![Government and the New Economy [D]Efict Reduction of This Magnitude Could Be 'Costless](http://data.docslib.org/img/c1ee6df5a44c4ec09a143c0546c5e2d8-1.webp)
Government and the New Economy [d]efict reduction of this magnitude could be 'costless... Three events could offset the contraction from cutting the deficit. First, traders could buy and sell bonds at lower long-term rates...Second, the Federal Reserve could lower short-term interest rates...Third, increased foreign buying from more trade could provide a boost to the American economy.
Introduction
In the early 1990s the press was filled with gloom and doom stories of the economy and government finances that were out of control. The Times Square National Debt clock that had been installed in New York City just a few years ago reached $4 trillion and there was talk of an amendment to the US Constitution to force the federal government to balance its books. By the end of the decade the economy was booming and the distance between the US and its closest competitors had widened significantly leaving the US as the sole economic superpower. Talk of jobless recoveries were replaced by talk of a "New Economy" that was breaking records for months of uninterrupted economic growth without inflation and those deficits had been replaced by surpluses. In fact Fed Chair Alan Greenspan was even expressing concerns about the prospect of the government paying off all of its debt. These were the best of times with parallels being drawn between the Information Revolution of the 1990s and the Industrial Revolution of the 1890s.
No one foresaw that within another decade the economy would be mired in the worst recession since the 1930s that closed a decade in which the country actually lost employment and a new competitor had surfaced to challenge US supremacy. As the US struggled to escape the Great Recession, it spread across Europe where it turned Europeans against Europeans – mostly northerners against southerners in a modern version of a civil war that threatened the euro – and it brought some countries close to bankruptcy. In the US once again there were calls for a balanced budget amendment as the debt clock actually ran out of digits as it passed the $10 trillion mark.
In this unit we will examine more closely government finances, a topic of considerable debate since at least the Reagan years that is only intensifying. We begin with a look at the government’s finances, and then review the transformation of Bill Clinton from a deficit dove presidential candidate into a deficit hawk president. This is followed by the boom and bust era George Bush presided over, and an examination of Obama’s fiscal, and Bernanke’s monetary, policy responses to the Great Recession. You will find an eerie similarity between the debates of the Great Depression and we started the course with those of the Great Recession. The unit closes with a look at the financial crisis that overwhelmed much of Europe and led some countries to the verge of bankruptcy and Depression era unemployment rates.
Government Finances
You can tell a good deal about a person's life and his/her priorities if you had their credit card records or tax returns for a year to see how much they earned and where they spent their money, and the same is true when we look at a government's "books." The financial condition of the government, like your financial position, is summarized in income and balance sheet statements. The government’s income statement is called the budget, and for the federal government we even have a government agency devoted to keeping the books – the Office of Management and Budget) (OMB) that is the source of most of the data in this unit. We are doing this because most of what we hear in the news pertains to the federal government,
1 although you should know that it is the state and local governments where spending and taxes are rising more rapidly.i
The income statement simply records the money coming in and the money going out for some specified period of time. Governments get their money from taxes and fees (Receipts) and spend on many things including roads, law enforcement, nuclear weapons, public schools, parks, and pensions (Outlays).ii Often there, however, is an imbalance in the finances. For example, I need to borrow money to buy a $600,000 house, you to pay $45,000 for a year of college, or the US government to pay $400 billion to fight a war. In each case the money coming in is less than the money going out, which we call a deficit. Somehow the money needs to be raised to finance the deficits, so in my case I get a mortgage on the house and you get a student loan that allows us to spread the payment over a number of years. For example, I would try to get a 30-year mortgage to spread the cost out over 30 years, and at a rate of 4.5% I would “own” the $600,000 house with monthly payments of about $3,000. In the case of a student loan, if you could spread the $45,000 out over 10 years at 4.5%, the monthly payment would be $466.
In the case of the government, because of its size and power, it has another option for borrowing the money. Where you and I might go to the bank to finance our borrowing, the federal government issues bonds (US Treasuries) that investors buy. Below right is an image of a US Savings Bond that is an example of a bond issued by the federal government. The US federal government prints these bonds and investors all over the world buy them. This is no different from governments all over the world that run deficits and pay their bills by issuing bonds. Below left is an image of an ad poster from WW II. Today investors all over the world buy these bonds, but in WW II when the government ran HUGE deficits it ran promotional campaigns with posters such as the one below left to get Americans to buy bonds. It also helped that some goods were rationed so people had limited uses for their funds.
The investors get the bonds with a promise to redeem them at a specified date in the future (6-months and 10-years are two examples) and the government gets the money to pay its bills.
These bonds have a specified length indicating how long the government can spread the payments over. If you purchase a one year $1,000 government bond at 3% interest, then the government pays you interest of $300 for borrowing the money for a year and then pays you back the principal of $1,000 at the end of the year. The government could also try to borrow money for 30 years, just as I would do with a home mortgage. The advantage to the government of borrowing for shorter periods of time is the interest rate is lower – something discussed in the macro course. The disadvantage is that when the debt comes due the government will need to borrow again to pay the holder of the original debt – a problem encountered by Greece that we examine at the end of the unitiii
If the income statement is a moving picture of what is earned and spent, the balance sheet is a snapshot of net worth. In my case I would add up the value of my home and car and other assets and then subtract the value of my liabilities (loan and mortgage balances) to get my net worth. When we look at the federal government we add up all of the bonds that are in the hands of investors, we have the national debt. One
2 difference between the federal and state and local governments is that most state and local governments are required by law to balance their budgets, while the federal government has no such restriction.iv
Government finances and functions: How to interpret the numbers
When talking about the size of government spending and taxes, you need to be careful because this is such a contentious issue there are a lot of numbers thrown around, and not all of them are that meaningful. For example, is it “crazy” for a government to spend $876 billion? Should we be worried that in 2010 the US government borrowed 26 times more than the most it borrowed in any year in WW II? The short answers are NO because these numbers are irrelevant. As for the borrowing figures, many things have changed between the 1940s and the 2010s that matter in any comparison over time. The actual numbers are not what are important; for the meal it would be the cost of the meal relative to monthly income, for the government’s spending and borrowing, you would want to make some adjustments to reflect the fact there are more people today, that prices are much higher today, and that the economy is much larger today. The adjustments exist - per capita figures for population adjustment, real figures for inflation adjustment, and outlays/GDP and receipts/GDP to adjust for the size of the economy.
The impact of the alternative measures can be seen in the graphs below. The growth in government revenues and outlays during the 20th century is evident in left-side diagram. In 2010 federal government outlays were approximately $3.72 trillion – about $9,700 per person or nearly $6 million a second - and revenues were $2.16 trillion. These were by far the highest in US history, but barely visible are the surges in outlays in the late 1910s and early 1940s associated with the two world wars and the Reagan tax cuts in the early 1980s. What you can see more clearly because they are more recent are revenue declines from tax cuts in the early 2000s (Bush) as well as the revenue declines and spending increases in the Great Recession in the late 2000s. It is very easy to look at these data and talk about runaway government spending and onerous taxes.
Things look very different, though, when we look at the ratio variables in the right-side graph. The two wars that barely registered in the first graph are quite visible. During WW II federal government outlays approached 50 percent of national output as assembly lines were converted from autos to tanks and consumers cut back their spending. Also evident is the increase in outlays during the Great Depression of the 1930s – an indicator of Roosevelt's New Deal. After WW II outlays did not return to 1920s levels because many New Deal programs such as Social Security remained after the war and because the US "slipped" right into the Cold War that turned 'hot' in Korea in the early 1950s. The combined effect of creating a more active federal government and a much bigger military can be seen in the upward trend in outlays - from less than 5% of GDP at the outset of the Great Depression to 10% before WWII to 15% in the 1950s to near 25% by the late 1970s. Beginning in 1980 the growth in federal government outlays slowed and the ratio to GDP dropped from 22% to 18%, so that in 2000 government spending was $341 billion less than it would have been if outlays had remained at 22% of GDP. The War on Terror coupled with rapid growth in other government spending in the Bush years helped halt the downward trend, and then the Obama stimulus during the Great Recession of 2009-2010 raised the figure to 25%, a number not seen since WW II.
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When looking at the outlays an important distinction is that between discretionary and nondiscretionary spending. Discretionary spending is spending that is specified in annual appropriations authorized by Congress and includes most of the military spending. Nondiscretionary spending is spending that is mandatory for those entitled to the payments and includes unemployment benefits (entitled by one’s unemployment status) and Social Security benefits (entitled by one’s age). As you see in the following slide, there has been a significant change in the composition of spending, with the share under control of government declining steadily from about 70% in the early 1960s to about 30% in the early 2010s. This is an important source of disagreement between Republicans who want to limit entitlement (nondiscretionary) spending, and Democrats who want to find the revenues to fund them. It is also an important distinction for those interested in balancing the budget since in the absence of entitlement reform – rewriting the legislation like raising the retirement age for Social Security – all of the reductions in spending will need to come from discretionary spending. This would be devastating to discretionary spending. For example in 2012, both the budget deficit and discretionary spending were about $1.3 trillion, which means to eliminate the deficit without additional taxes or and changes in nondiscretionary spending, ALL of discretionary spending would need to be eliminated.
On the revenue side, the tax increases to finance WW I, WW II, and the Korean War are evident, as is the rise in federal revenues’ share of GDP from the 1930s through the 1950s – from 3% in 1932 to 19% in 1952 - and then its fluctuation between 17% and 21% through 1999. If you look carefully you can see a dip in revenues due to the Reagan (early 1980s) and Bush (early 2000s) tax cuts plus the increase from the Clinton tax increase (mid 1990s). In addition to policy changes there is also a business cycle effect – with taxes rising in good years and falling in bad years. You can see this in the rapid economic growth of the 1990s that combined with the Clinton tax increase, helped push revenues higher (to 21% in 2000), and in the combined effect of the Great Recession and the Obama payroll tax cut of 2008-2010 that reduced revenues to 15% of GDP, a number last seen in 1949. Looked at a bit differently, if taxes had remained at 20% of GDP in 2012, tax revenues of the federal government would have been 25% higher – a cool $627 billion higher than actual revenues.
Another feature of the government’s finances evident in the graphs is the government rarely balances its budget. It generally runs budget deficits, which means it must find a way to raise funds to pay its annual bills. Here is one place government’s finances are different from ours. You and I have one option if we are to pay the bills – we must borrow the money. Governments can do this, but they also have another option – they can simply print money, which some countries might do this if the same people making the spending and taxing decisions control the printing presses. In the US that is not the case, so when the government runs a deficit then it must borrow the money to pay its bills. This is generally not a problem, but if investors get nervous about the borrower’s ability to repay the loan, governments can have real problems raising funds as we saw in Greece in 2011-2012.
Now let’s look at the history of budget deficits in the US, a subject of very heated debates that have a clear ideological dimension. You barely see the deficits incurred during WW II and the Great Depression, the last budget surplus was during the latter years of the Clinton presidency (late 1990s), and the largest
4 deficits in history are clearly the Obama deficits (2000s). In 2011 the US government’s budget deficit was $1.3 trillion, three times the Bush deficits and twenty six times the deficits of the WW II years.
As with the receipts and outlays, however, these numbers are not particularly important unless you want to grab a headline. To see why, ask yourself how much you could borrow this year before you get into financial trouble and think about comparing it to my number. The numbers would probably be different, with mine substantially larger because how much we can safely borrow depends on how much we make because payments will need to be made on the borrowed money. For example, let’s look at the $1,060 monthly cost of a $100,000 10-year loan at 5% interest. The burden of that payment is very different for someone making $2,000 a month than someone making $5,000 a month, which is why on most loans you will need to provide information on your income.
For this reason when we talk about the government’s deficit, the best approach would to look at the deficit relative to the size of the economy. When looking at the finances of the government we adjust them to account for changes in the size of the economy by creating a new variable - deficit/GDP. Looking at the deficit/GDP graph, WWI and WW II are very evident in the dips (bigger deficits) just prior to 1920 and after 1940, but you cannot really see the Korean and Vietnam wars. The deficits caused by the Reagan and Bush tax cuts can be seen in the dips in the early 1980s and just after 2000. The combined impact of economic downturns and government policies can be seen in the small dip before 1940 during the Great Depression and the big dip after 2008 in the Great Recession. These reflect a loss in government tax revenues due to decreases in income taxes – if you do not have a job you do not pay income taxes – plus spending increases and tax cuts to stimulate the economy. And sometimes it is a combination of the two as in the Clinton surpluses in the late 1990s that came from a strong economy and a tax increase.
When we add up all of your IOUs we end up with an amount of money you owe your creditors, and we would call it your liabilities or your debt, and stories about these often end up in the press. For example, in 2012 stories began to surface that student loan debt passed a $trillion, while in 2013 stories noted that consumer credit card debt was rising again, which was taken as a sign the economy was improving. When talking about the government, we are talking about government debt that measures what the government owes its creditors. When the federal government runs a budget deficit its indebtedness rises.
When we look at the data we see two sets of numbers that represent the US debt – total debt and debt held by the public. It is the latter of these that is the more important measure of the government’s indebtedness, and it includes the securities sold to investors outside the federal government. In 2011, the two biggest owners of US debt were domestic private investors (you and me) who owned about one-third of the debt and international investors (China’s government) that owned almost one-half of the debt. Of these two groups, when the government pays interest on the debt to domestic investors it is simply transferring funds from those who pay taxes to those who collect interest on the government bonds they own. This would be similar to financing that loan with borrowing from a sibling or parent. It's still a loan, but it's family.
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Source: http://www.gao.gov/special.pubs/longterm/debt/index.html
What is the real concern, and what caused so much trouble in the financial crises in the 1990s and 2000s was the part of debt owned by international investors who could move their money into and out from a country quickly. In the US the share owned by foreign investors has risen substantially – from 37% in 2001 to 46% in 2011 - and of those foreign investors, the two largest holders of US debt in 2011 were China with $1.3 trillion and Japan with $882 billion.v Also included in this list are the energy rich areas (Middle East, Russia, and Brazil), international banking centers (Switzerland, Cayman Islands, and Luxembourg), and countries with large trade surpluses (Taiwan and Hong Kong).
As for the size of the debt, once again we should adjust it for the size of the economy. In the first graph is the actual data and it appears as though the debt of the US began “exploding” in the 1980s with the Reagan deficits, and then after only a brief reversal in the late 1990s with those Clinton surpluses, it began to rise again with the Bush deficits and then the Obama deficits. By 2012 total federal debt was $16 trillion with $4.8 trillion held by the government (think SS) and $1.6 held by the Federal Reserve (think Quantitative Easing). These are big numbers for sure, but to make them meaningful historical comparisons we once again need to normalize the data.
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When we adjust the debt for the economy's size, which is really what you should look at to gauge the “burden” of the debt, you see a very different picture. The buildup of debt to pay for WW II is very obvious and by the end of the war US debt equaled the size of the economy. After WWII the ratio fell to 18% in 1974 and then began to rise when the Reagan deficits began adding to the government’s debt. It then fell during the Clinton surpluses of the 1990s before rising again during the Bush deficits of the 2000s and then rising sharply when the Great Recession hit and Obama ran large deficits as a result of spending increases and tax cut.vi
What do these numbers mean? If someone called in the loans made by the US government in 2012 it would cost the US about 60% of the value of all goods and services produced that year to pay off our loans. The big question on many people’s mind now is: Does the country’s indebtedness mean the US is headed for its own sovereign debt crisis? We will talk more about this in the later when we examine the European Sovereign Debt Crises of the early 2010s, and when we do you will see it is largely the same debate that raged in the 1930s. On one side were the liberal Keynesians arguing for more spending, while on the other were the conservatives arguing for austerity and the elimination of any government deficits. First, however, we will look at Clinton’s transformation into a deficit hawk.
Before leaving our discussion of the government’s finances, you should note three important differences between your finances and the finances of the federal government.
1. The government has no life expectancy: When people die their estate is settled and all debts must be repaid. This is not the case with a government that has no time limit and thus may never need to settle its debts. 2. The government can print money: To pay your debts you will need to earn money, but the government can print money to pay its bills - at least as long as people accept the money. There are limits to how much money a government can print, though, and when governments exceed those limits inflation appears. 3. The government owes much of the debt to itself: Some of you probably own US savings bonds, which mean you own a small piece of the government's debt.
Now let’s move on and take a look at Clinton and his transformation.
Clinton and the New Economy
The 1992 election pitted the incumbent president, who just a year earlier had achieved approval ratings above 90% after the country emerged victorious from a quick “war” in the Middle East, against a young politician with a simple message. In many respects it seemed to be a replay of the 1960 election pitting a vice president in an administration that had approval ratings above the 70% in the year preceding the election, seeking to move up against a young politician with a simple message. In both cases the upstart opponent had focused on a poorly performing economy and promised to turn things around with some traditional Keynesian fiscal policies. In both cases they won close elections. Kennedy delivered on his
7 promise to get the economy moving with large tax cuts, and it worked as the nation experienced the longest uninterrupted expansion in history – 106 months.
Bill Clinton followed Kennedy’s lead and campaigned with the promise of a middle class tax cut and a pump priming increase in spending to get the economy moving. Once elected Clinton did an about face and raised taxes and cut spending, but he did deliver on his promise of economic growth. The economy set off on an expansion that set a new record for uninterrupted growth when the expansion hit 120 months. So why did Clinton change his policies and how did he deliver on his economic goals?
The short answer is that Clinton had one of those “born again” moments where he "saw the errors in his ways." The person behind this rebirth was conservative Alan Greenspan who had succeeded Paul Volcker as chair of the Federal Reserve. In response to the sluggish economy, Greenspan lowered the discount rate reductions from 7% to 3%, but unfortunately for Clinton this monetary policy failed to produce speedy growth and the deficit continued to grow. What Greenspan found troubling was that by pushing down the discount rate he was unable to push down long-term interest rates, and he convinced Clinton that this was the problem he must address.”vii
We begin with candidate Clinton's initial plan that included increased government spending and tax cuts to help get the economy moving. This traditional fiscal stimulus shows up as an outward shift in the AD (AD Ú), which would raise GDP output that should push the unemployment rate lower.viii The only downside would be higher prices.
Greenspan, however, looked back to Classical economists for his solution. He believed Clinton’s proposed spending and tax cut package would increase in the budget deficit would and this would be financed by increased borrowing that would drive up long-term interest rates – a simple restatement of Crowding Out. These higher rates would discourage businesses from borrowing funds to modernize their plants and individuals from buying homes and autos. In Greenspan’s view, the initial increase in AD (AD Ú1) from the Clinton stimulus (éG) would be offset by decreased investment and consumption spending (êC & I) that would shift the AD inward (AD Ù2).ix
And that was not the end of it. As a result of rising interest rates, wealthy investors looking for a high return would invest in US government bonds with their high interest rates and this would increase demand for US $s. This rise in the exchange rate would make it more difficult for domestic producers to compete with foreign producers. The result would be a decline in export spending (êX) that would translate into a further leftward shift in the AD curve (AD Ù3).
And that was not the end of it either. In the long-term the loss in investment spending today would lead to older factories and machines - a reduction in the nation’s productive capacity so the AS would shift inward (AS Ù). If we add all of the effects together we get the initial stimulus (AD Ú1) offset by two reductions in (AD Ù2 & AD Ù3) plus a reduction in AS (AS Ù). The result is no outward sift in AD and an inward shift in AS, and if you draw this in an AS-Ad diagram you find you have recreated the dreaded stagflation of the 1970s. If Clinton's were to deliver on his prosperity claim, he needed a new plan.
8 The solution seemed counterintuitive, especially for a Keynesian.x Greenspan convinced Clinton at their meeting to redirect his efforts away from the tax cut and spending increase toward deficit reduction. As Greenspan explained to Clinton:
[h]istory showed that with such vast federal expenditures, inflation would inevitably soar at some point. The double-digit inflation of the late 1970s had been induced by the budget deficits from the Vietnam War. Investors were now wary and demanding a higher long- term return because of the expectations on the federal deficit.... if the new administration removed or altered that expectation...the market expectations would change. Bond traders would have more faith that inflation would stay under control. Long-term rates would drop, galvanizing demand... In addition, as inflation expectations dropped, investors would get smaller returns on bonds. As a result, they would shift their money to the stock market. The xi stock market would climb - another payoff.
Alan Blinder, a participant at that meeting, also delivered the message to Clinton that there were long-term growth benefits from a budget reduction, and short-term costs of a cyclical downturn. According to Blinder:
[d]eficit reduction of this magnitude could be 'costless... Three events could offset the contraction from cutting the deficit. First, traders could buy and sell bonds at lower long- term rates...Second, the Federal Reserve could lower short-term interest rates...Third, increased foreign buying from more trade could provide a boost to the American economy.xii
Clinton understood the message, although he was not happy about the power wielded by the bond market. According to Woodward, Clinton’s response to the news he was hearing was, "You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of fucking bond traders."xiii And there was no one there to say he was wrong.
The Greenspan plan, in terms of the AS-AD diagram, went like this. The initial decrease in government spending and or tax increase reduces AD (AD ¡1). The economy would then “receive” the gift of a sharp reduction in long-term interest rates that would trigger an increase in investment spending that would increase AD (AD ¢2). Also, stock prices would begin to rise as investors moved their money out from low interest bonds and began buying stocks, and this new wealth would make people feel wealthier and increase consumption spending (AD ¢3) The increase in investment spending, meanwhile, would translate eventually into new factories and machines that would push the AS curve to the right (AS ¢). This alternative provided a "costless" solution to the problem of a stagnant economy, and it was far more likely to work than his original plan.
Clinton bought into the plan, something that angered many of his liberal supporters, but the results were beyond anyone's expectations. After decades of watching other nations catch-up, the US distanced itself from the crowd. Investment spending surged as the rise in stock prices lowered firms' cost of raising funds. Growth was fastest in business investments in equipment and software as firms loaded up on information technology, but there was also a surge in residential construction as a housing boom took off. Consumption spending kept pace, fueled by debt-funded purchases of durable goods - think computers – and exports also increased as foreigners stocked up on US technology products. These increases in AD were more than enough offset reductions a near 20% reduction in government spending.
And, Clinton also benefitted from a supply-side effect. According to the Council of Economic Advisors (CEA), somewhere in about the middle of the decade US companies began to realize productivity gains from their massive investment in computer technology.xiv In terms of the AS-AD diagram, the initial outward shift in AD (AD Ú) is accompanied by an outward shift in the AS curve (AS Ú). The result was a rapid rate of growth with downward pressure on prices. This was called the “New Economy” and the US became the marvel of the world.
9 The promise of the New Economy, and the budget surpluses it created, didn’t last long. By the end of 2000 technology stocks were way down, an average of 50 percent, the economy was in recession, and the US had a new president – George Bush II - who had promised the American people to get the economy moving. In the following year there were two additional “shocks” to the US economy - China entered the WTO and manufacturing employment began falling by more than 120,000 a month in the year after China’s entry, and the 9/11 terrorist attack.
The president responded to the shocks with a 2002 invasion of Iraq to bring capitalism and democracy in the tumultuous Middle East and spread economic growth and peace across the region. At home the “solution” would be a massive tax cut modeled on Reagan’s and targeted at the nation’s wealthiest. As of mid 2003 Middle East peace had not arrived, and the NASDAQ market for tech companies had not regained its peak, although the broader measures of stock were reaching new highs by that time. The US the recovery was unusually slow, taking nearly 4 years to recapture the losses in the recession. But, all was not lost because Federal Reserve chair Alan Greenspan drove down interest rates setting the stage for the housing boom - and the great bust that triggered the Great Recession of 2007? This is the signature economic event of the 2000s and it provides an opportunity to pull together for one last time many of the pieces of the semester’s macroeconomic story.
The Great Housing Boom
Financial crises have been around for quite some time and have affected countries all over the world, but there is something different today. These “bubbles were once very rare … [but] nowadays we barely pause between such bouts of insanity.”xv In the last 30+ years I have lived through a stock market bubble and two real estate bubbles in the US, stock market and real estate bubbles in Japan, Latin America and Asian financial crises, the European debt crisis, and two gold bubbles.
So what’s going in here? There is no single factor that explains all of these bubbles, although there is no shortage of accusations as to the causes of the Great Recession in the US and debt crisis in Europe. It was the perfect opportunity for conservatives and liberals to sift through the ruins of the economy and provide vindication for their policies and vilification of the policies of their opponents. What we do know is the catalyst behind both was the financial crisis that began in the US, so that is where we will start – with this short definition.
A financial bubble is a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression.xvi
The financial crisis that precipitated the Great Recession certainly fits this definition, and here we will examine some of the major forces that created the bubble – the promotion of home ownership, a stagnant and increasingly leveraged economy, deregulation of the financial sector and a proliferation of new financial instruments, increased availability of funds due to globalization, international trade imbalances, Federal Reserve policies, fading of memories of the Great Depression that led to an underestimation of risk,
10 and badly behaving players. Embedded in the story of the Great Recession will be a number of graphs, so pay attention to them and make sure you see how they relate to the story.
Promotion of home ownership
Homeownership has been important since colonial times when you needed to own land to vote. Eventually this restriction on voting was eliminated, but homeownership remained a focus of public policy because it was viewed as “a pillar of economic and social welfare is deeply ingrained across much of the rich world.”xvii It is associated with better communities, more involved citizens, greater social stability, and wealth accumulation, and as a result there is a long history of policies to promote home ownership – “nudges towards the purchase of a home. Tax policy frequently subsidizes those who borrow to buy, financial rules reduce loan costs by providing guarantees to institutions that offer mortgages, and local governments craft zoning rules that favour properties more likely to attract buyers than renters.”xviii
We’ll pick up the story in the US in the first decades of the 20th century when the home ownership rate was about 45%. At that time there were no long-term mortgages – 3 to 5 years were the norm then v. the 30- year fixed rate of today - and down payments would be in the 50 percent range rather than today’s 10-25 percent. Once the Great Depression hit, mortgages could not be refinanced and new mortgages were not issued because of all of the uncertainty. Without access to funds, home foreclosures, along with unemployment, surged, while home construction and sales plummeted. Roosevelt needed to act, and the National Housing Act of 1934 established the Federal Housing Administration (FHA) to insure mortgages and set terms for mortgages making homes more affordable. In 1938 the Federal National Mortgage Association (Fannie Mae) was established, which marks the beginning of the securitization of the mortgage market. Fannie Mae had the backing of the federal government so it would borrow money at low rates and then use the money to purchase mortgages from financial institutions. The mortgage payments would go to Fannie Mae that would profit from the difference in interest rates, and the banks would have more funds, and less risk, to expand home lending.xix
The next government initiative to increase homeownership was the Servicemen’s Readjustment Act of 1944 – the GI Bill. This bill created a number of benefits for returning veterans including subsidies to attend college and low interest mortgages to by homes. By 1960 the homeownership rate had risen from the low 40% range to 62% by 1960 and then continued to rise slowly through1980 to almost 65%.
Source: National Association of Realtors’, Social Benefits of Homeownership and Stable Housing, April 26, 2012
Growth stalled in the 1980s, though, and among the young the rate actually declined. Large differences also persisted across racial and ethnic groups. The homeownership rate among blacks and Hispanics was less than 60% of the rate for whites, which prompted president Clinton to unveil his National Homeownership Strategy in 1995 designed to lower the barriers to home ownership. George W. Bush also wanted to promote homeownership, but his motives were a bit different. In the aftermath of the .com stock market bust and 9/11, with the US economy heading into recession, the president picked up on the theme of
11 Roosevelt’s 1st inaugural message that the “Only Thing We Have to Fear Is Fear Itself.” Bush encouraged Americans to overcome any fear from the 9/11 attacks and get out there and spend.xx Bush promoted the ownership society, as you can see in an excerpt from a speech on Oct. 15, 2002
We can put light where there's darkness, and hope where there's despondency in this country. And part of it is working together as a nation to encourage folks to own their own home.
To achieve this goal, people who had been unable to own homes would have to now qualify for mortgages. One possibility would be a growth in income so they could afford mortgages, but as you will see, it was not what happened.
Stagnation and leverage
By the early 1980s two important trends were becoming apparent. First, annual income gains for many were slowing down. From 1947 to 1977, income across all segments of the income distribution doubled as a result of an annual growth rate of 2.3%. This was the American Dream – rising income ensured each generation a better life than the one of their parents. In the following 30ish years (1979- 2011) median income barely budged – rising only .16% a year, with all of the gain occurring before 2000. Second, those averages conceal a significant change in the composition of income growth. Since the late 1970s income of those at the very top (95th percentile) far outpaced those in the middle (Median) and lower ends (20th percentile) of the income distribution. In fact, the income of those in the 20th percentile was actually lower in 2009 than it was in 1979. The American Dream was truly just a dream for many in society including blacks and Hispanics, and this made them susceptible to snake oil salesmen offering them an alternative route to that Dream.
One potential “solution” to stagnating incomes was higher labor force participation rates – primarily more women entering the labor market – and between 1980 and 2000 the rate increased 3 percentage points to 67 percent. A second potential “solution” was increasing indebtedness / leverage with Americans going further into debt to sustain the Dream, which they did. In 1951 total financial liabilities – debt - of households was 32% of personal income, and by 2000 it had risen to 54% as more Americans took out mortgages to buy homes and started using those credit cards that began to replace cash in our pockets.
Household Debt and Personal Income Mortgage Total Liability / Liability / Mortgage Total Disposable Personal Personal Personal Liability Liabilities Income Income Income Income 1951 52 85 236 265 0.20 0.32 1980 856 1,348 1,932 2,216 0.39 0.61 1990 2,334 3,483 4,164 4,745 0.49 0.73 2000 4,493 6,880 7,175 8,380 0.54 0.82 2007 10,096 13,514 10,256 11,714 0.86 1.15 2013 9,379 13,379 11,998 13,603 0.69 0.98 Data source: FRED
Then the heavens unloaded. As income growth disappeared, credit appeared and between 2000 and 2007 total household liabilities doubled, rising more than twice as fast as personal income and enough to drive the liability/income ratio to 1.15 and the mortgage liabilities to 86% of personal income. Americans had
12 managed to sustain their lifestyles, but they did it by working longer hours and going further into debt, and now we’ll look at one of the sources of those funds.
Availability of funds
American households would need to borrow BIG money to buy homes, and it turns out American households were the beneficiaries of some international developments. First, with the advance of globalization, capital was moving around the world pretty freely in search of the highest rate of return. This is how globalization is supposed to work, but there was a downside to it. In the 1970s money flowed into Latin America to finance economic growth there, but in the early 1980s investors withdrew their money and the Latin America Debt Crisis pushed the region into a lost decade. In the 1990s it was Asia that was booming and attracting investors wanting to cash in on the growth, but in 1997 those same investors turned against Thailand and began withdrawing their money. The impact was quick and dramatic. Thailand was unable to finance its foreign debt and its currency quickly lost half of its value, which you can see in the graph below.
And that was only the beginning as the dominos began to fall. The crisis spread and soon we had the Asian Debt Crisis – a good example of financial contagion. In the following year investors began to worry about Russia that was struggling through the transition from communism and falling oil prices – its primary export – and their withdrawal of funds created the Russian Financial Crisis.
In this environment the US looked like an attractive place to invest, and money began to pour in. This pushed interest rates down and the stock market up. There was also China – the rising economic power that had escaped the financial crises. As you recall from the 1970s unit, the US spent way too much buying China’s exports and $s poured into China and out of the US. This should have lowered the value of the $ (raised the value of the yuan) and raised interest rates in the US, but this would have slowed the US economy and reduced US demand for China’s exports. China’s “solution” was to pour money into the US by buying US government bonds, and this inflow of funds helped keep interest rates low and the value of the US $ high as you can see in the exchange rate graph above.
The Federal Reserve also played a key role. When the economy was “shocked” by 9/11 and the bust in technology stocks, the Fed responded quickly. As you can see in the graph below, in a matter of months the federal funds rate dropped from 6.5% to 2% - a Keynesian move by the conservative Greenspan – and this pushed mortgage rates lower (7.8% to 5.3%). These lower rates allowed American consumers to increase their borrowing and spending. For example, a drop in the mortgage rate from 6.5% to 2% would reduce the monthly payment on a $106,400 mortgage from $766 to $380, which would allow more people to afford to purchase a home. This is precisely what was needed to expand the number of homeowners, and it worked.
13
The increased flow of funds may have been necessary for a housing boom, but it was certainly not sufficient. Another factor behind the boom was change in the finance industry brought on by deregulation and rapid innovation that helped funnel that money to the housing sector.
Deregulation and innovation in the financial sector
We start discussion of deregulation with the 1930s since this was when many of the financial regulations originated. By the time Roosevelt took office on March 4,1933 the country was in free-fall and at the center of his stabilization plan was banking reform. In the stock market boom of the Roaring 20s everyone, including banks, invested heavily in stocks. These banks used depositors’ money for their investments, and when the market crashed banks were unable to sell their stocks to raise the cash needed when consumers, nervous about the safety of their money in the banks, began withdrawing their money and “stuffing it in their mattresses.” These “runs on the banks” forced banks to close their doors and businesses and individuals with checking or savings accounts lost access to their funds. Consumer and business spending dropped sharply, which prompted layoffs and further declines in spending and business investment - precisely the multiplier effect Keynes laid out in The General Theory.
