SHANGHAI DECEMBER 9TH 2010

Thoughts on the Ongoing Global Financial Crisis/Recession

Robert J. BarroHarvard University

ORIGIN OF FINANCIAL CRISIS/RECESSION

Central is U.S. housing/mortgage market.

Private sector underestimated systemic risks concerning national declines in average house prices.

Combination with new forms of securitization magnified the mistake. But this mistake has been learned; won’t be repeated in this form.

Increasingly, over several decades, U.S. government became far too involved in housing/mortgage market.

Subsidies through Fannie Mae and other government-sponsored enterprises (GSEs). Government encouraged lowering of lending standards, maintained legal system without recourse on mortgages. Canada and other countries did not have this problem.

Need to phase out role of GSEs, such as Fannie Mae.

U.S. Federal Reserve has amassed almost $1 trillion of mortgage-backed securities since August 2008. Need to phase this out also.

Should eliminate mortgage interest deduction, which has inflated demand for housing. Will help also with fiscal deficit.

U.S. FISCAL RESPONSES TO CRISIS

In recent U.S. midterm Congressional elections, sharp move away from Democrats. This move reflected opposition to all forms of added government spending/intervention by Obama administration.

I distinguish financial-institution bailouts started under Bush in 2008 and continued by Obama from other forms of expanded government spending.

Around time of Lehman collapse (September 2008), threat to global financial system implied possible contraction akin to Great Depression of 1930s. Lehman really was too big to fail, but U.S. government (mistakenly) allowed it to fail anyway.

After that, bailout for AIG and commitments to Morgan Stanley, Citibank, etc. necessary to avoid depression threat. Convinced markets that Lehman-type failure would never again be allowed (good for stability, bad for moral hazard).

FISCAL-STIMULUS PACKAGE

Fiscal-stimulus package of 2009-10 of around $800 billion mostly waste of money. Obama administration continues to overestimate positive effects on economy (spending multiplier).

Large fiscal deficit appropriate during recession/financial crisis. But deficit should have been focused on tax cuts, particularly cuts in marginal tax rates.

U.S. evidence—for example, for Reagan programs in 1980s and Bush programs in 2000s—is that cuts in marginal income-tax rates stimulate economic growth. Incentives to work and invest important here.

Tax cuts more powerful than comparable size spending increases.

Last several years, U.S. experienced large run-up in public debt without much benefit from fiscal stimulus. These developments fostered concern about lack of long-term fiscal discipline by U.S. and other governments. Threat especially to holders of U.S. government bonds (including China).

Other programs by Obama administration also mistakes:

Bailouts of General Motors, Chrysler bad ideas—these companies do not have systemic role like large financial institutions. Auto company bailouts served mainly to transfer money to labor unions at expense of bondholders/taxpayers.

Healthcare law of 2010 another error. Adds to long-term problem of managing entitlement spending (in this case for Medicaid). No reform, just more spending promises. (As with Bush Medicare prescription drug expansion in 2003.)

Worst Obama program was “Cash for Clunkers,” a way to spend money by destroying used cars, changing timing of new car purchases. But this program not so large.

More important mistake was increased duration of unemployment-insurance benefits to 99 weeks—compared to previous maximum during recessions of 50-60 weeks.

UI expansion sharply raised long-term unemployment. Program likely explains 1-2 percentage points of currently high unemployment rate—could have been around 8% now, rather than 9.8%.

Bush administration also lacked spending discipline: large increases in Medicare, education budget, ethanol subsidies, farm subsidies, …

FEDERAL RESERVE’S MONETARY POLICY

Another concern is sharply expansionary policy of U.S. Federal Reserve.

Some of this was reasonable response to crisis; Ben Bernanke’s desire as Fed Chair to avoid threat of depression. Explains sharp drop in short-term nominal rates to around zero.

Since August 2008, Fed’s balance sheet has expanded by over $1 trillion. Hard to understand massive accumulation of mortgage-backed securities. Adds to subsidy to mortgage market. Threatens “central bank independence,” makes Congressional intervention likely. Fed’s portfolio now very risky, not unlike Lehman’s in September 2008.

New plan for quantitative easing (QE2), focused on purchases of long-term U.S. Treasury bonds.

Since nominal interest rates already near zero, QE2 will not have much expansionary effect on GDP. Effect equivalent to U.S. Treasury shortening maturity of its debts.

QE2 complicates Fed’s exit strategy for avoiding inflation if economy recovers and short-term nominal interest rates rise above zero. Fed is over-confident about its ability to manage exit strategy. But inflation expectations in bond market still low.

CRISIS OF GOVERNMENTS

World economic future fragile. Next crisis, already begun, is likely of governments. Reflects lack of fiscal discipline in U.S., Europe, … Some of this problem long term, some a response to crisis.

Serious threats to viability of Euro zone. Already crises in Greece & Ireland. Portugal likely next, but more serious threat is Spain—much larger.

Threat revealed by prices on financial markets—CDS (credit-default swaps) and yield spreads on government bonds. Range of 600-900 basis points for CDS. Factors in probability of default—most likely, some kind of forced restructuring of debts. Problems spreading to center of Euro zone—Germany & France?

Fiscal problems of many U.S. states analogous to problems in Europe. For example, California and Illinois have massive problems with unfunded (defined-benefit) pension liabilities. Will U.S. government, already stretched, provide guarantees and bailouts?

Are governments too big to fail? (I thought yes on “too big to fail” for Lehman, AIG, …, no for General Motors.) We will find out soon for governments.

FISCAL REFORMS

U.S. and other governments need fundamental fiscal reforms. Has to feature sharp curtailing of spending, particularly on major entitlement programs (social security, medicare, medicaid in U.S.).

Should also feature major tax reforms. Eliminations of “tax expenditures,” such as favored treatment in U.S. for mortgage interest, state & local taxes, health-insurance premiums.

Might entail substantial tax increases. Two main candidates for incremental efficient taxation in U.S. are expansion of payroll taxes and introduction of value-added tax (VAT) or analogous general sales tax. (Corporate income tax and estate tax should be zero.)

Problem, as illustrated by Europe, is that existence of VAT makes it easier politically to raise government spending.

U.S. DEFICIT COMMISSION

Recent proposals by U.S. deficit commission surprisingly good. Reflects growing consensus on seriousness of fiscal crisis. Atmosphere where basic tax and spending reform politically feasible (as in 1986 under Reagan). But U.S. may need new President to do it.

U.S. ADVICE

Given background of problems and bad policies, remarkable that U.S. government officials so eager and confident in advice offered to other countries.

U.S. criticized Germany for moving toward fiscal discipline—as though smaller fiscal deficit meant that Germany not contributing fair share to world. With this logic, Greece a great hero. But, in fact, Germany now doing better economically.

U.S. has also provided lots of unsolicited advice to China, although China has been doing better than U.S. on economic growth.

Key issues are China’s exchange rate and current-account surplus. These issues are connected.

With its high real exchange rate (measured as China’s goods per unit of U.S. goods), China has provided large quantities of high quality products at low prices. Clearly a good deal for U.S. and rest of world. (What if China gave away the goods for free?) Yet U.S. complains about this. Reflects a mercantilist approach that values exports above imports.

Yet from China’s perspective, the current deal may be bad. Better to allow real exchange rate to appreciate faster—then China gets more foreign goods (imports) for each unit of goods exported.

Related matter is that China’s saving rate has been high and rising, as reflected in enormous current-account surpluses. Why does China want to amass so much in international reserves, rather than consuming and investing more? Particularly when reserves held as U.S. or Euro-zone bonds pay such low interest rates?

If I were advising China, I would advocate policies that raised domestic consumption and investment and, thereby, reduced current-account surplus. This approach would involve faster real appreciation of currency, faster growth of real wages.

Odd thing is that U.S. government offers this advice to China, although implementation bad for U.S. (because fewer imports available at low prices).

Maybe China should be offering economic advice to U.S. and other western countries. After all, China seems now to be most capitalistic country on earth.