Sustaining U.S. Prosperity in a More Competitive World

Robert M. CoenDepartment of EconomicsNorthwestern University

December 2, 2008

Better title:Maintaining U.S. Prosperity in a

Shaken World

Robert M. CoenDepartment of EconomicsNorthwestern University

December 2, 2008

Challenges for Obama• Short-run: Financial crisis and recession

Restore stability and trust in financial marketsModerate declines in employment and production

• Long-run: Slow productivity growthEnvironmental degradationEnergy inefficiencyGrowing income inequalityGrowing inequality in access to health

care

• Short-run crisis overshadowing all else

How bad is the situation?• GDP growth: -0.5% in Q3, but +2.8% in Q2.

Modest decline thus far by historical standards.

• Employment: 10 months of decline; 1.2 million jobs lost, but percent loss not yet huge.

• Industrial production: down 4.7% from peak in Jan. 2008, but actually rose 1.3% in October.

• Stock market: major collapse, but not unmatched historically.

• Housing starts in free fall since 2006, but similar to some previous housing cycles.

-15

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-5

0

5

10

15

20

50 55 60 65 70 75 80 85 90 95 00 05

Change in GDP, 1948Q2 to 2008Q3Percent

Job Losses in Recessions

(thousands, nonfarm)

Peak Trough m’s Loss %Loss 12-2007 ??? 10 1,179 0.9% 02-2001 08-2003 30 2,708 2.0% 06-1990 05-1991 11 1,621 1.5% 07-1981 12-1982 17 2,838 3.1% 03-1980 07-1980 4 1,159 1.3% 07-1974 04-1975 9 2,171 2.8% 03-1970 11-1970 8 1,044 1.5% 04-1960 02-1961 10 1,256 2.3% 04-1957 06-1958 14 2,326 4.4% 07-1953 08-1954 13 1,711 3.4% 09-1948 10-1949 13 2,344 5.2%

Production Losses in Recessions

(Industrial Production Index)

Peak Trough m’s %Loss 01-2008 ??? 9 4.7% 11-2000 12-2001 13 5.8% 09-1990 03-1991 6 4.2% 08-1981 12-1982 16 9.4% 02-1980 07-1980 5 6.6% 11-1973 05-1975 18 13.0% 10-1969 11-1970 13 7.0% 01-1960 02-1961 13 8.6% 02-1957 04-1958 14 13.6% 07-1953 04-1954 9 9.5% 07-1948 10-1949 15 10.1%

Housing Starts, 1960Q1 to 2008Q3Housing boom ends in 2006 Q1

0

500

1,000

1,500

2,000

2,500

3,000

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Year

Th

ou

san

ds

of

Ho

usi

ng

Sta

rts

879

How bad will it get?

• Credit crisis still snowballing

• Epic decline in housing prices not over, moremortgage defaults likely

• Excess inventories of houses/cars must be worked off

• Job cuts will create more mortgage/consumer credit defaults

• Falling household income and wealth will reduce spending

• Business, state-local govts can’t get short-term finance

• Auto industry bankruptcy?

• World economies slowing, reducing our exports

• Spreading gloom and doom

Credit Crisis BackgroundFinancial Innovation/Deregulation

• Deregulation of interest rates

• Permission for branch banking

• Certificates of deposit

• Money market mutual funds

• Mutual funds, stock index investing, competitive brokers’ fees

• Flexible mortgages

• Home equity loans

• Development of futures and options markets

• Securitization of mortgage and consumer debt

• Floating currency exchange rates

• Venture capital, private equity, hedge funds

• Freer flow of money internationally

• Credit default swaps

Where Your Father’s Banks Got Funds

(Remember those Greek Temples)

Commercial banks, billions of dollars

1952 Q4 Financial liabilities $157 Deposits 151 96% Credit markets 1 1% Other 6 4% Other securities 16 9%

Where Today’s Banks Get Funds

(Now store fronts/counters)

Commercial banks, billions of dollars

1952 Q4 2008 Q2 Financial liabilities $157 $11,362 Deposits 151 96% 7,534 66% Credit markets 1 1% 1,394 12% Other 6 4% 2,433 21% Other securities 16 9% 4,651 40%

How Your Father’s Banks Used Funds

Commercial banks, billions of dollars

1952 Q4 Financial assets $169 Cash 23 14% Loans 66 39% Treasury securities 64 38%

Other securities 16 9%

How Today’s Banks Use Funds

Commercial banks, billions of dollars

1952 Q4 2008 Q2 Financial assets $169 $11,694 Cash 23 14% 79 1% Loans 66 39% 6,864 59% Treasury securities 64 38% 100 1% Other securities 16 9% 4,651 40%

Banks Grow Riskier: Why?• More competition from non-banks

MMMFs, investment banks, hedge funds

• Equity holders unable to impose discipline

• Regulatory capital requirements not effective

• Bankers inclined to take greater risksBig payoffs to them if bets winDepositors, equity holders, or taxpayers absorb lossesCollect fees in either case

• Gramm-Leach-Bliley Financial Services Modernization Act of 1999 repealed Glass-Steagall and added to potential conflicts of interest

Financial Innovation/DeregulationGood Effects

• Promotes competition – better deals for savers and investors

• Securitization allows lenders to expand loans

• Promotes homeownership rate (from 64% in 1995 to 69% in 2004)

• Creates insurance against many financial risks

• Improves allocation of investment and business risks

• Improves allocation of capital to most profitable uses

Financial Innovation/DeregulationBad Effects

• Innovation often an escape from regulationHedge funds a good example

• Need for new regulation (like automobile)But can it work? Innovation runs ahead of regs

• Securitization separates debtor from creditor (cf. new mortgage market vs. old)

Spurs irresponsible lending practicesIncentive to generate commissionsComplicates recontracting for troubled debtors

• Gives false sense of security from risk

• Can lead to increased leveraged speculation

Who Held Your Father’s Home Mortgage?

Billions of dollars, end of year

1952 Total mortgages $58 S&L, CU 24 41% Life ins, pensions 12 20% Banks 11 19% Households 8 14% Governments 3 5% Other 1 2%

Who Holds Your Home Mortgage?

Billions of dollars, end of year

1952 2007 Total mortgages $58 11,171 S&L, CU 24 41% 1,187 11%

Life ins, pensions 12 20% 17 0%

Banks 11 19% 2,208 20% Households 8 14% 131 1% Governments 3 5% 105 1% Other 1 2% 7,523 67%

“Other” Holders of Home Mortgages

Billions of dollars, end of year

2007 Total other $7,523 Agency, GSE backed pools 4,320 57% ABS issuers 2,163 29% Finance companies 474 6%

Govt sponsored enterp 449 6%

REITs 78 1% Other 39 1%

Other Factors Spurring Credit Expansion

• Low interest rates (courtesy of Greenspan) encourage borrowing and leverage

• Growth in international savings seeks home in U.S.Our trade deficit builds up foreign reservesBurgeoning profits of oil exportersFinances of developing countries improves

following crises of 1997-98

• Failure to oversee lending practices, capital ratios

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100

120

140

50 55 60 65 70 75 80 85 90 95 00 05

Total debtMortgage debtConsumer credit

HOUSEHOLD DEBT, 1948-2007Percentage of Disposable Personal Income

Snowball effects when credit bubble bursts

• Sharp rise in mortgage defaults and foreclosures

• Prices of mortgage-backed securities (MBS) go south

• Highly-leveraged holders of MBS’s find value of assets dwindling; their creditors want more collateral

• Liquidation of MBS’s difficult

• Turns out risk of MBS’s erroneously rated

• Hard to recontract mortgages in pools

Snowball effects when credit bubble bursts

• Foreclosed properties further depress house prices, leading to more defaults, etc., etc.

• Venerable financial institutions brought down

• Sellers of default insurance on MBS’s face huge payouts (AIG)

• Panic spreads to other financial firms, even healthy onesE.g., MMMF’s -- some “break the buck”

Others suffer withdrawals, become conservativeUnload commercial paper, drying up credit in that

crucial market

• Lack of business, political leaders to calm waters

Auto Industry Bailout?• Output down 20% since 2005 Q3 peak

• Sales down 25% from 2005 Q3 peakSales of more profitable trucks down 37%

• Losses every year since 2000“Good year” 2005: $4 billion lossCumulative losses 2000-2005: $46 billion

• Employment down sharply1,319,000 in 2000 994,000 in 2007

0

100

200

300

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90 92 94 96 98 00 02 04 06 08