Roosevelt’s first act was to declare a national bank holiday and shut down the nation’s banks, and within a week the Emergency Banking Act of 1933 was passed. To get people to trust banks again the Federal Deposit Insurance Corporation (FDIC) was created to insure all bank deposits. There was now no reason to hoard it in those mattresses. To get banks to behave better, there was the Glass-Steagall Act that essentially separated commercial banking activity from investment banking. Now when money was deposited in insured commercial banks, those bankers could not use the funds to finance risky investments. There was also Regulation Q that imposed limits on interest rates they could offer on deposits, including no interest rates paid on checking accounts. While it sounds anti consumer to limit the rates banks could pay on deposits, regulators saw it differently. Banks in financial trouble had been offering ever-higher interest rates on deposits to attract funds, which reduced their profit margins and made them more vulnerable, so by eliminating this competition bank profitability would rise and the risk of default would fall.
Things returned to normal as banking got “boring” – pay a little on depositors’ money and charge a little more on the loans issued, and work bankers’ hours (10-3) except on Wednesday when you were closed for afternoon golf. Things changed in the tumultuous late 1970s, though, as the financial industry struggled to deal with double-digit inflation that pushed interest rates to unprecedented highs. Mortgage rates reached 18.5%, a rate I actually paid on a house, but even these record high rates did not match inflation so real interest rates were actually negative by the late 1970s.
This was bad for those in the lending business, which prompted a good deal of experimentation with new financial
14 instruments and the relaxation of regulations. Memories of the 1930s bank failures were fading plus the ideological shift in the country to the right was returning conservatives, who distrusted government regulation, to positions of power. Conservatives believed regulation was unnecessary because rational bankers would never take risks that would put their institutions at risk, and soon Regulation Q was phased out. Banks were also allowed to offer “exotic” mortgages such as those with adjustable rates, balloon payments, and negative amortization and the savings and loan industry was also largely deregulated.
Unfortunately, they were very wrong as you can see in the graph below. After decades of virtually no failures of financial institutions, by the late 1980s it peaked at over 500 a year. It turns out that once the government reduced supervision and expanded the range of investments the S&Ls could make, the industry was overrun by fraud and bad investments that fueled a real estate boom. But that boom came to a dramatic end with a bust that triggered a recession in 1990 and by the time the S&L crisis was over, nearly a quarter of the S&L were closed.
Construction Employment Indexes
1.9 1.8 1.7 RI 1.6 1.5 1.4 1.3 1.2 US 1.1 1 1983 1985 1987 1989 1991 1993
In RI the bust was very bad, as you can see in the graph of employment in the construction industry. Beginning in 1983, employment in the construction industry nationally expanded about 33% by 1989, twice as fast as overall employment, but substantially slower than the 85% growth in RI. As happens, what goes up comes down, and by 1982 nearly all of the state’s gains in construction in the last decade had been lost and by 1990 the state closed all of its credit unions, just as Roosevelt had done back in the Great Depression.
By the mid 1990s the S&L collapse had faded into history as the US economy soared in the Internet boom. The US was back on top with the fantastically successful Netscape IPO in 1995 and talk of a New Economy had replaced talk of the fading US economy. Conservatives remained in control pushing their anti-regulation agenda and by 1999 a long-running debate on Glass-Steagall ended with repeal of the act (Gramm–Leach–Bliley Act).
To see how the changes in the industry, let’s look at the process of buying a home that changed greatly in this period.xxi Gone were the days of the Traditional Model, which was in place when I bought my first home in the mid 1970s. I borrowed money from my neighbors at my local bank that would check out the home valuations and my income to make sure the price was “realistic” and they would check my IRS and employment records to make sure I would be financially able to repay the loan. And when I bought the home it was because I needed the shelter – some place to work on my lecture notes - and if I were lucky, I could sell the house for more than I bought it as some time in the future.
Today that looks so old-fashioned. By the 2000s the change to the “New and Improved” model was completed. In this model roles changed dramatically as the distance between borrowers and lenders increased sharply. Now I would go to a bank, or maybe just a mortgage brokerage because these operations were opening up everywhere, and they would issue a mortgage and then sell the mortgage to investors all over the world in the mortgage bond market.
15 Banks and mortgage brokers liked it because they would get a fee for originating the mortgages, sell it and get their money back to make other investments, and not have to worry about people repaying the mortgage.
Financial innovators liked this because they would buy those mortgages and combine them in creative ways to issue securities (bonds) that were backed by the mortgages and get a BIG fee for doing this. Where investors in the past would have owned an IBM bond on which IBM promised to pay interest from its profit in the future, now the investor would by a bond where the payments came from those monthly mortgage payments. This is when we began to hear about shadow banking, “tranches,” collateralized mortgage obligations (CMO), collateralized debt obligations (CDO), financial derivatives, and subprime mortgages.
Investors all over the world liked it because in the low interest rate environment they were looking for a decent return, and now they owned a piece of those mortgages and would receive a steady stream of income from those monthly payments. Some of those investors would be banks that bought the bonds to cash in on the real estate boom just as banks had bought stock in the 1920s to cash in on the stock-market boom.
Potential homebuyers also liked it because they were more than willing to take the mortgages because the home had been transformed from shelter to an investment. Home ownership, rather than a job, was now the way to achieve the American dream that had been slipping away for many. Refinancing allowed homebuyers to turn their homes into ATM machines. Here is how that worked. You buy a home for $250,000 and pay an interest rate of 5.5% on an 80% mortgage of $200,000 anticipating the house would be appreciating at a rate of 14% a year. At the end of a year the $250,000 home would be worth nearly $285,000, so the house’s owner had a paper profit of $35,000. They also had a mortgage of only $200,000 that was less than 80% of the home’s value. Banks looked at this and decided lending more money to homeowners was not very risky because the home would be collateral and it was rising in price steadily, so they pushed refinancing for which they got a fee. Homeowners could go back to the bank and say the house was worth $285,000 and ask for an 80% mortgage – about $228,000.xxii They would pay off their $200,000 mortgage and have $28,000 to spend as they wished. And they spent wildly - enough so that the savings rate actually turned negative. Why save for that rainy day if you could always refinance? Saving made no sense, especially in a world where memories of the Great Depression had faded.
Politicians also liked it because the rate of homeownership could increase, especially among those groups that had traditionally been underserved. To do this, however, lending standards would need to be lowered to get more buyers into the game, especially minority borrowers. Lenders came up with “special deals” because they had no “skin in the game” once they sold the mortgages. The offered adjustable-rate mortgage (ARM) in which the lender offered a lower introductory rate to get that payment down, but the rate would change in the future depending on how interest rates changed. This was great if interest rates continued to fall, but the Fed raised interest rates in 2005 and mortgage rates adjusted upwards and monthly payments rose.
They also began to sell some “no income no asset” (Nina) mortgages to “help” put people with no income or assets into a home and some balloon mortgage that specified a certain low-introductory rate, often the borrower would pay only interest without any principal payment, for a specified period of time at which time the borrower would need to repay the loan in full by getting another mortgage at the prevailing rate. Both of these worked well in a world of falling interest rates and rising home prices, but once the Fed decided to push interest rates higher,
16 things went badly. And then there were still some that did not qualify, but they could qualify for a sub- prime mortgage that “exploded” in 2004-2006 when they accounted for about 1 of every 5 mortgages issued. These mortgages are issued to people with higher credit risks and they were generally ARM mortgages. The justification was that even with poor credit ratings, these new homeowners would be able to live off of the increase in value of their homes. This was important because homes represented the majority of a family’s wealth – 81% by 2005.
The boom
It all worked as increasing numbers of Americans were able to buy into the American dream. The homeownership rate peaked at 69% in 2006, although not all shared equally in the gain of the housing boom – and the pain of the recession. Homeowner rates increased most for the rapidly growing Hispanic population and lower income households, and this helped push housing prices up more in the lower tier of the housing market. Using Miami where the boom and bust was quite big as an example, by 2006 when home prices peaked, in the Low Tier group prices were nearly 5 times higher than in 1990, while in the High Tier prices were “only” 3 times higher.
It truly was a period of irrational exuberance, but in 2005 Shiller was generally ignored in his talks on the risks of irrational exuberance after publication of the second edition of Irrational Expectations with a new section on the housing industry.xxiii It turned out that Shiller was right and we had a classic bubble.
In addition to the price increases, the bubble also showed up in a shift in the economy toward housing. In a 2005 study it was estimated that 43% of the nation’s private sector employment was in housing related industries.xxiv A few months later it was reported that between the 2001 recession and mid 2005 the housing sector had added 700,000 jobs, while the remainder of the economy lost 400,000 jobs.xxv This masked some deeply troubling data in the manufacturing sector where by 2008 at the beginning of the Great Recession, about 3.5 million manufacturing jobs – about 20% of the total – had been lost since 2000.
17 It also masked problems with slow growing income. In the 1990s income of all racial and ethnic groups, adjusted for inflation, generally kept up with home prices as measured by Shiller’s 10-city Average. After rising 1% - 2% a year in the 1990s, however, incomes of all groups declined between 2000 and 2006, with the biggest declines among blacks – down 8% in the six years. Housing prices, however, continued to soar, rising 14% a year, so that by 2006 the average home price had risen 122%.
You should be able to see the problem. “If something cannot go on forever, it will stop,”xxvi and rising home prices and falling income could not go on forever. Now we’ll look at what brought the boom to an end.
The Bust: Great Recession
The boom had gotten the attention of the Fed by mid 2004 and it responded by raising the target federal funds rate from 1% in mid 2004 to 3% in mid 2005 to 5% in mid 2006. This was too much for the housing sector to sustain, and foreclosures began to grow, although as you would expect the foreclosures were unevenly spread across buyers. The biggest hit came in the subprime market with ARM mortgages. As interest rates rose in 2005 and 2006 the foreclosure rate rose rapidly – exactly what you would expect since these borrowers would have no cushion of savings on which to fall back.
18 This had two negative effects on the economy. First, rise in foreclosures had a direct impact on the construction industry. Housing starts dropped 75% - a loss of about 1.7 million units - that was more severe than in the bust caused by the dramatic spike in interest rates and recession in the late 1970s and early 1980s. Sales dropped even more rapidly – 80% - and drove down employment in residential construction by 45% and wiped out virtually all jobs added since the boom began in the mid 1990s. And you know from the multiplier, that behind those new homes not sold was furniture and appliances not sold and real estate agents and lawyers not getting their fees.
Second, the rise in foreclosures showed up in falling home prices prompting households to deleverage. Having gone deeply into debt in the boom years, households were now trying to sell their assets and this was driving down the price of those assets. Based on Shiller’s 10-city index, in the housing bust prices fell by and unprecedented 33%. In the early 1990 recession following the S&L crisis, home prices fell only 6%, and in the early 2000 recession they never fell. The biggest declines were in the Low Tier homes, the segment of the housing market where the holders of subprime mortgages were concentrated. There is no national 10-city average breakdown by tier, but in the four cities chosen from across the country the declines were steepest in those Low Tier homes. In Las Vegas and Phoenix, the epicenter of the collapse, prices in the low tier dropped 70%, while in Boston the decline was only 28%.
Shiller Housing Price Indexes: Peak-Trough Declines
Low Tier High Tier Las Vegas -70% -57% Phoenix -70% -49% Miami -67% -44% Chicago -55% -29% Boston -28% -7%
This decline in home prices had a devastating effect on household wealth. According to one estimate “owners’ equity in their real estate fell from almost $13.5 trillion in the first quarter of 2006, to a little under $5.3 trillion in the first quarter of 2009.”xxvii This is 60% decline in household wealth - unprecedented in the post Great Depression era - quickly led to a precipitous drop in consumer confidence that was replaced by pessimism and fear. This had a devastating impact on the economy, especially on the non-rich, because of the wealth effect. A home represents by far the biggest share of household wealth, especially for those not at the top of the income distribution. Before the bust, home equity represented 84% of the net worth of those in the second quintile of the income distribution, and only 55% for those at the top. For blacks and Hispanics homes represented more than 80% of household wealth, so they were more affected by the bust in housing prices. In 2011, in the early stages of the recovery, the median net worth of an American household was nearly $69,000, down more than a quarter from $93,200 in 2005 before the bust.
19 Minorities, those with less education, and those at the lower end of the income distribution took the biggest hit. The net worth of blacks, Hispanics, those with a high school education was 1/3rd bigger than the decline among those with a college degree, the decline among those in the second lowest quintile suffered losses 4/3rd larger than those in the top quintile.
Median Value of Assets for Households, by Type of Asset Owned and Selected xxviii Characteristics: 2005 & 2011
2005 2011 Median Change in % Change 2005 Home 2011 Home Median Net Net Worth Median in Median Share of Share of Worth NW NW NW NW TOTAL 93,200 68,828 -24,372 -26% 81% 75% White 113,543 89,537 -24,006 -21% 77% 73% Black 11,013 6,314 -4,699 -43% 86% 66% Hispanic Origin 17,078 7,683 -9,395 -55% 82% 48% 35 to 44 years 72,970 35,000 -37,970 -52% 75% 59% 65 years and over 177,520 170,516 -7,004 -4% 82% 84% High School Graduate 63,081 43,945 -19,136 -30% 85% 82% Bachelor's Degree 190,841 147,148 -43,693 -23% 63% 57% Second income quintile 37,030 24,284 -12,746 -34% 84% 74% Highest income quintile 343,863 292,646 -51,217 -15% 55% 44%
On the macro level, the talk was about the size of the wealth effect – the change in spending created by changes in wealth. One estimate was “that a dollar of extra housing wealth triggers five to eight cents in additional spending."xxix If the wealth effect is 5% to 8%, then the $8 trillion loss in wealth would translate into $400-$640 billion in reduced spending, and as you can see in the graph, the decline in personal consumption spending was about $460 billion.
You know by now what follows. The decline in consumer spending (-3%) has3 a multiplier effect on the economy as businesses cut back on their investment spending (-20%) and households cut back on their home purchases (-41%). Offsetting these were increases in government spending (6%) and a dramatic decline in imports that improved the net exports (+45%) and created a BIG problem for China where many of those imports originated.
The economy’s implosion showed up in the labor market where neither the rise in the unemployment rate nor the decline in employment we saw earlier captures the full magnitude of the decline. What is missing in these numbers is the fact that increasing numbers of people decided not to join the labor force, partly a reflection of a quadrupling of the number of discouraged workers; that among the unemployed nearly half had been unemployed for 27 weeks and the average length of unemployment reached 10 months; and that among those working, the likelihood of someone working part-time for economic reasons doubled.
20
The financial system also took a big hit. Many of the financial institutions that had “bought into” the booming housing sector were now in trouble – just as the banks were in trouble in the early 1930s after buying into the stock market boom. The bubble began to burst in 2007 when we saw our first wave of bankruptcies, annual reports with significant losses, and greatly reduced lending (credit crunch) among the financial firms, including overseas institutions, that had been involved with the subprime mortgages. In the next year the financial markets began to look like falling dominoes as those high real estate prices disappeared and the US economy fell into recession. In 2008 the DOW, reflecting growing pessimism, fell sharply, some failing institutions were merged with others (Ex. JPMorgan purchases Bear Stearns and Merrill Lynch is sold to Bank of America) and the Feds began to bail out some of the major players (Ex. AIG is lent $85 billion). As with the S&L crisis, the government eventually establishes a fund (Troubled Asset Relief Fund (TARP)) to purchase troubled assets to help the banks.
The Bust: European Debt Crisis
Globalization that had held out the prospect of world peace after WW II and fueled rapid growth in developing countries such as China now put the world economy at risk. Producers around the world began to feel the effects of the decline in US merchandise imports that fell by about 25% by 2009 – dragging down worldwide merchandise exports by 22%. Investors were also feeling the effects of the collapse of the subprime mortgage market. By late 2008 we were reading about the hardship faced by small Norwegian town that had lost on its investments in the US subprime securities.xxx
The big story in Europe, however, was the financial crisis that became the European Sovereign Debt Crisis as it spread across the continent, reminding people of the contagion in the Asian Crisis and threatening to reverse the decades long process of integration. Here we look briefly at the situation in two of the countries that were at the center of the crisis and that I know well - Greece and Ireland.
Before you start, however, please look at the following graph of interest rates on 10-year government bonds from a sample of European countries including Ireland and Greece. This graph is from the BBC’s story “Top economists reveal their graphs of 2011.” You may not have travelled there, and you may not have been keeping up with the news from there, but by now your forensic economic skills should be adequate for you to “reverse engineer” this graph and develop a good story about those countries. Remember this is a macroeconomics course where macro indicators convey a story about life and economic conditions – so look at the graph and try to think of what might be happening in these countries over this time period that could explain the pattern of interest rates. You can also see there are three separate time periods, separated by two events, with their own distinctive pattern. Try to explain how these two events altered the behavior of interest rates, and for those who need a little clue, start with that interest rate equation from the 1970s unit. And look at the map to see if you can find a geographical dimension to the map that you can relate back to any of the earlier material.
21
OK – for those who have struggled getting going, here is a little more info for you – some of the primary macro measurement variables from 1981 for a number of European countries. See if this helps you get going with the story of Greece and Ireland, as well as Spain, Portugal, and Cyprus that experienced their own crises. As you look at the data do not try to find one story that explains everything. It turns out there is no one indicator – one magic number - that if we only looked at we might have seen the problem coming.
22 Greece
Greece, the cradle of western civilization, was also the cradle of the European Debt Crisis. It is a small country - about 50,000 square miles (size of Louisiana) with a population of almost 11 million (size of Ohio or the Chicago metro area). In 1981, after a tumultuous post WW II era with a long-running civil war, coup d’états, and military dictatorship, Greece joined the predecessor of the European Union (EU). At that time it was a poor country with GDP per capita that was one of Western Europe’s lowest - only about 1/3rd the level in Scandinavian countries. The unemployment rate was low by Europe’s standards, but this is probably a reflection of its low-income levels and larger agricultural and informal sectors.
Greece also had a high inflation rate relative to the rest of Europe in much of the 80s and 90s that led to a decline in the value of Greece’s currency – the drachma – and high interest rates that you could see in phase 1 of the interest rate graph. Between 1981 and 1990 the drachma lost 2/3rds of its value relative to the US$ and then by 2000 it had dropped by another one-half. The decline of the drachma was offset by rapid inflation, so Greece continued to buy more from the world than it sold to the world and ran current account deficits that made it dependent on an inflow of foreign capital – just as the US is today.
Things changed on the inflation front across Europe by the late 1990s as many countries moved to meet the requirements to join in the “euro club” in 1999. One of the requirements was a low inflation rate and as a result European inflation rates fell sharply bringing down those interest rates. In Greece, the rate fell from 24% fell to nearly 2% by 1999.
This brings us to that first line in the opening graph – the introduction of the euro. I can remember traveling in Greece in 1999 before the euro arrived and seeing the political posters and thinking the leadership of Greece saw the move to the euro as a way to bring discipline to its finances and reduce inflation by moving control of printing money out of the hands of Greeks who had a history of inadequate control and printing too much. I was not the only one who though Greece had now become fiscally responsible, which you can see in interest rates that converged because of the convergence in inflation rates. To investors, Greece and Germany were indistinguishable, so after 1999 there was little difference between the rate of interest paid by German and Greek governments when borrowing money. And Greece would borrow money as you can see in the graphs below. Greece cleverly “managed” its books to satisfy the budget deficit criterion for the euro, but in general between 1980 and 2009 when the crisis began, Greece consistently ran large budget deficits due to its inability to get the rich to pay taxes and its “buying off” the rest with government jobs. This increased substantially the country’s indebtedness that had reached 100% of GDP by 2007.
23 This brings us to the second line in the opening graph – the Lehman bankruptcy. By then investors were reassessing their investments, and this was certainly true when they looked at their investments in Greece. When Greece joined the euro money poured into the country despite the fact they did not have a good track record with managing their finances. This looks a bit like the subprime crisis in the US where in the boom period some riskier borrowers were able to get loans despite the fact they hadn’t been very good with money in the past. The homeowners were part of the housing boom so it was OK, and Greece was part of the euro area so it was OK too.
In both cases it was unsustainable, and for Greece the turning point came shortly after an October 2009 election only a month after the Lehman bankruptcy in the US that had investors on edge. By the end of the year the new Socialist government admitted Greece’s debt was far larger than previously reported. Greece was running a budget deficit so its government needed to borrow money to pay its bills and refinance some of its debt coming due, and the country was running a trade deficit so it needed to either borrow money or sell assets to sustain current spending. Unfortunately it found no investors willing to lend it the money – or at least no one to do so at an affordable interest rates. You can see in that opening interest rate graph that as investors began to get increasingly nervous about Greece’s ability to pay its debt and by July of 2011 Greece needed to pay 16% interest to “coax” them into lending them the money.
Greece had no good options, just as the UK in 1925 and the US in 1971 when these countries faced an outflow of gold. In all three cases the countries were constrained by the trilemma so there were essentially only three choices in theory – reduce the trade deficit by slowing the economy, restrict capital outflows, or devalue the currency. In practice, by having adopted the euro Greece could not devalue its currency plus capital was free to move where it wanted to go. To stop the outflow, Greece would need to eliminate the trade deficit with some combination of lower imports to reduce the outflow and higher exports to increase the inflow, and eliminate the budget deficit with a combination of tax increases and spending cuts.
So Greece went to the troika – officials of the European Union (EU), European Central Bank (ECB), and International Monetary Fund (IMF) – and asked for a bailout, which they got. The bailout had strings attached, however, and those strings were an aggressive closing of the budget deficit with a combination of higher taxes and lower spending. This exposed a rift between northern Europeans (Germany) and southern Europeans (Greece) with the German government demanding Greece reform its finances as a precondition for receiving the bailout. For a few years this battle between countries raged, but eventually Greece reduced government spending that helped “push” Greece’s economy into a recession that many compare to the US Depression.xxxiAfter five years Greece’s GDP and consumption spending had fallen by 20%, investment spending was down by 60%, import spending was down over 30%, and the unemployment rate had reached 25% - all numbers comparable to what the US experienced in the first five years of the Great Depression. The big difference was that in the US government spending had increased as a result of the New Deal, while in Greece government spending, forced upon Greece by its creditors, shrank 15%. On a more personal level, in the summer of 2012 the evidence of the recession and the social unrest generated by the government’s policies was very visible in Athens. Graffiti and closed storefronts seemed the norm and there was a strong police presence.
24
Ireland
Greece may have been first, but Ireland had by far the most dramatic turnaround. Ireland is also a small country – even smaller than Greece at 27,000 square miles (about the combined size of Massachusetts, New Hampshire, & Vermont) with a population of 4.6 million (similar to Louisiana). It was also a poor country with GDP per capita only slightly above Greece’s in 1981, an enormous trade deficit, a high inflation rate, and a high unemployment rate that remained high in the 1980s as employment in the decade actually declined. In fact I remember well the Irish kids in Newport looking for summer jobs in the 1980s because Ireland’s economy was not generating enough jobs. Ireland’s economy had hit bottom and people were fleeing the country, just as they had in the Potato famine in the mid 19th century.
