hasn't.

"The biggest success of development," he writes, "has not been making people richer but, rather, has been making the things that really matter - things like health and education - cheaper and more widely available."

NYU professor William Easterly argues that the Eastward movement of economic activity is a good thing for the West:

the richer are our trading partners, other things equal, the more demand for our products, the more and better jobs created thereby, the more gains from trade, the more innovation as the extent of the world market grows, and the more we can benefit from the additional human capital and innovation happening in the East.

Amar Bhidé, a professor at the Tufts University's Fletcher School of Law and Diplomacy, has a new book out chronicling how the use of algorithms and pricing models in finance has "replaced the judgments of thousands of individual bankers and investors, to disastrous effect."

For you econ wonks out there - the Brookings Papers on Economic Activity are now available for free. Yes, free!

Finally, (h/t Ben Smith) a Rolling Stone article on how two early 20-somethings in Miami became global arms dealers is a gripping read.

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

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

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

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

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

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

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

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

The new issue of Democracy Journal is out today, and - as usual - makes a strong contribution to the national conversation around the economy. Of interest to followers of NDN Fellow Dan Carol's work on bottom-up economic development is Andrei Cherny's piece entitled "Individual Age Economics," Cherny writes:

The task ahead in the Individual Age is to create a Horatio Alger economy, a drive to rebuild the possibility of upward mobility that is at the heart of the American experience. For today's middle-class Americans, life is a game of "Chutes and Ladders" with more chutes than ladders. While individuals have been thrown back upon themselves, both progressives and conservatives have acted as if the economy still functions from the top down. If America is to recapture the economic growth that was Hamilton's concern and the broad equality of opportunity that was Jefferson's dream, our mission must be to forge a new economics for the Individual Age that rethinks our economy from the bottom up.

Read the rest of the current issue here.

Ezra Klein points out that Congressional Republicans are being penny-wise and pound foolish about deficits. It's a crazy situation, but taken in totality, the House Republican economic strategy of cuts this year, health care repeal, and making the Bush tax cuts permanent offers, by independent estimates, less growth, fewer jobs, and more debt.

According to a new Gallup poll, 54 percent of Americans see either jobs/unemployment or the economy as the most important issue facing the country. That number compares to the 13 percent who see the deficit/debt as the number one issue.

And a poll conducted by the National Opinion Research Center at the University of Chicago shows that Americans overwhelmingly favor increased spending on domestic programs:

The public's top priority for increased spending - education - provides a contrast, with views across partisan lines holding steady despite sharper concerns about the deficit. Three-quarters favored higher spending on education.

Majorities also supported higher spending on assistance to the poor (68 percent), protecting the environment (60 percent), halting rising crime (60 percent), Social Security (57 percent), dealing with drug addiction (56 percent) or drug rehabilitation (52 percent), and assistance for childcare (52 percent).

In governing, there are generally two reasons political leaders make decisions: policy and, more often, politics. That's why the current obsession with near term budget cuts is so mind-boggling. While the long-term fiscal picture is an important policy question, there are not political or policy reasons to make anywhere near the cuts currently on the table.

From a policy perspective, we often hear that the United States is broke. If you only read one thing today, read about why the United States is not. Not only is the US not broke, it's not anywhere close. Bloomberg's David Lynch lays out why:

"The U.S. government is not broke," said Marc Chandler, global head of currency strategy for Brown Brothers Harriman & Co. in New York. "There's no evidence that the market is treating the U.S. government like it's broke."

The U.S. today is able to borrow at historically low interest rates, paying 0.68 percent on a two-year note that it had to offer at 5.1 percent before the financial crisis began in 2007. Financial products that pay off if Uncle Sam defaults aren't attracting unusual investor demand. And tax revenue as a percentage of the economy is at a 60-year low, meaning if the government needs to raise cash and can summon the political will, it could do so.

From a political perspective, while, again, people care about debt, the fiscal picture is, at best, a secondary issue. From a new Bloomberg poll:

Americans are sending a message to congressional Republicans: Don't shut down the federal government or slash spending on popular programs.

Almost 8 in 10 people say Republicans and Democrats should reach a compromise on a plan to reduce the federal budget deficit to keep the government running, a Bloomberg National Poll shows. At the same time, lopsided margins oppose cuts to Medicare, education, environmental protection, medical research and community-renewal programs.

While Americans say it's important to improve the government's fiscal situation, among the few deficit-reducing moves they back are cutting foreign aid, pulling U.S. troops out of Afghanistan and Iraq, and repealing the Bush-era tax cuts for households earning more than $250,000 a year.

The results of the March 4-7 poll underscore the hazards confronting Republicans, as well as President Barack Obama and Democrats, as they face a showdown over funding the government and seek a broader deficit-reduction plan.

"Americans do not have a realistic picture of the budget," says J. Ann Selzer, the Des Moines, Iowa-based pollster who conducted the survey. "We all know people who are in debt yet cannot for the life of them figure out where the money goes."

Overall, public concern about the deficit -- which is projected to reach $1.6 trillion this year -- is growing, although it's still eclipsed by employment, with poll respondents ranking job creation as a higher priority.

I understand why a conservative movement would listen to a base obsessed with shrinking government. What I don't understand is why anyone else would.

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

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

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

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

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

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

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

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

In the past weeks, NDN and the New Policy Institute hosted two major events on the economy. The first, a discussion with Rob Shapiro of NDN, William Gale of Brookings, budget expert Stan Collender, and Kevin Hassett from AEI, is called "The Budget and the Economy:"

At the second event, NDN's Rob Shapiro led a discussion on "Winning the Future" with National Economic Council Deputy Director Jason Furman:

Simon Rosenberg along with Brad Blakeman; former Deputy Assistant to President George W. Bush, discussed President Obama's remarks about Wisconsin's labor union debate at the National Governors Association's 2011 Winter Meeting.

Hoping to avoid the fate of other leaders in the Arab world, the King of Saudi Arabia has introduced a number of welfare measures targeting unemployed or poor young people.

Martin Wolf, in the FT, tells us why youth are in such a revolting state of mind.

David Leonhardt looks back on the debate between Germany and the United States on stimulus versus austerity. Turns out austerity didn't really work - Why Budget Cuts Don't Bring Prosperity. Now if only there were an ongoing debate to which this evidence could be applied...

Mother Jones says "It's Inequality, Stupid" and has some snazzy charts to back it up.

Jonathan Chait tries to understand why Republicans are moving things in the direction of a government shutdown.

The National Journal counts down to government shutdown.

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

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

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

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

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

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