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: