Bernanke’s Double Bubble Bind

In a speech to the American Economic Association on January 3, Ben Bernanke, chairman of the Federal Reserve System, took on the question of whether easy monetary policy led to the recent bubble in housing prices. I don’t disagree with his broad conclusions about the importance of regulatory policy. But it wasn’t until the end of his speech that he dabbled briefly with the far more important question: whether new types of monetary, fiscal, and regulatory actions are required to contain bubbles in all major assets, not just housing.

Constraining unreasonable inflation in asset prices, while still minding commodity prices and promoting growth, is a formidable goal. Formidable because dampening an asset bubble could constrain recovery. Formidable because inflows of foreign saving influence asset prices and can be difficult to control. Formidable because the growing power of hedge funds, banks, private equity managers, and others to take advantage of even tiny differences in returns across assets may be weakening central banks’ power.

As a student of economic history, Bernanke was well aware of the extraordinary tightening of credit during the Depression. And he reacted accordingly. But as someone who looks at the data, Bernanke also knows that each new economic cycle is unique. A few years ago, economists thought economic cycles were growing less frequent and severe. But now? We don’t know. In the recent great recession, things got much worse. In the financial markets (whose collapse made this downturn so severe) we’ve also seen some unusual and disturbing trends, including two asset valuation bubbles-each way out of line with the post-World War II pattern, and each followed by a recession.

The figure below depicts those bubbles. It shows the net worth of U.S. households as a percentage of their disposable income. Throughout the postwar period until the late 1990s, the ratio averaged about 500 percent-less if you exclude the bubbles. For every $1,000 of income, households in aggregate had net worth valued at about $5,000.

chart, described in previous paragraph

Increases in stock market valuations, largely for tech stocks, caused the first great financial bubble, which burst in 2000. Rises in housing and stock and other real estate values-an unusual combination-drove the second great bubble, peaking just recently. Typically, when one market experienced unusual growth relative to income (as housing did in the 1970s), others experienced atypical relative declines (think stock in the 1970s).

Despite a huge overall decline in net worth, by the end of 2009 we had already recovered to about the average level for the post-World War II period. Further significant spurts in asset values could easily move us back well into the above-average range. At this point, further steep asset gains may not be desirable. A wiser hope is for incomes to rise at above-average levels to make up for lost ground, with net worth rising in tandem.

If net worth should shoot up too much, however, the Federal Reserve and the Treasury will start asking themselves whether they must act to prevent a third financial asset bubble. They could react by trying to tighten regulation-e.g., lower loan-to-value or higher capital requirements, although in many areas that requires legislation. They could respond by raising interest rates. They may already be responding in part by selling back to private markets some of the many assets acquired during the downturn. Or they might simply threaten to do something. I was present in 1996 when Alan Greenspan, then chairman of the Federal Reserve, asked in a speech whether “irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” Although he did not intend it, the stock market took a fleeting dive the next day.

The influx of foreign money makes choices more complex. Bernanke hints at this by noting that cross-country comparisons show that greater inflows of capital tended to produce higher housing price inflation. But he didn’t carry his analysis past the housing market, where these inflows help explain the broader asset bubble. If housing had been better regulated, would other U.S. assets simply have bubbled more? Greenspan also confessed in a recent book that he felt he had limited ability to offset the effects of the inflow of foreign saving. Recent efforts to jawbone the Chinese to let the value of their currency rise and to invest more in their own economy represent one not-yet-fully-successful response.

Next we get to the hedge funds, banks, and private equity managers of money. As long as both foreign governments and the U.S. Federal Reserve try to keep interest rates or the value of their currency low, private money managers can effectively borrow at subsidized rates, or invest in undervalued currencies, while buying assets with higher expected rates of return and selling (relatively) overvalued currencies. (Another caution: this is almost all short-term financial investment, not real investment aimed at improving output or long-term productivity.) Without going into details here that are part of a longer story, this opportunism has sapped the Federal Reserve’s ability to spur increased real investment by subsidizing borrowing. In effect, many of the subsidies born of monetary and fiscal policy simply benefit those who can “arbitrage” or take advantage of the differential rates of return generated for existing assets.