ALL VEHICLES AUTOS TRUCKS

Domestic Vehicle Output, 1990Q1 to 2008Q3Down 20% from 2005Q3 peak: trucks down 33%

Bill

ion

s 2

00

0 d

olla

rs, S

AA

R

50

100

150

200

250

300

350

90 92 94 96 98 00 02 04 06 08

AUTOS TRUCKS

Domestic Vehicle Sales, 1990Q1 to 2008Q3Autos down 15% from 2005Q3, trucks down 37%

Bill

ion

s o

f 20

00

do

llars

, SA

AR

Auto Industry Bailout - Pro

• Huge job loss if bankruptcy2007 employment levels, vehicles & parts

Manufacturing 994,000Retail 1,969,000Total 2,963,000

• Finance groups afflicted by credit crisis

• Domestics disadvantaged by health and pension costs

• Default would create CDS bombshell

Auto Industry Bailout - Con

• Job loss overstated

New owners will continue some operations

Demand for parts won’t disappear

• Merge finance arms into healthy finance companies

• Bankruptcy only way to reduce costs (break contracts)

• CDS writers need to be disciplined

Policies to Mitigate Recession

Is monetary policy “spent”?

• Interest rates already low

• Loan demand weakening - can’t “push a string”

• Lower rates could weaken $, grow exports

• Provide capital and liquidity to financial institutions to prevent “runs on the bank”

Greater govt regulation, ownership roleIn Sweden in early 1990s, banks socialized!

Fiscal Policies to Mitigate Recession

Refinance failing mortgages: little long run cost?

Extend unemployment benefits

Stimulate spending with tax cuts or new govt spending

Tax cuts less potent: partly saved, spent on imports

Govt spending can be directed to productive investmentsInfrastructure, education, energy, environmentProblems: Takes time to plan and execute

Political waste (e.g., Japan in the 1990s)

But fiscal actions add to budget deficits and national debt

Burden of National Debt: A Concern? • National debt is sum of past deficits

• Deficits of about 3% of GDP don’t raise debt burden, because GDP grows at that rate (see 1970s)No need to balance the budget

• Larger deficits do not add to burden if they finance productive public investment

• U.S. debt not out of line with other nations

• Not a burden if we owe to ourselves

• Government can tax or print moneyBut are tax rates already too high? Not in perspective

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ReceiptsExpendituresBudget Surplus

Federal Receipts, Expenditures, and Budget Surplus, 1952 Q1 to 2008 Q3Percent of GDP

Per

cent

Government Debt as Percent of GDP, 2006

France 71 Germany 69 Italy 118

Japan 191 Sweden 53 UK 55

US 62

Source: OECD

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9

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11

12

13

55 60 65 70 75 80 85 90 95 00 05

Effective Personal Income Tax Rate, 1952 Q1 to 2008 Q3

Per

cent

Personal Income Tax Receipts as Percent of Personal Income

16

20

24

28

32

36

40

44

48

52

55 60 65 70 75 80 85 90 95 00 05

Effective Corporate Profits Tax Rate, 1952 Q1 to 2008 Q3

Per

cent

Corporate Profits Taxes as Percent of Corporate Profits

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1.0

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3.0

55 60 65 70 75 80 85 90 95 00 05

Effective Tax Rate on Products and Imports, 1952 Q1 to 2008 Q3

Per

cent

Product and Import Taxes as Percent of GDP

2

3

4

5

6

7

8

9

55 60 65 70 75 80 85 90 95 00 05

Effective Social Insurance Tax Rate, 1952 Q1 to 2008 Q3

Per

cent

Social Insurance Taxes as Percent of Personal Income

Tax Receipts as Percent of GDP, 2006

France 44 Germany 35 Italy 41

Japan 27 Sweden 51 UK 37

US 27

Source: OECD

Concerns About Long-Run Economic Leadership

• Deteriorating infrastructure• Weak math and science education• Financial crisis undercuts trust, leadership • Heightened security, xenophobia limit talent pool• Growing business concentration, monopoly• Large-market advantage threatened by EU, China, India• Lag in important technologies – energy, environment• Growing inequality limits opportunities for many• No room in present federal budget to address needs

Important Reasons for Optimism

• Most open, flexible society

• Economic adaptation our hallmarkExample, floating of $ in 1971

• Ready funding for new ideas, risks

• Tolerance of nonconformity fosters creativity, originality

• Protection of intellectual property assures incentives for innovation