Tag: martin feldstein

No, an Above-Average P/E Ratio Does Not Show Stocks Are Overpriced

Writing in The Wall Street Journal on April 27–making another last-ditch pitch for a 20% border tax on business imports–Martin Feldstein asserts that unless corporate tax rate cuts are “offset” by tax increases on imports or payrolls then larger projected deficits would crash the stock market by raising long-term interest rates. “The markets’ current fragility,” he writes, “reflects overpriced assets–the S&P 500 price/earnings ratio is now 70% above its historical average–after a decade of excessively low long-term interest rates engineered by the Federal Reserve.” 

The odd notion that the Fed could somehow depress bond yields for a decade is an irrelevant ambiguity, since the whole point of Feldstein’s story is to claim budget deficits raise bond yields and higher bond yields threaten “overpriced” stocks.

In a recent blog, I found no evidence to support the dogma that bond yields rise and fall with rising or falling budget deficits (actual or projected). Wall Street Journal columnist Greg Ip opines that “interest rates haven’t responded to deficits lately because private investment has been so lackluster.” But that excuse makes interest rates dependent on private investment, not deficits, and leaves us tangled in circular illogic. If interest rates depend on private investment and deficits “crowd out private investment,” then interest rates could never respond to deficits because private investment would always be lackluster when deficits were large (which would also make deficits the opposite of a “fiscal stimulus”).

Switching from bonds to stocks in this blog, I find no evidence that the S&P 500 stock index is “overpriced” relative to long-term interest rates (which is the only meaning of “overpriced” that relates to Feldstein’s argument about deficits and bond yields).

Feldstein claims stocks are “overpriced” because “the S&P 500 price/earnings ratio is now 70% above its historical average.” But there is no reason to expect the p/e ratio to revert to its long-term average unless bonds yields revert to their long-term average.

Inverted P/E ratio Tracks Bond Yield

No, Higher Deficits Don’t Raise Long-Term Interest Rates

According to former Reagan adviser Martin Feldstein, “Higher projected budget deficits could raise long-term interest rates, potentially triggering… a serious economic downturn.”

Has that ever happened?

From 1977 to 1981 10-year bond yields nearly doubled, rising from about 7.4% to 13.9%, but budget deficits were relatively small, around 2.5% of GDP.  Budget deficits were doubled from 1984 to 1993 (about 5% of GDP), yet bond yields were nearly cut in half, falling from 12.4% to 5.9%. Bond yields were no lower from 1997 to 2000 when the budget moved into surplus. But yields fell dramatically in 2008-2012, a period of record budget deficits.

One possible objection is that larger budget deficits were caused by recessions, which is why bond yields did not rise with larger deficits or fall with surpluses.  The graph addresses this concern by using CBO estimates [.xls] of cyclically-adjusted budgets (“with automatic stabilizers,” in CBO vocabulary). Deficits and Bond Yields

Still, there is clearly no correlation between bond yields and any measure of yearly budget deficits and surpluses. And that is also true in other times and places – Japan’s chronic large deficits and debt being an obvious example.

Another possible objection centers on Feldstein’s use of the phrase “projected budget deficits,” as though the CBO’s notoriously inaccurate long-run projections could somehow have an entirely different effect from actual deficits. I criticized the analysis and evidence behind that conjecture in a Treasury Department presentation which was condensed and simplified in a Cato Institute paper. I found the underlying analysis illogical and contradictory and the evidence worthless.

There is no need to make up stories about alleged effects of deficits on bond yields in order to make a strong case for minimizing frivolous government borrowing (e.g., to pay for transfer payments or government employee compensation).

Chronic deficits add to accumulated debt, and that debt will have to be serviced with future taxes even if it is rolled-over indefinitely. That is reason enough for Congress to keep growth of federal spending below the growth of the private economy – a task which requires frugality in spending but also a tax and regulatory climate which minimizes impediments to investment, entrepreneurship, education and work.

Martin Feldstein on the Defense Budget

Martin Feldstein, a distinguished economist and a former colleague, made a surprising case for maintaining a large U.S. defense budget, despite a huge federal budget deficit, in the annual Irving Kristol lecture Tuesday night at the American Enterprise Institute.

On one point, he was clearly right: we can afford it. “There is no danger of bankrupting ourselves by so-called ‘imperial overreach’ when we spend less than 5 percent of GDP on defense” (in fact, 5.6 percent of GDP in 2010).

But he failed to make a convincing case that we should spend this much for defense, especially given the dire outlook for federal deficits and the debt. In 2010, U.S. real (inflation-corrected) spending for national security was over twice the annual spending during the Ford and Carter administrations and over 40 percent of total current world defense spending. What conditions, what national objectives, might justify continued U.S. defense spending of this or a higher magnitude?

Feldstein first plays the China card, arguing that “The United States should maintain a military capability such that no future generation of Chinese leaders will consider a military challenge to the United States or consider using military force to intimidate the United States or our allies,” maybe forgetting that a much weaker China successfully challenged us in Korea in the early 1950s. He next makes the case for the importance of a global military presence, arguing that “We have to make it clear by our budgets and by our actions that we are the global force now and will continue to be that in the future.” And finally, “we have to ask ourselves whether we have a moral obligation to defend our allies. …. There are those who say the United States should not be the global policeman. But if not us, who? As the only democratic superpower with the ability to defend and punish, do we not have a moral obligation to be willing to use that power?” All of this assumes without argument or evidence that it is important for the world to have a global policeman, that we can play this role effectively, and that it is a moral obligation for the United States to serve in this role.

The U.S. military had a central role in the most important strategic development since World War II — prevailing in the Cold War against the (former) Soviet Union. But it is critical to recognize that our military has not been very effective as a global policeman or nation builder. The Korean War ended in a draw, leaving a despotic communist government, now with nuclear weapons, in control of North Korea. After 20 years of a U.S. military presence, we abandoned Vietnam to a communist government that now controls most of southeast Asia. The U.S.-sponsored invasion of the Bay of Pigs was defeated, leaving a communist government in control of a large island 90 miles from Florida. U. S. forces have now been in Afghanistan for nearly 10 years without securing it from lightly armed local forces without significant external support. And U.S. forces have now been in Iraq for over eight years without securing it from frequent terrorist attacks.

I wonder what evidence Feldstein or anyone else would offer to support a view that the United States has a comparative advantage as the global policeman. Most of our allies can afford higher defense spending if our support is reduced. The total GDP of the European Union is higher than the U.S. GDP. The GDP of South Korea is many times that of North Korea. There is no obvious calamity that would result if the U.S. contribution to the collective defense with our allies were reduced.

Yes, we can afford a large defense budget, and national security is one of the few federal programs for which there is clear constitutional authority. But like the budgets for most other federal programs, the defense budget is too large. So a substantial reduction of the defense budget should be on the table in any serious effort to avoid a fiscal collapse, a threat that is more serious and more urgent than any that might be effectively countered by trying to maintain the role of a global policeman.