I suppose that the U.S. (and world) economy could settle down to a new level of valuation of net worth relative to income: the two peaks seen in the graph, with net worth closer to 650 percent of income, could become a new norm. That could happen, for instance, if the U.S. and world economy became more stable, worldwide saving rates increased, and investments in total became less risky. But the two financial bubbles so far tell us a different story: worldwide government efforts to control economies, combined with the creation of large subsidized opportunities, have been inadequate to deal with, and perhaps even helped create, destabilizing arbitrage opportunities that are brought back into balance by a collapse.

My bottom-line bet: Bernanke’s double bubble bind tends toward trouble if triplicated.


Unwinding the Stimulus Package

Now that the United States has discovered that it was easier to fall into a recession than to climb out of one, the Obama administration needs to learn an equally urgent lesson.  Timeliness is important not just for getting into, but also backing out of, an economic stimulus package.

With a price tag of around $800 billion, the package as currently envisioned by the Obama economic team translates into about $7,500 of new cash and new government debt for every household in America.  Whether or not you believe that a stimulus program is a good idea, its goal should at least be to get the money out when it is most likely to have the greatest impact on the recession and on the health of the economy.

The sorry record in many past recessions has been that the money was spent when recovery was already well underway or it generated limited impact on demand.  For understandable reasons, then, the debate about the package has focused on the front end.  Will infrastructure projects be “shovel-ready?”  Will other spending or tax cuts have an immediate impact?  Congressional Budget Office analysis already makes clear on the front end that a number of projects won’t be fully underway until 2010.

But it is equally crucial to start thinking about the back end, however counterintuitive that may sound when crisis is at hand.  Not doing so risks an increase in budget deficits and debt that would force interest rates up over the long term, limiting the strength of a recovery.

This issue of “unwinding”—how to back out of the stimulus programs when they might introduce problems into a recovering economy—is a growing concern among economists.  Most of them—at least the honest ones—know that our knowledge is limited in dealing with a crisis that is unprecedented in many ways.  Smart planning today at least will give us more discretion and latitude over policy choices tomorrow.

Although new countercyclical actions by Congress are being demanded, it is important to remember that countercyclical policies are already in place—automatic “stabilizers” that drain government coffers during downturns and fill them during upturns.  With a downturn, federal and state taxes go down and outlays for unemployment insurance and food stamps go up.  Accordingly, for every dollar of loss in income in the economy, the government already returns about 35 to 40 cents to households and businesses.  This is a far higher level of automatic stimulus or adjustment than occurred when John Maynard Keynes, often considered the intellectual author of deliberate countercyclical policy, first advocated a more active or discretionary government fiscal policy during the Great Depression.

The great advantage of automatic stabilizers is that they get the timing right on both ends—not depending upon discretionary action to begin or end.

Following are some other possibilities for tweaking tax and spending programs so they become more like automatic stabilizers—packing maximum punch in the downturn and pulling back when the economy recovers:

  • Beef up the level of food stamp benefits with adjustments downward triggered automatically when no longer needed.  Peg higher food stamp and unemployment benefits to the level of unemployment benefit applications, or a similar indicator.  In other words, let the spending go up or down automatically during both the downturn and the upturn.
  • Make the tax and transfer system as a whole more progressive. When incomes fall, let people’s tax rates fall even more.  When their incomes rise, they can make up for what they got on the downside.
  • Let the tax cut be reflected in withholdings but end on the basis of the economy’s condition rather than some arbitrary date like December 31, 2010.  At the end of 2010, say, if the unemployment rate was still unacceptably high, the cut would apply for the whole year.  If it came down substantially by September 2010, the withholding adjustment would be reduced, possibly to zero depending upon the extent of the economic improvement.
  • Peg the continuance of any new assistance to the states to requirements that their own fiscal house be set in better order for the future, e.g. that they establish rainy day funds and during stock market upswings adjust downward assumptions on future rates of return on the stock investments in their pension funds.  These requirements needn’t slow down the initial flow of payments to the states.

It is not just payments to individuals and states where policy makers seem to set cut-off dates arbitrarily.  Consider proposals for new investment incentives, which look very much like the several other “temporary” investment incentives that applied in late 2001, 2002, 2003, 2004, and 2008.  No one yet has offered any rationale for the dates any of them ended.

Even as the Obama team joins with Congress, the Federal Reserve and other players to design the best possible recession-induced initiatives, they will be doing a disservice if their discussion does not extend to how to unwind those initiatives when they reach the point of doing more harm than good—to the economy, to the budget, and to your pocketbook.


“Investment” and Obama’s First Budget

President-elect Obama’s chief in-house economic advisor Larry Summers suggests in a recent Washington Post piece that the new Administration will put a lot of effort into addressing long-term growth challenges, not just short-term policies that generate consumer spending.  How?  Through “investments.”  To make sure we get the point, Summers uses that word or some variation 12 times.

But the first Obama budget will not be oriented toward investment.  Just as with recent administrations, the words will stress “investment” but the numbers will emphasize “consumption”—not only in the short-term but, more dangerously, in the long-term.  In fairness, this is the budget the new administration inherits.  They gain control of the wheel of a battleship sailing full-steam ahead toward the icebergs.  But by using terms like “down payment” to describe new proposals, Summers hints that no major course correction will be sought.

Consider first the short-term.  If, by the time the recession is over, the government takes on net additional liabilities of, say, $2 trillion and invests even as much as one-fourth of that amount, then its net investment is minus $1.5 trillion.  And that assumes that the investments really are investments.  Believe me, politicians will now be calling every item they favor, even the subsidized importation of tsetse flies, an “investment.”

I’m not suggesting that a faster economic recovery, if achieved, could not bring enormous benefits, eventually including higher private investment and higher government revenues.  But regardless of Summers’ pitch for investment, the means toward that end still rests primarily on financing additional consumption through higher debt.

So the real issue is the long term.  If we consume more temporarily as a means of recovering our economic health while moving toward a path of long-term investment, it’s one thing.  If we’re planning on only increasing our consumption even further down the road, it’s another.

Recently, I led a study sponsored by the Partnership for America’s Economic Success that comprehensively examined total investment policies by the federal government (see http://www.urban.org/UploadedPDF/411539_investing_in_children.pdf).  While we paid special attention to investments in children because of their extraordinary long-term importance and potential high rates of return, we nonetheless reviewed all types of investment.  Because researchers disagree on exactly how to measure investment, especially if counting some forms of social spending, we also used a variety of measures.

No matter how we parsed the numbers, the message was clear: relative to GDP or domestic spending, total federal investment and investment in children fell over the past few decades.  More importantly, overall government investment, and especially investment in children, is declining in relative and sometimes absolute importance.

The cause of the problem: these potential investments are being squeezed out mainly by faster, automatically growing programs that tend to favor consumption.  For instance, while growth in the economy would provide some additional $650 billion in additional domestic spending annually by 2017, the amount going toward education and research would be about zero under current law.  Alternatively, the share going toward kids’ education and research and work supports for families with children and social supports for children would be only about $26 billion, and that number is weakly positive only because of bad news: constantly growing health costs.

Unlike the one-time costs of dealing with a recession, such large numbers would repeat over and over again at ever higher levels each succeeding year.  For almost all purposes, including investment, how we spend hundreds of billions and eventually trillions of dollars of additional revenues year after year swamps in importance how well we allocate stimulus spending meant to be temporary.

Despite several mentions of the long term and a few mentions of children, Summers did not really intend for his Washington Post piece to set out the long-term policies of the Obama administration.  He was more narrowly addressing an ongoing debate, primarily among Democrats, about how to spend new stimulus money made available today.  Should we aim only to get money out to people as quickly as possible to stimulate their demand and consumption?  Or should we determine that if we are going to spend so much money, we ought to get something back for it in the form of “investment.”  That Summers published the piece tells us that his side won the internal debate within the Obama camp.

The issue for many of us is not just about whether we do a little maintenance on the side while we fix the battleship’s leaking hull.  The ship is still heading in the wrong direction—not without potential consequences for both the hull and the battleship as a whole.


The Breadth of Brokenness

The breakdown in the financial markets, our huge budgetary mess, and multiple government scandals have only highlighted the depth of our government’s problems. Recently, I noted that the required governmental reforms are so extensive that President Obama will find it difficult to succeed by taking one-off approaches to each of the nation’s problems rather than addressing them in a more unified way. Here I strengthen my case by turning from the depth to the breadth of brokenness of government.

Unfortunately, it’s an easy case to make. If you have any doubt, try the following exercise: stretch your mind across the landscape of government program areas or departments and consider how much spadework must be done almost everywhere you look. See if you agree with my own list:

Health Care: The problems here extend far beyond the number of uninsured and an unsustainable cost growth that compounds this number by making insurance less affordable. Our system subsidizes acute care but seldom prevention, encourages drug companies to work on chronic care drugs rather than on cures that might not require as many drugs, and pays doctors who specialize far more than those who provide the kind of primary care that may be more valuable. Our tax system, meanwhile, gives much larger subsidies to high-income workers than low-income workers to buy insurance.

Tax Policy: Because of multiple tax subsidies, tax rates continue to vary widely among people of equal incomes, means, and needs—thus violating standards of equal justice under the law. The IRS, meanwhile, has so many programs under its jurisdiction that it administers few of them well. It can’t even provide much information on who benefits from its subsidies for housing construction, empowerment zones, or appreciated property.

Social Security: With benefits extending to most couples for more than a quarter of a century of retirement, the program has evolved into a middle-age retirement system. Spreading benefits over so many years means that increasingly smaller shares of spending go to those who are truly old or in need. All of this would be true even if the system were in financial balance.

Disability: Government programs for the disabled are themselves on the disabled list! They exhibit almost total inability to help the disabled get off the disability roles and return to work. Meanwhile, the Social Security Administration simply cannot handle its backlogged caseload of applicants.

Environment: The EPA has become so heavily politicized over time that it makes it hard to move forward on the environment and energy front. The benefits and costs of environmental efforts are often hard to measure, but we’ll never get anywhere so long as the public sees the agency as basically a shill for whichever party is in power.

Housing: As if current housing woes weren’t enough in a financial meltdown, the tax system provides generous tax subsidies to those who are rich enough to own several homes, but nothing to those with too little income to pay tax! Meanwhile, the Department of Housing and Urban Development has been continually plagued with accusations of mismanagement and sometimes even corruption.

Consumer Protection: Where was consumer protection as the mortgage crisis developed? Who’s helping those who today are trapped in bad student or car loans? What protections are provided against junk mail with checks that really aren’t checks or apparent government contacts that aren’t from the government?

Antitrust: Where are the attacks on modern oligopolies? Hollywood tells us to hate the industrial concentration of power, but what about concentration in modern industries like entertainment or health care? These oligopolies bear some of the responsibility for the increasing inequality in income.

Justice: How did the Justice Department become so politicized that political checks were being made against even new civil servants? If we can’t trust Justice to promote a rule of law, then we’re all in big trouble.

Transportation: Although infrastructure arguments are sometimes exaggerated, there is much merit to concerns about crumbling bridges and about building a 21st century transportation system that would supplement and move beyond the rail and highway developments of the 19th and 20th centuries.

Education: While the federal government’s latest big effort, No Child Left Behind, encouraged states to better measure children’s progress, its overall focus has been too narrow—passing some minimum standard of qualification. That simply led to incentives to focus resources on about 10 percent of all kids—those just below the minimum standard—so that “progress” could be proven on that basis alone. Those above the standard and too far below it to stand much chance of passing the qualifying test were effectively left out of the equation. More generally, primary and secondary education remains stuck in a 19th century model in which kids are supposed to go home in the afternoon to do the chores and in the summer to take in the crops.

Pension Policy: How can our elected officials justify a system that subsidizes pension saving to the tune of $150 billion a year, yet results in little or zero personal saving? Meanwhile, the data are clear: most low and average income households go into retirement little or no retirement saving. By any measure, this subsidy system is not working.

Need I go on? How about agricultural subsidies to the rich? Or the risks faced by the Pension Benefit Guarantee Corporation because of inadequate funding of many pension plans? Or the scandals surrounding the General Services Administration and military contracting? One day you may even find that the way we appoint Senators to a vacant seat may lead some governor to seek bribes. Nah! But you get the picture.

Many government programs were created decades ago for a different economy, a different family and industry structure, and even a different understanding of our economic and cultural opportunities. Meanwhile, many of the agonizing debates over the past three decades have represented a see-saw battle, more often over symbol than substance, leaving in place agencies and programs often moribund and incapable of meeting many modern needs.

We’re not going to fix a government this broken with a little glue.


Employment and That Magical Year, 2008

Everyone knows that 2008 promises to be a bellwether year, rife with dramatic changes already glimpsed. Some harbingers of change are obvious. A new president will be elected—though campaigns hide as much as reveal what that president will choose or be forced to do. The subprime mortgage market also portends dramatic changes in the financial markets in 2008 and beyond. But perhaps the biggest change of all is a sleeper so far—the first year of a scheduled drop-off in employment growth that will last for some 30 years running. If this decline is left unchecked, the net impact on employment will be far greater and longer lasting than the temporary employment dip during the Great Depression.

Suppose that the economy was about to suffer the equivalent of an increase in the unemployment rate of about 3/10 of 1 percent every year for the next 30 years. Further suppose that in many of those years, the number of workers declined rather than rose. Meanwhile, suppose that the rate of revenue growth declined along with employment growth—at the very same time that the rate of government spending starting rising rapidly because more and more people qualified for “elderly” benefits.

If you were an official in charge of economic policy, would you be worried? If you’re an investor in stocks and bonds, should you be concerned?

Well, you should be. These ominous trends and more are now at the starting gate. The unprecedented mega-transition scheduled for the U.S. economy stems from both demographics and public policy. The rise and coming fall in employment of the baby boom generation—those born between 1946 and 1965—provides much of the demographic impetus.

Tracing the impact of the baby boomers on the economy over the years has often been likened to following a pig swallowed by a python. First, the boomers affected their parents’ demand for post-World War II housing. Then their ranks swelled enrollment in primary and secondary schools. From the mid-1960s to the mid-1980s, college enrollment ballooned. Lately, the baby boomers have been stocking away retirement assets, adding to the national total, and, through increased demand, driving up the prices for second and vacation homes.

So how does the swallowed pig affect the national employment picture? When the Reaganites and the Clintonites brag about job growth during the 1980s or 1990s, they are mainly trying to claim personal credit for the number of human eggs fertilized from 1946 through 1965. Those embryos became babies who became workers and swelled the labor markets a few decades later.

Two other demographic factors added to labor market buoyancy and lack of fiscal pressure during the period that boomers stocked the workforce. First, these boomers came on the heels of a baby bust population born during the Depression and World War II, so growth in the ranks of the elderly was restrained. Also, women entered the labor market in droves, eventually reaching employment levels close to men’s.

One net result was that U.S. employment grew 12 percent in the 1950s, 20 percent in the 1960s, 26 percent in the 1970s, 20 percent in the 1980s, and 15 percent in the 1990s. From 2000 to 2007, the growth was roughly 7 percent.

Public policy adjusted to the pig in the belly of the snake partly by taking advantage of the additional revenues provided by the new workers. Occasionally, elected officials increased subsidies for housing, education, and retirement saving to accommodate this generation. They also offered more and more years of retirement support and higher annual benefits to each succeeding generation of retirees.

But that was then. If higher employment growth spurred economic demand and growth, as well as government revenues and spending, in the past, what is lower employment growth likely to mean for the future?

We often read statistics about when Social Security funds will become inadequate to pay promised benefits. But the current system’s obligations aren’t confined to giving bigger benefits to more people. Besides that tall order, policymakers will have to deal with the projected decline in revenue growth rates as close to one-third of the adult population moves onto Social Security.

We can hold off on the hand-wringing only if we believe that demand for older workers will swell and that many boomers will stay in the workforce. I, for one, think that can happen and that many of the doomsday scenarios for this new labor market are wrong. Yet, the supply of older workers will be crimped as long as public and private employment policies stay rooted in the 1970s—or even the 1990s. How fast and well employers and government officials adjust will determine whether demographic changes poised to unfold starting in 2008 bolster or drag down the economy. Among the tallest of orders is to move away from private and public policies that now encourage retirement in middle age—a subject for another time.