Things changed dramatically in the next decade though as the Irish kids disappeared from Newport’s streets. They stayed home where they found many opportunities in Europe’s growth star – its Celtic Tiger. In the 1990s employment in Ireland increased almost 4% a year after no growth in the 1980s, GDP increased at 7.4% a year, trade and budget deficits were transformed into consistent surpluses, and the country reduced the debt / GDP ratio to 11%. The boom also showed up in real estate. I remember traveling there in the mid 2000s and seeing building cranes fill the sky in Dublin, although not as many as I saw in China recently. In Ireland’s beautiful countryside you could also see too many housing developments in the middle of nowhere. Accompanying this boom in construction were rising homes prices. European Central Bank data shows that by 2008 home prices in Ireland had risen twice as fast as they had in the US and they were more than triple levels in 1990.
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By now you know how this ends – the bubble burst and Ireland’s banks that had issued the mortgages were vulnerable. After Lehman and Greece, there was an exodus of foreign money from Ireland that threatened the collapse of the country’s big banks. The Irish government, to avoid a collapse of the banks and banking system, assumed the banks’ bad debt, which wreaked havoc on the country’s finances. Between 2007 and 2010 government outlays, as a percent of GDP, expanded more than 75%, while receipts declined 7%, which transformed a budget surplus into a deficit approaching 50% of the country’s GDP and a debt/GDP ratio that went from 10% to 75%. The government’s deteriorating financial condition “scared” foreign investors and this “forced” the Irish government to pay high interest rates when borrowing money to finance those purchases of bad mortgages from the banks. Ireland also went to the troika seeking a bailout that would come, and it would get the funds if it took the measures needed to eliminate its budget deficit. As of 2012 Ireland had been successful at reducing, but not eliminating the budget deficit, and government debt/GDP continued to rise reaching above 100 in 2012. During this period Ireland’s economy sank into a severe recession. Between 2008 and 2012 employment in Ireland fell 14%, GDP was down, the trade and surpluses were gone, Ireland’s debt/GDP ratio rose to 102 by 2012, and housing prices fell 50% from the peak.
These were bleak times for Greece and Ireland, yet they were not the only countries affected by the financial contagion. Soon it spread to the other PIGS - Portugal, Ireland, Greece, and Spain – and then to Cyprus. In each case the trigger was a bit different, although they were generally variations on a theme. In Spain the government’s finances were in good shape, but it had experienced its own real estate boom that burst and pushed the economy into recession, while in Portugal it was the public finances that were the trigger. In both cases this led to international financial aid with those “strings” to reduce government budget deficits attached, and a severe recession that put people in the streets protesting government policies. In Spain the unemployment rate reached 25%, the same level as the US in the Great Depression.
As of 2013 the crisis is not over, yet the debate is still raging over the appropriate course of action, which is where we will shift our attention to now.
The Response: Quantitative Easing, the Stimulus, and Austerity
Yogi Berra, a famous baseball player not known for his articulate speech, once said, "This is like deja vu all over again." This is certainly true in macroeconomics as we have come full circle in the course. We started in the 1930s with the debate over what government should do in the Great Depression and we end with a debate over the proper role of government in the Great Recession and the Sovereign European Debt Crisis. In 2013 there were conservatives who believed Obama was a socialist bankrupting a country that simply needed a good dose of austerity to set it back on the right path forward; and in 1935 there were conservatives campaigning against Social Security as a socialist plot. Liberals in both eras, meanwhile, pleaded for expansionary fiscal policies – tax cuts or spending increases to get that multiplier process going. They believed Obama’s fiscal stimulus was essential for stabilizing the US economy teetering on brink of a free fall, just as Roosevelt’s New Deal softened and shortened the Depression.
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There were also debates about monetary policy with the Fed chair Ben Bernanke being characterized by conservatives as dangerous and, if you believed Rick Perry, the governor of Texas and an unsuccessful Republican candidate for the presidency in 2012, guilty of treasonous behavior.xxxii Some were even pushing for a return to the gold standard that conservatives clung to until Roosevelt abandoned it in 1932. Liberals were unhappy with Bernanke whom they believed was intimidated by inflationists,xxxiii but they supported his efforts to stimulate the economy and many would agree that Fed chair “Ben Bernanke saved the economy—and has navigated masterfully through the most trying of times.”xxxiv In this final section we will assess those fiscal and monetary policies undertaken in the aftermath of the financial crisis.
Monetary policy
The US was lucky that Fed chair Ben Bernanke was an academic with expertise on the Great Depression who was determined to use monetary policy to avoid a second Great Depression. Bernanke’s research highlighted the role played by banks in the Great Depression, so his first task was to get the banking system back and running. Without money circulating the economy would seize up – just like a motor would seize up without oil – and by the end of 2007 he announced a plan to exchange $ for bank assets, a complement to the Troubled Asset Relief Program signed into law by president George W. Bush in October of 2008.
The plan, while incredibly complex in the detail, is pretty straightforward. Banks had made some bad investments and as a result they had run out of money and some banks were at risk of bankruptcy and others were unable or unwilling to lend any money to businesses and individuals. It was essential to keep these banks operating and lending, so the government would buy some of the troubled / nonperforming assets from the banks and other financial institutions in the “shadow banking” sector and give them cash. A few decades earlier in the S&L crisis the US had done the same with creation of the Resolution Trust Corporation. Japan did not make this choice when its real estate bubble burst and many blame the decades long “silent depression” on that choice. Banks held on, but they essentially stopped lending money, which earned them the name “zombie banks,” and without access to funds, Japan’s businesses and households cut spending and the economy never fully recovered.
The Fed’s focus then shifted to stimulating the economy, which was difficult since interest rates were already close to zero as you can see in the left-side graph below. This is what Keynes warned about in the Great Depression and in fact he gave it a name - liquidity trap. In this environment the Fed could not use its traditional policy of driving down short-term interest rates by buying short-term government bonds with the expectation this would drive down long-term rates that affected aggregate demand. Rates were already at the bottom, so traditional monetary policy would be ineffective, which is why Keynes promoted fiscal policy as the best means of escaping from a depression.
The Fed needed a new, more direct approach, so it began buying other financial assets including those mortgage-backed securities that had lost their value in the financial crisis from financial institutions. This was quantitative easing and it flooded the system with money, which you can see in the right-side graph above. The monetary base “exploded,” doubling during the recession and then almost doubling again by
27 2012. As you would expect, this did not sit well with conservatives who never gave up their faith in the Quantity Theory of Money. What they saw in a banking system awash with money is future inflation and blasted Bernanke for risking a repeat of the inflationary spiral of the late 1970s.
The increased money / liquidity did show up in a few places not captured in the traditional CPI, just like it did in the 2000s when the run up in house prices did not show up in the inflation rates that remained low. Some of that extra money ended up in the stock market and helped push the US stock indexes higher. The DOW Industrials, which had dropped over 55% in the recession, recouped all of its losses and reached all time highs by 2013.
The extra money also showed up in the price of gold. Gold’s price had changed little in 30 years after the bust in the early 1980s. Investors did what they have done before, invest it in gold in the face of financial insecurity, and this drove up its price. Between early 2009 to early 2012 gold’s price rose 27% a year to peak at $1,788.
And Bernanke and the US Fed were not acting alone. Central banks around the world \ embarked on their own programs of quantitative easing, which was important because government’s were not as aggressive in their fiscal policy stances, to which we will no turn our attention.xxxv
Fiscal policy
Despite the importance of monetary policy, the headlines were dominated by fiscal policy debates that revealed two of the features mentioned in the 1960s unit – fiscal policy’s quick action lag and its long discussion lag. We’ll pick up the story in 2000 when George W. Bush, closely following Ronald Reagan’s script, proposed a massive tax cut favoring those at the top. In a move that angered liberals who remember his role in persuading Clinton’s to forego his proposed tax cuts, Greenspan supported the Bush tax cuts. The size of the fiscal changes can be seen in the table below that compares the federal budgets in the year Reagan and Bush were elected (1980 & 2000) and their last year in office (1988 & 2008).
28 As a result of these tax cuts, the federal government’s receipts share of the US economy declined in both administrations, although the decline was fare deeper under Bush. On the outlays side, meanwhile, in both administrations national defense spending more than doubled - to finance Reagan’s defense buildup to defeat communism and Bush’s wars in the Middle East to defeat terrorism. Reagan was able to offset some of the losses in revenues with spending cuts so outlays/GDP declined slightly, something not achieved by Bush who lost a good deal of support among conservatives because he was unable to slow the growth of human resource spending. In Bush’s eight years government spending’s share of GDP increased nearly 10%. The net effect in both administrations was an increase in the budget deficit that would act as an economic stimulus, at least if you believed in the Keynesian multiplier. The increase under president Bush was substantially bigger though, as a surplus equal to 2.4% of GDP was transformed into a deficit of 3.2% of GDP.
RECEIPTS, OUTLAYS, AND SURPLUSES OR DEFICITS (–) AS PERCENTAGES OF GDP Reagan Bush Receipts Outlays Deficit Receipts Outlays Deficit Opening 19.0 21.7 -2.7 20.6 18.2 2.4 Closing 18.2 21.3 -3.1 17.6 20.8 -3.2 Change -0.8 -0.4 -0.4 -3.0 2.6 -5.6
And after the @#$%^& hit the fan in late 2007, the US government was already running substantial deficits when Bush signed the Economic Stimulus Act in February of 2008. The act contained tax rebates for individuals to get their after-tax income up and tax incentives for businesses to invest. Obama followed this with the American Recovery and Reinvestment Act of 2009 that, like Roosevelt’s New Deal, contained a mix of recovery and relief aid. Among the relief components, the largest was an expansion of unemployment benefits. On the recovery side there was increased spending on infrastructure, green energy, health and education. The breakdown from the official web site is below. The goal was to replace the decline in private sector demand with public sector demand and “Induced” private sector demand.
Allocation of American Recovery and Reinvestment Act Spending
The impact of the stimulus, combined with the slowdown of the economy, was a substantial increase in the US deficit and national debt that was not unique to the US. In nearly every developed (rich) country there was an increase in the budget deficit during the recession that contributed to a rise in national debt and generated a heated debate on the impact of the rising indebtedness – at least in Europe and the US. That debate was largely absent in China when it enacted the most ambitious economic stimulus – a $586 billion stimulus of 2008 to offset the negative impact on China’s aggregate demand of the sharp drop in US imports.
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In the US this rise in red ink produced the Tea Party movement in 2009 that moved the government budget to center stage in the elections of 2010 and 2012. The debate was less about the appropriateness of deficit reduction and more about the best approach to reducing the deficit, which infuriated liberals like Krugman. Liberals focused on the country’s short-term problem because there was no reason to focus on the long run since they agreed with Keynes, “In the long run we are all dead.” The country’s biggest problem was a loss of private sector aggregate demand as individuals and businesses cut back their spending in a massive “deleveraging.” A stimulus to replace that demand was needed, although they did also push for additional taxes on the wealthy to appease the debt hawks.
Conservatives, meanwhile, focused on ways to speed up the country’s growth rate, which is no surprise given that conservatives represent those at the top of the wealth spectrum whose wealth provides a cushion to soften the effects of bad times. They were not completely insensitive to the plight of the millions whose lives had been adversely affected by the recession; they just hadn’t advanced much from the “urge to purge” views of Andrew Mellon, US Treasury Secretary in 1929. Recessions are simply a “normal” feature of an advanced economy and they serve a useful purpose by purging “the rottenness out of the system.”xxxvi They still believed in Mellon’s trickle down theory. Then it was "Give tax breaks to large corporations, so that money can trickle down to the general public, in the form of extra jobs," while today it is simply give tax breaks to the wealthy who are the “job creators.”
Unfortunately, there was no middle ground, so Congress and the president engaged in a game of chicken over extensions of the debt ceiling. Ultimately the inability to reach any “Grand Bargain” led to sequestration – an across the board cut in government spending.
In Europe the rise in red ink also triggered a heated debate, although the outcome was a bit different. You can see this difference in the two graphs above where those increases in red ink seem to be a bit smaller in European countries not experiencing financial crises. Europe took a more conservative path – one with less stimulus and more austerity. Some took this route by choice, such as English Prime Minister David Cameron’s decision in 2010 to impose austerity on the English people, while some, such as Greece, were forced to take this route. The decision was made to impose temporary pain on the country’s people in the short run to generate longer term, sustainable growth, and the major justification for this was a research paper by Carmen Reinhart and Kenneth Rogoff’s 2010, “Growth in a time of debt.” The message was simple – too much debt is a bad thing, and once a country’s debt/GDP ratio reaches 90% the economy begins to slow.
Median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise; average (mean) growth rates are several percent lower.xxxvii
This became the definitive source for those opposed to deficits and debt, and since in Europe many countries exceeded this rate, austerity became the chosen strategy.
30 The eurozone countries, the United Kingdom, and the Baltic states have volunteered as subjects in a grand experiment that aims to find out if it is possible for an economically stagnant country to cut its way to prosperity. Austerity -- the deliberate deflation of domestic wages and prices through cuts to public spending -- is designed to reduce a state’s debts and deficits, increase its economic competitiveness, and restore what is vaguely referred to as “business confidence.” The last point is key: advocates of austerity believe that slashing spending spurs private investment, since it signals that the government will neither be crowding out the market for investment with its own stimulus efforts nor be adding to its debt burden. Consumers and producers, the argument goes, will feel confident about the future and will spend more, allowing the economy to grow xxxviii again.
Things did not turn out quite as expected. In 2013 a paper was released that suggested Reinhart & Rogoff’s paper was overstating the costs of debt,xxxixwhile the experience of the countries that went the austerity route clearly indicate it did not live up to its advance billing. Here is how Bloomberg describes the situation in England in 2013.
the economy looks sicker than ever, the Fitch and Moody’s ratings agencies have stripped British sovereign debt of its AAA grade, and the government’s budget deficit still sits at a worrisome 7 percent. “Fiscal consolidation has got stuck in the mud of near-zero [gross domestic product] growth,” … Cameron’s countrymen are all-too aware that things aren’t working as planned. Unemployment rose to 7.9 percent in the first quarter, real wages are falling, and businesses aren’t investing, despite record-low interest rates.xl
The situation is not much better elsewhere.
The results of the experiment are now in, and they are equally consistent: austerity doesn’t work. Most of the economies on the periphery of the eurozone have been in free fall since 2009, and in the fourth quarter of 2012, the eurozone as a whole contracted for the first time ever. Portugal’s economy shrank by 1.8 percent, Italy’s fell by 0.9 percent, and even the supposed powerhouse of the region, Germany, saw its economy contract by 0.6 percent. The United Kingdom, despite not being in the eurozone, only barely escaped having the developed world’s first-ever triple-dip recession.xli
And hidden behind these numbers are social costs that can be enormous, as even a casual observer can see. We began the course by noting that macro matters and we are seeing that in Europe today. We may not yet be seeing an environment that will produce another world war, but we certainly are seeing the rise of many social maladies and the dismantling of Europe’s social contract.
The victims are visible almost anywhere you go in Mediterranean Europe. You see shuttered groceries and clothing shops, abandoned restaurants, idled factories and half-built housing developments overgrown with weeds. Newspapers carry heartbreaking stories of families evicted from modest apartments, people losing their jobs and then their health benefits, young and not-so- xlii young women turning to prostitution to make ends meet, even suicides by self-immolation.
One flaw with austerity as a solution to excessive debt is a simple math mistake. The debt burden is measured by Debt/GDP so an obvious “solution” for a country with a high debt ratio is simply reduce Debt by raising taxes or cutting spending. The problem is that GDP is not a constant and that fiscal policies can have an impact on GDP large enough to offset the decline in debt. Mexico offers evidence of the problem with austerity from an earlier crisis in the early 1980. “If there is one overwhelming lesson from the debt crisis that struck Mexico and other Latin American countries so hard three decades ago, it is that countries that cannot grow will not pay. It is up to creditors, too, to allow them to grow.”xliiiThis did not stop Europeans from going this route, and their experiences are consistent with that of Mexico.
The only surprise is that any of this should come as a surprise. After all, the International Monetary Fund warned in July 2012 that simultaneous cuts to state spending across interlinked
31 economies during a recession when interest rates were already low would inevitably damage the prospects for growth. And that warning came on top of the already ample evidence that every country that had embraced austerity had significantly more debt than when it started. Portugal’s debt-to-GDP ratio increased from 62 percent in 2006 to 108 percent in 2012. Ireland’s more than quadrupled, from 24.8 percent in 2007 to 106.4 percent in 2012. Greece’s debt-to-GDP ratio climbed from 106 percent in 2007 to 170 percent in 2012. And Latvia’s debt rose from 10.7 xliv percent of GDP in 2007 to 42 percent in 2012.
A second flaw surfaced in a report from the IMF that had been part of the troika imposing austerity on the European countries including Greece and Ireland. The IMF believes it underestimated the multiplier, which is what you would expect from conservatives. The austerity policies were imposed in part because of a belief the multiplier was less than one, but the IMF reported that in distressed times the multiplier was significantly greater than one. Now you will recall from the 1930s unit, the multiplier is
Multiplier = ΔY/ΔG
Under an austerity plan ΔG < 0, which suggests the impact on income (ΔY) should be less than the cut in government spending (ΔG) because of offsetting private sector growth. Austerity will hurt, but not that much. Unfortunately the IMF’s revision means that the change in income will be greater than the change in government spending; austerity will hurt a lot.
The future
So, should the US commit itself to reducing the national debt – and if so how should it do it? First, any assessment of the burden of the deficit must begin with what the deficit "bought." For example, assume two friends each take out $50,000 loans and they must pay 5% interest - an annual payment of $2,500. The first friend uses the money to pay for a college education that will increase her earnings by $20,000 a year once she graduates. The second friend uses it to take an extended vacation. Clearly the impact of the debt would be different in the two cases. In the first, the additional income would more than compensate for the costs of carrying the debt, while in the second case there would be a real cost since the debt did not contribute to an increase in earnings.
The same is true when we look at the federal borrowing. There are very few people who question the enormous debt incurred in the two world wars since they preserved American freedom, and the Bush administration worked hard in the aftermath of the Iraq invasion to convince Americans the same was true with the War on Terror. You would also find general agreement on the merits of government spending that produced the interstate highway system because it increased the productive capacity of the nation (GDP) more than enough to pay for the interest costs on the investment.
It does not take long, however, to reach spending projects people consider the equivalent of a vacation because there is a bias in democracies toward deficit spending that pushes expense onto future generations. Imagine if you could take out a loan and you did not have to pay it back until sometime in the future. In fact, assume you could push the repayment onto the next generation so you could actually escape the repayment. This is a question of intergenerational equity in which the choices cut across generations: we pay for those drugs to extend our seniors’ lives while we cut back on education spending that are critical to the success of the grandchildren.
What about the way forward? Let's ignore the two poles and try to see what's beyond the hype. First, we need to understand why deficits are so hard to eliminate? Why can’t we seem to balance them? One reason is that politicians have realized it is a far better strategy to push costs onto future generations since voters do not act kindly to those asking for sacrifice. There will be calls for austerity, as we saw in the 2012 campaign, but there were no details in the promises. We saw this with the Reagan “promise” to balance the budget by cutting taxes and government programs. It turns out to be pretty easy to get people to vote for tax cuts, but spending cuts are more difficult because cutting them does have a cost. In the 2012 campaign
32 Romney was caught on tape describing the 47% of the population that lives off government handouts, but the reality could be that far more benefit from the government’s largesse. A Cornell study from 2008 found “96 percent of Americans have taken part in government benefit programs in one form or another.”xlv The reality is while many may support efforts to control government spending programs, it shouldn’t be the programs they benefit from because they are needy. You see a little bit of this in the fact that the red states in the US that vote for Republicans who are leading the anti government charge, are states that pay less in taxes than they receive in government spending. “Support for Republican candidates, who generally promise to cut government spending, has increased since 1980 in states where the federal government spends more than it collects. The greater the dependence, the greater the support for Republican candidates.”xlvi
It will not be easy, but if we are to do anything it makes sense to look at the last time the US moved from budget deficits to budget surpluses - the transformation of the budget deficit inherited from president Bush into a surplus under president Clinton. How did he do it? In February of 1993 President Clinton delivered his budget, which included
a three-pronged fiscal strategy: (1) a short-term stimulus package to boost economic growth and create jobs, (2) a long-term public investment program to increase productivity and growth and create jobs, and (3) a long-term deficit reduction package composed of both spending cuts and tax increases to reduce long-term interest rates and stimulate private investment.
The results were remarkable. The deficit, which was approximately $290 billion in 1992, about 5 percent of GDP, was gone within six years. In 1998 the federal government recorded its first surplus since 1969, a feat no one would have thought possible in 1992 during the depths of the recession. This turnaround was accomplished with a combination of reductions in outlays and increases in revenues. On the revenue side, it was personal income and corporate income taxes that were responsible for the turnaround. The tax increases fell disproportionately on the wealthiest Americans, the same individuals who benefited from the Reagan tax cuts. This would be accomplished by raising the marginal tax rates from 31 to 36 percent for those couples with incomes exceeding $140,000.
On the outlay side, Clinton was the beneficiary of the Reagan defense build-up and the collapse of the Soviet Union that provided him with the "Peace Dividend." And Clinton cashed in this dividend with sharp cuts in defense expenditure - nearly 20 percent in inflation-adjusted dollars. Additional help came from outlays for physical resources and net interest on the debt which both grew slower than the economy during this period.
It will not be easy to duplicate the Clinton record, in fact it may be impossible, but the path the country is on now is unsustainable. You can expect the debate to continue unless some event far bigger than the Great Recession alters the current trajectory.
For those who want to make this personal, think of the country as a family with young children thinking about college expenses and their retirement. While the children are young the family intends to save for the college and agrees to save $200 a month for college tuition. Unfortunately, they find that they cannot cover their normal living expenses so they "borrow" from the college fund to help pay their bills. By "raiding" the savings fund and running up debt on charge cards, they are able to pay their bills. Unfortunately, there are limits to this system because the credit card debts continue to build up and the kids eventually reach college age. What they find is that over time the interest payments on the debt they are building up gets crushing and all other expenses are "squeezed out," and when the kids are ready to enroll for college, there is no money in the account. If the kids do go to college the family will need to find other expenses to cut in order to pay the tuition so there will be very little left to pay for normal living expenses after paying the interest and college tuition.
