It is a pleasure to be once again before a CFA Society audience. I so much enjoy the CFA that I have lost track of how many chapters have invited me to speak, and I have accepted almost every invitation.
My remarks today reflect my first effort to put together a line of thought that has been bouncing around my brain for some months. What medicine do we have to swallow to get the economy moving again? And why this medicine rather some other medicine? Before prescribing medicine, we had better get the diagnosis correct. What is that diagnosis?
Broadly speaking, there are two competing explanations of the current economic problem. One is fully Keynesian. The problem is simple: The economy is suffering from a lack of aggregate demand and it is the responsibility of the federal government to make up for the missing private demand. That means budget deficits supporting tax reductions to support consumption, infrastructure spending and the like. The Obama economic program reflects this line of thought. I will call this diagnosis and prescription the K, for Keynesian, approach.
The competing explanation is that regulations, taxes and fears of higher future taxes are retarding business hiring and investment. This argument is almost daily fare on the editorial page of the Wall Street Journal. Although not original with the Wall Street Journal, I will call it the WSJ approach. Keynesians scoff at this approach; they say that the business community and the Wall Street Journal always complain about regulations and taxes.
I am much closer to the WSJ view than the K view. Although I agree with the Keynesians that systematic evidence supporting the WSJ view is lacking, I nevertheless find the anecdotal evidence convincing. Anecdotal evidence is better than no evidence. Deficient aggregate demand is not an explanation — it is a restatement of the problem. Why is demand deficient? Some aspects of the answer to that question are agreed by all parties.
Let’s consider the various components of GDP one by one. The national income identity is that GDP = consumption plus investment plus government consumption expenditures and gross investment plus net exports of goods and services. A convenient base year to discuss the issues is 2005. That year seemed normal and conditions were highly desirable. Unemployment was drifting down; the rate dropped to 4.8 percent at the end of the year. It was a happy year for the economy; we did not understand at the time that bubbles in house prices and housing finance were taking the economy into a crisis.
Consumption is the largest single component of GDP. In 2005, the consumption share of GDP was 69.7 percent. In the first half of 2011, the share was 71.1 percent. GDP in 2011Q2 — the latest quarterly data available — had not recovered its peak in 2007Q4; aggregate consumption was a tad higher, divided across a larger population. The unemployment rate is 9 percent; it is not a happy economy.
Clearly, we cannot count on consumption spending to lead the way into a vigorous economic recovery. The consumption share of GDP has actually risen slightly, and is now well above its long‐term average, 1969 to date, of 66 percent of GDP. Before the recession, the consumption share rose in part through equity extraction from housing as mortgages were refinanced. But that process is over now that housing values are lower and many households do not have ready access to credit.
Consumption cannot power the economy forward. Indeed, it is reasonable to expect the consumption share to drift down, as households rebuild their balance sheets and as current tax relief is necessarily scaled back. More on that issue shortly.
In the National Income Accounts, private investment is divided into several analytically distinct categories. Residential structures, loosely called “housing investment,” includes construction of new houses and renovations and additions. Since 1969, the average housing share was 4.4 percent; currently, the share is 2.2 percent.
With lower housing investment, incomes of those in the home‐building industry are lower and their consumption is lower. This problem cannot be corrected by somehow boosting house construction. During the past decade, we simply built too many houses. At the peak of the boom, in 2005, the housing share of GDP was 6.1 percent. We now have more houses than the demographics will support. Building more houses when we have a surplus makes no sense.
U.S. population is growing slowly; that, along with demolition of old units will gradually bring the number of houses into balance with the number of households. Restoring equilibrium in the housing market will take a few years; housing starts will gradually climb from the current level of about half a million per year to about three times that number. It will take time and we cannot expect housing to power us out of the recession the way it did out of the 2001 recession.
From 1969 to 2010, exports averaged 9.3 percent of GDP; the fraction has tended to rise over time and by 2005 had reached 10.3 percent. Imports have also grown, to 16.1 percent of GDP in 2005. The difference between the two — net exports — was ‑5.7 percent in 2005. Although there is all too much protectionist babble in political discourse today, trade is not the source of our sluggish recovery. In fact, by the first half of 2011 net exports were at ‑3.9 percent of GDP. The “drag,” as it is sometimes put, from net exports is lower than it was in 2005. However, “drag” is entirely the wrong word to use. Trade improves economic welfare here and abroad. Imports include materials necessary for our production, such as rare‐earth metals not available here, and goods available at lower cost through trade.
In any event, there are no policies available that would produce a material increase in net exports to power the economy forward. As we saw with the tsunami in Japan earlier this year, a disruption of trade will have a negative impact on U.S. economic activity. Disruption through a trade war would be much worse, because of the uncertainty created about restoration of normal trade and risks of future disruption.
Government Consumption Expenditures and Gross Investment
It is important to distinguish between government consumption expenditures and gross investment — which I will just call “G” — in the national income accounts and the total government budget. G includes outlays for salaries and “stuff” ranging from military aircraft to public school supplies. To get total government spending, we add to G transfer payments such as Social Security and unemployment benefits. G is large — 19.1 percent of GDP currently and 19.9 percent on average since 1969. G was only slightly smaller in 2005, at 18.8 percent. Total government expenditures are currently about 38 percent of GDP, of which the federal government accounts for 27 percent.
State and local spending is constrained by balanced budget provisions and by discipline from markets that may not readily finance budget deficits considered too large. For the U.S. state and local governments as a whole, borrowing is now about 4 percent of spending, which is down from about 8 percent in 2008. State and local governments do not have the financial capacity to power the economy out of recession. The issue is, obviously, whether the federal government can pull the economy into a faster pace of recovery.
The federal government is currently borrowing about 40 percent of its expenditures. That level of borrowing cannot persist for long. The Congressional Budget Office has called the current situation “unsustainable.” I agree, and believe that for that reason federal government stimulus cannot be the answer to the sluggish recovery. I encourage anyone who wants the federal government to do more to examine the CBO analysis carefully.
Indeed, the federal government will have to take dramatic action to close its budget gap. In principle, closing the gap could take the form of lower spending, higher taxes or some combination. Economists of the WSJ persuasion believe that most of the gap must be closed by cutting spending. Promises on the books today — especially Medicare in its current form — cannot be financed by any set of taxes consistent with the operation of a market economy. I will not argue that case in detail because it is not the main point I want to emphasize in this lecture. The fiscal imbalance is immense and if you look carefully at the CBO analysis you will see that current budget data actually understate the problem.
I continue the analysis on the assumption that the federal government is fiscally exhausted. It cannot drive the economy forward through increases in spending or cuts in taxes. Even if you accept the standard Keynesian story, which I do not, a federal budget deficit can only prop up the economy as long as the deficit can continue. At some point, the deficit must be reduced to a sustainable level. Thus, the private economy must carry the main weight of economic growth in the years ahead.
Business Fixed Investment
Business fixed investment is the component of GDP I have left to the end, because that is where the weight of my argument lies. I hope I have persuaded you that the other components of GDP cannot be expected to power the economy into a satisfactory recovery.
A line of argument similar to the one outlined so far led Keynesians, during the 1930s and World War II, to expect that the private economy might well not be able to reach a full‐employment equilibrium.
Alvin Hansen, in his 1938 book Full Recovery or Stagnation, argued that investment spending might not be adequate to bring the economy to full employment, even if interest rates were pushed to zero. Sylvia Nasar, in her most recent book, Grand Pursuit: the Story of Economic Genius, puts the point this way:
[President Roosevelt’s] position reflected only one side of a hot debate between Keynesians and anti‐Keynesians. The more upbeat the public and businessmen became about postwar prospects, the more American disciples of Keynes worried that the economy would sink into another slump. Public spending would plunge with demobilization. Alvin Hansen, an advisor to the Federal Reserve who was sometimes called “the American Keynes,” foresaw “a postwar collapse: demobilization of armies, shutdowns in defense industries, unemployment, deflation, bankruptcy, hard times.” Paul Samuelson, a consultant for the main postwar planning agency, warned the administration not to become complacent about unemployment. “Before the war we had not solved it, and nothing that has happened since assures that it will not rise again.” They had little faith that business and consumers would pick up the slack. As Samuelson put it, “If a man goes without an automobile for 6 years, he does not then have a demand for six automobiles.” Having concluded from the 1930s that business was too timid to invest and that monetary policy was a poor weapon with which to fight recessions, the Keynesians were convinced that the only solution was to slow the cuts in public spending by slowing demobilization and by beefing up spending on infrastructure. (pp. 385 – 86)
The argument is eerily familiar to what we are hearing today. Even though corporations hold hundreds of billions of cash, and interest rates are practically zero, business investment is far from booming. In 2010, using annual average data, GDP rose by 3.0 percent but business fixed investment contributed only 0.42 percentage points of that growth. Inventory investment — necessarily transient — contributed 1.64 percentage points. Averaged over the first two quarters of this year, GDP growth was only 0.85 percent; business fixed investment accounted for 0.59 percentage points of that growth.
But why had the economy grown vigorously in the hundred years before 1930 and then run out of steam? Hansen and others argued that the earlier drivers of growth had been exhausted. The frontier was now settled. Rapid development of the steel and railroad industries in the 19th Century was no longer available to bring the economy to full employment. Automobiles and radio were important in the 1920s, but had become mature industries. Without new investment from new technology, the economy would sink back into depression once World War II spending stopped.
That is not what happened. Everyone in this audience could name ten powerful technological developments that required large investment. And the ten that each of us could name would not all be the same. The market economy of the United States has continued to be a remarkable engine of growth.
What has happened to the U.S. growth engine? Part of the story — but only part — is that there is no point in further investment when there is so much excess capacity in the economy, Just as we do not need more houses built this year, so also we do not need more shopping centers. In Keynesian terms, the level of investment even at a zero interest rate need not be sufficient to bring the economy to full employment.
A convincing counterargument was presented in a 1962 textbook by Martin J. Bailey, with whom I studied at the University of Chicago. Bailey argued that investment spending would not reach a limit at a zero rate of interest because there are some investments that have an annual return that continues in perpetuity. If an investment has an infinite life, then the present value of the project can be made as large as you please by making the interest rate as low as you please. Mathematically, as the discount factor on future returns goes to zero the present value becomes indefinitely large. The lower the rate of interest the greater the number of investments there would be with present value above their capital cost and the total size of these investments would be easily large enough to bring the economy to full employment.
Bailey used the example, and had estimates of the cost, of creating new farmland by filling shallow coastal areas in the Gulf of Mexico. The newly created land would have a return in agricultural output that would continue indefinitely.
Another example discussed by Bailey is leveling the Midwest. This argument always yielded a few smiles from the class. However, anyone who lives in the hugely productive farm areas of the Midwest knows that the land is not perfectly flat. Water collects in the lower spots, damaging agricultural productivity. At finite cost, a farmer can strip off topsoil, level the land, and put the topsoil back. The increase in output continues indefinitely. At a low enough interest rate, the value of the investment exceeds its cost. Bailey had other examples of investments that would create a long string of returns and that, at a low enough interest rate, would be worth doing.
As I speak, the yield on the inflation‐protected Treasury bond is about zero at the 10‐year maturity and slightly below 1 percent on the 30‐year maturity. Yet, I have not observed a rush to fill in the Gulf of Mexico or level the Midwest. Why?
For Bailey’s argument to work, environmental permits have to allow the investment in the first place. And, the relevant return is on an after‐tax basis. Will future tax law permit such an investment to earn enough to cover its capital cost?
I am convinced that the issue in the United States today is not that business is shortsighted and unwilling to take risk. Consider the enormous investment, and risk, Boeing assumed when it launched the 787 Dreamliner project. The exact timing does not matter for my argument, but a quick Internet search suggests that Boeing went public with the project in early 2003. Although the plane is currently about 3 years late to market, when Boeing decided to proceed it must have had a planning horizon of at least five years to bring the first model into service. Boeing expected the 787 to yield a stream of extra returns over many years; discounting those returns back to the decision date, Boeing must have thought the project had a present value above its enormous cost.
This sort of long‐horizon investment is frequent in U.S. history. We do not see more such investment now because of uncertainty over the tax and regulatory environment. Martin Bailey, writing before establishment of the Environmental Protection Agency, could not have foreseen that creating new agricultural land in the Gulf of Mexico would have been impossible, and that plans to level sections of the Midwest might have been held up for years and years. And given the unsustainable federal budget situation, returns from risky projects might never be realized because they would be taxed away.
We learn a lot about economic principles by examining extreme cases. No amount of monetary or fiscal stimulus can raise output in many of the countries in sub‐Saharan Africa, for example. Economic growth is impossible with kleptocratic governments characterized by rampant corruption and a population living without security of person and property. Today, it is perfectly rational for U.S. investors to sit on mountains of cash rather than to commit to projects that might well have negative returns.
So, there we are. What medicine do we prescribe? Consumption cannot power the recovery because household balance sheets are still impaired; jobs and income growth are slow. Housing cannot lead the way because the economy already has too many houses. Net exports and inventory investment are too small to be material. Government is fiscally exhausted; continuing large federal budget deficits will only make the long‐run situation worse. The key to recovery is business fixed investment. Incentives matter for investment and that is where our focus must be.
Given this analysis, the appropriate medicine is clear. The federal government needs to settle uncertainties over the tax law and the regulatory environment. There is no possible monetary policy that can fix these problems, or offset them to a substantial degree.
President Obama wants higher taxes on upper‐income taxpayers, but seems unwilling to engage in conversation about tax reform. I suspect that many in the upper brackets would be delighted to see reform — even with some increase in the tax burden — that would provide reasonable certainty about tax rates and tax structure in the future. Our tax system is terribly expensive to administer. My personal guess is that record keeping and fees for tax preparation absorb about 5 percent of my income. I would be interested to hear about other’s estimates of these costs. A far simpler tax system would eliminate most of these costs — pure dead‐weight loss in economist’s lingo.
The U.S. regulatory environment is becoming ever more complex and inefficient. I am not an environmental expert, but it does seem to me that the EPA is going much too far. As for financial regulation, Dodd‐Frank is adding an enormous burden, as yet to unknown degree because most of the regulations have not been written. That burden comes on top of the overkill from Sarbanes‐Oxley. In short, the federal government is strangling the economy. These are self‐inflicted wounds. The stagnation has been created by government and can be fixed by government.
Thank you and I would be pleased to take your questions.