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i In both graphs the ratio to GDP is being used: in the left-side graph it is total government (federal, state & local) and in the right-side graph it is federal government data. When looking at total government receipts, there has been a noticeable upward trend between 1950 and 2000, while the trend is missing in the right-side graph of the federal government. This difference reflects the fact that during this period state and local government receipts were growing faster than federal government receipts, although we barely hear anything about state and local finances.
ii In the US we have a federal system so we actually have three levels of government, each with its own receipts and outlays. For example, the local governments get most of their money from property taxes and spend most of it on education, while the sales tax is a major source of revenues for state governments and health and welfare are their biggest outlays. Income and payroll taxes are the primary sources of funds for the federal government and defense, health, and retirement are the major expenses. iii In your case with the student loan, the short-term financing would be the equivalent of you taking out a one year loan knowing you would not be able to pay it off in one year so you would need to refinance it at the end of the year. And you would keep doing this for 30 years. The alternative would have been to simply borrow the money once for 30 years. iv State and local can borrow money, however, for special projects. For example, if RI wants to build a bridge it can issue a bond just as you or I would do. What it can’t do is at the end of the year find that it can’t pay its ills and then issue a bond. v For information on US debt, the US GAO Office has a web site devoted to it. Source: http://www.gao.gov/special.pubs/longterm/debt/index.html vi Here is a longer view. The financing of the wars with borrowed money is very clear. The US financed wars with borrowed money, which you see in the increases for the War of 1812, the Civil War (1860), WW I (1918…), and WW II (1945…). The only non-war peaks were in the Great Depression and the Great Recession.
vii To see what was happening we can revisit a shortened version of the interest rate equation from that 1970s unit. As Greenspan saw things, he was pushing down the discount rate (rr) and that should have brought down all interest rates
35 including the rate on long-term securities (rLT). But it was not working for long-term rates, which Greenspan interpreted as an indication that something else was also happening. That something else was investors’ concern about the long-term deficit prospects of the US. Either the US would print money to cover the deficits, which would raise the expected inflation rate risk (ri) or the government would have trouble paying its bills, which would increase the risk of default (rd). So, the Fed would push down rr, but greater investor risk would push rd and ri higher and the Fed’s policy efforts would be ineffective. rLT = rr + rd + ri viii
ix De Long provides some evidence that the bond market was poised to raise rates as Greenspan had suggested. He examined the spread between short-term and long-term interest rates, and found that at the end of the 1992 recession, long-term rates were higher than expected based on the experience in other recessions. At the end of the previous recessions, the gap between short and long-term rates averaged 2.1 percent, far smaller than the 3.5 percent gap in 1992. Furthermore, he shows how the higher rates for long-term debt means that future short-term interest rates can be expected to rise, and the rise would be related to the size of the gap. 3-Mo. Treasuries 10 Yr. Treasuries Gap (% Points) 1979-82 8.63 11.1 2.47 1973-75 4.99 7.61 2.62 1969-70 4.35 6.16 1.81 1959-60 2.38 3.88 1.5 Average post Recession 5.09 7.19 2.1
End of 1992 3.29 6.79 3.5 x For Clinton to be successful in jump-starting the US economy, long-term interest rates needed to be pushed down, a situation captured in the The Maestro. “There was no magic to coordinating the economic efforts of a president and Congress with the Federal Reserve. But there was a crucial new reality. The short-term rates the Fed controlled were at about the right level. The critical interest rates were the long-term rates, the rates that mattered to businesses with large debts and to people paying mortgages. Lower long-term rates would leave businesses and people with more money to spend, causing the economy to grow. Perhaps no single overall event than a drop in long-term rates would do more to help the economy, businesses, and society as a whole. The long-term rates were also the most sensitive to the federal budget deficit. Credible evidence that the federal deficit was going to be controlled could cause long-term interest rates to drop.” Woodward, The Maestro xi ibid xii ibid If you needed a second, more recent, example of the power of the bond market, you could look at the experience of Brazil in the aftermath of the Asian crisis of 1997-98. Once international investors became wary of foreign governments' ability to honor their debts during the crash of 1997 and began "snooping around" for the next financial crisis. They found two candidates - in Brazil and Russia - and money started to leave the countries. To keep the money from leaving, both countries raised interest rates substantially, a reflection of the greater risk attached to this borrowing. Once Brazil responded with "appropriate" legislation that included pension reform, interest rates began to fall - just as they would in the US if an "appropriate" deficit reduction package was adopted. xiii ibid
36 xiv DeLong is a little more specific when he points to the following four indicators of the new macroeconomy - although not quite in this order. 1. A possible macroeconomic consequence of the computerization of American business is a decline in the inventory fluctuation-driven component of the business cycle. Already the decline in aggregate inventory-to-shipments ratios in manufacturing is substantial. However, we have not yet seen whether theoretical predictions that a leaner inventory chain means a smaller business cycle come true. 2. Another possible macroeconomic consequence is increased financial market volatility, which would take the form of both a faster and more complete response of financial markets to news and a faster and more exaggerated response of financial markets to noise. This is worth worrying about because of its potential significance for the making of economic policy. But as of yet we have no real data with which to assess this possibility. 3. The information technology revolution has almost surely driven the recent acceleration in American productivity growth, and there is good reason to believe that trend productivity growth will continue at its current, higher rate for at least a decade. 4. A likely important macroeconomic consequence of the acceleration in productivity growth is the improved labor market and reduced NAIRU that we are seeing today. The high-pressure economy, tight labor market, and gratifyingly low unemployment rate is hard to envision without the productivity speedup, which is largely driven by the technological revolutions in data processing and data communications. xv ibid xvi Eric Janszen, “The Next Bubble,” Harpers, February 2008. Here is a summary delivered just as the US crisis was unfolding in Carmen Rienhart and Kenneth Rogoff, “Is the 2007 US subprime financial crisis so different? An international historical perspective,” AER, May 2008 While each financial crisis no doubt is distinct, they also share striking similarities in the run-up of asset prices, in debt accumulation, in growth patterns, and in current account deficits. The majority of historical crises are preceded by financial liberalization … While in the case of the United States, there has been no striking de jure liberalization, there certainly has been a de facto liberalization. New unregulated, or lightly regulated, financial entities have come to play a much larger role in the financial system, undoubtedly enhancing stability against some kinds of shocks, but possibly increasing vulnerabilities against others. Technological progress has plowed ahead, shaving the cost of transacting in financial markets and broadening the menu of financial instruments. xvii Ryan Avant, “The moderator’s opening remarks,” Home ownership: Should it be discouraged? The Economist, September 12, 2012. For a report on the benefits of home ownership, there is the National Association of Realtors’, Social Benefits of Homeownership and Stable Housing, April 26, 2012 xviii ibid xix In 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was created to buy mortgages from savings & loan (S&L) institutions, and together these two institutions created marketable securities guaranteed by the US government. xx Remarks by the President to Airline Employees, O'Hare International Airport, Chicago, Illinois, September 27, 2001 When they struck, they wanted to create an atmosphere of fear. And one of the great goals of this nation's war is to restore public confidence in the airline industry. It's to tell the traveling public: Get on board. Do your business around the country. Fly and enjoy America's great destination spots. Get down to Disney World in Florida. Take your families and enjoy life, the way we want it to be enjoyed. xxi BBC News, The downturn in facts and figures, November 21, 2007 Here is a diagram that captures the key changes in the purchase process.
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xxii Another reason they liked refinancing was that in the tax reform of 1987 interest deductions on federal income taxes for interest payments were eliminated except for home mortgages. With this ruling, if you wanted to buy a car the interest on the car loan would not be tax deductible, but if you took out a home equity loan, that interest would be tax deductible. xxiii According to Wikipedia, in 2005 a paper was delivered at the Fed’s annual conference in Jackson Hole that warned of credit default swaps. The warning was ignored by Fed chair, Alan Greenspan. In the following year Noriel Roubini warned the International Monetary Fund, and Merrill Lynch fires one of its executives after a presentation on the risks of CDOs. xxiv Asha Bangalore, Daily Economic Comment, The Northern Trust Company, May 23, 2005 xxv David Leonhardt, “Boom in Jobs, Not Just Houses, as Real Estate Drives Economy,” NYT July 9, 2005 xxvi a quote from Herbert Stein who was Chair of the Council of Economic Advisors under Nixon and Ford. What I think: Essays on Economics, Politics, and Life, AEI 1998 xxvii John Yedinak, “Home Equity Declines More than 60% During Great Recession says Fed Report,” Reverse Mortgage Daily, February 13th, 2011 xxviii Wealth and Asset Ownership, US Census, http://www.census.gov/people/wealth/ xxix Housing Wealth Effects: Arithmetic Lesson for Neil Irwin and the Washington Post,” Center for Economic and Policy research, January 26, 2013. This is reporting the findings of a study by Charles Calomiris, Stanley Longhofer, and William Miles, “In The Housing Wealth Effect: The Crucial Roles of Demographics, Wealth Distribution, and Wealth Shares” NBER Working Paper No. 17740, 2012 xxx “Norway's unlucky towns are the latest victims - and perhaps the least likely ones so far - of the credit crisis that began last summer in the U.S. subprime mortgage market and has spread to the farthest reaches of the world, causing untold losses and sowing fears about the global economy.” Mark Landler, “The curse of U.S. mortgage crisis reaches northern Norway,” NYT December 2, 2007 xxxi Floyd Norris, “Seen from Greece, Great Depression looks good,” NYT March 15, 2013 xxxiiDuring his campaign in Iowa, Perry said the following: “If this guy prints more money between now and the election, I dunno what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in history is almost treasonous in my opinion.” xxxiii Paul Krugman, The intimidated Fed,” NYT April 28, 2011 xxxiv Roger Lowenstein, “The Villain,” The Atlantic, April 2012 xxxv “But the economic stagnation of the major developed nations has driven central banks in the United States, Japan, Britain and the European Union to take increasingly aggressive action. Because governments are not taking steps to revive economies, like increasing spending or cutting taxes, the traditional concern of central bankers that economic growth will cause too much inflation has been supplanted by the fear that growth is not fast enough to prevent. “ BINYAMIN APPELBAUM, JACK EWING, HIROKO TABUCHI and LANDON THOMAS Jr., “Central Banks Act With a New Boldness to Revitalize Economies,” NYT May 28, 2013 xxxvi Paul Krugman, “The urge to purge,” NYT April 4, 2013
38 xxxvii Carmen Reinhart and Kenneth Rogoff’s 2010, “Growth in a time of debt.” AER, May, 2010 xxxviii Mark Blyth, “The austerity delusion,” Foreign Affairs, May/June 2013 xxxix The paper that criticized R&R was “Does higher public debt consistently stifle economic growth? A critique of Reinhart and Rogoff,” Political Economy Research Institute, April 15, 2013 xl Carol Matlack, “How David Cameron could boost UK growth,” Bloomberg Businessweek, April 23, 2013 xli Mark Blyth, “The austerity delusion,” Foreign Affairs, May/June 2013 xlii David Unger, “Europe’s social contract, lying in pieces,” NYT, June 8, 2013 xliii Eduardo Porter, “From Mexico, some lessons for Europe,” NYT April 9, 2010 xliv Mark Blyth, “The austerity delusion,” Foreign Affairs, May/June 2013 xlv Ann Carrns, “How many government programs have you benefitted from?” NYT September 25, 2012 xlvi ibid
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