US Competitivenss and the Global Economy

http://www.nytimes.com/2010/11/12/business/global/12group.html?src=me&ref=business

This article illustrates several of the major problems in the global economy and in our domestic economy. President Obama got a cool reception at the G20 meeting which dealt with the important issue of global trade imbalances as well as the role of government in fostering economic growth.

Nations with trade surpluses, such as Germany, China and emerging market countries, expressed concern over the Fed's decision to purchase $600 billion of long-term US treasuries. They believe that efforts to maintain low interest rates in the US will cause investors to seek higher returns by increasing the flow of dollars to surplus nations with higher interest rates and faster growth rates. They worry that this could fuel inflation in their economies and cause their currencies to appreciate relative to the dollar. This could also make their exports more expensive and increase the prices of commodities which are traded in dollars. In short, they believe that the US is worried more about its domestic economy than it is about the global economy

China took the position that the US was not taking its responsibility as the issuer of the world's major reserve currency seriously. Of course, the US has been after China, which pegs its currency to the dollar, to let market forces work to increase the value of is currency to the dollar.
This is a familiar issue that has been with us for some time.

Germany's response was deeper and more telling. It has a trade surplus with the US (as well as with other nations) and it has been able to export its way to economic growth. It suggested that the US should make products that the rest of the world wants to buy instead of trying to devalue the dollar to make US products less expensive in world markets. This raises questions about structural issues in the US economy. Manufacturing wages in Germany are higher than those in the US yet Germany has been able to run a trade surplus while the US has run huge trade deficits. Germany exports manufactured products, which create jobs, while the US has lost its competitiveness in many areas in which it was able to create surpluses. For example, up until 2002 the US ran a trade surplus in many high technology areas. The surplus turned into a $17 billion deficit in 2002 and the deficit increased to $53.6 billion in 2007. This is a trend that should worry us. We may not be able to restore our trade balance by selling financial products or agricultural products to the rest of the world. Besides, these are high productivity sectors which do not create jobs.

There was also a lack of consensus about the role of government to stimulate economic growth. Germany was opposed to government actions that would increase deficits and debt. This may make sense for Germany which is a leading exporter. The UK took a similar stance but for different reasons. Its newly elected conservative government is intent upon using spending cuts to restore fiscal balance. Conservatives in the US would like to take a similar approach by cutting spending, and strangely enough by cutting taxes which will deepen our deficit.

The global financial crisis has exposed major weaknesses in the global economy and in the US. Our domestic economy was fueled by debt instead of by growth in income. Average wages in the US have been relatively flat for 30 years. Growth in consumer spending has depended upon rising debt levels which has been exposed by the bursting of the real estate bubble and a weakening of the banking system. Unfortunately, Obama does not have the full support for taking the necessary actions in his own party and the Republicans will continue their policy of placing the destruction of the Obama presidency above that of restoring the US economy. Things could get worse before they get better.

http://hbr.org/2010/11/column-wealth-and-jobs-the-broken-link/ar/1

This link is to an interesting article in HBR. It offers an explanation of why corporate America is doing well with over $1.5 trillion of retained earnings, and why there are 5 people looking for every job that is available. Essentially, the link between business value creation and job creation has been broken. For example, Google and Facebook are growing rapidly but the growth in their workforce is not like it was in the past when GM's growth stimulated growth in middle class jobs. Similarly, hedge funds trade billions of dollars with much fewer workers than a bank dealing with the same dollar volume. A small number of workers share a very large pool of profits. Its hard to imagine how the US economy can move forward without reinvesting in manufacturing technologies that they are exporting to low-cost regions of the world.

Washington Post is an education company

http://www.nytimes.com/2010/11/10/education/10kaplan.html?_r=1&scp=2&sq=Kaplan&st=cse

The above link is to a NY Times article on the Washington Post Company. According to the article most of the companies profits come from its Kaplan subsidiary. Most of you probably associate Kaplan with its SAT prep courses. It also runs an online college and most of the growth in Washington Post Company profits comes from the online college. It turns out that only 28% of the students who matriculate at Kaplan pay back their government subsidized student loans. This is well below the 44% rate that is expected from the government subsidized student loan program. The Department of Education has proposed changes in the program that would essentially close the Washington Post Company's profit engine. In response to this problem the Post has spent $350 million lobbying Congress to protect its financial interests in Kaplan. Apparently, the effort has been successful in winning support from influential GOP members of Congress.

Although there is nothing wrong with a newspaper owning an online college, and there is no law against lobbying Congress, I find this troubling. The Post is one of our most widely read newspapers, and it is regarded as one of the most influential papers in the country because of its access to political leaders in the capital. It strikes me as a potential conflict of interest for the Post to be lobbying Congress on behalf of its subsidiary. It also seems like a bad investment for the taxpayer and for the students who enroll in Kaplan. We are subsidizing a program that turns out students who lack the skills needed to acquire a job that would permit repayment of their loans. I wonder how the Tea Party crowd would react to GOP support for using taxpayer dollars that primarily benefit the Washington Post Company.

I was surprised to learn that the total amount of money flowing into student loans exceeds the dollar value of residential mortgage loans. Colleges like Kaplan may be analogous to sub prime mortgage lending. Unlike mortgages, however, which are non-recourse, it is very difficult for those without the ability to pay to get rid of their student loan obligation.

Obama's Deficit Commission Report Analysis

Obama's bi-partisan deficit commission reported it's first plan on fixing our deficit and national debt problem. They included a number of spending cuts in the report and they recommended some changes to tax policy. I have provided a graph of spending and tax revenues from the CBO which I have used to criticize the current version of the Commission's plan.

The first problem is that they assume that tax revenues are flat at around 20% of GDP. In other words, they have shifted the tax burden around but they refused to deal with possibility that taxes may have to increase in order to reduce future deficits. The second problem is that the spending issue is absolutely clear from the graph. Medicare is growing much faster than revenue and GDP. This is because health care prices are rising twice as fast as GDP, and because the number of Medicare recipients will increase as the baby boom generation becomes eligible for Medicare. Unfortunately, the report is long on cuts in discretionary spending which is only a small part of the budget and is not growing faster than GDP or tax revenue. The report also proposes major changes to Social Security which is only a minor problem relative to growth in Medicare spending.

In conclusion, a lot of people wasted their time on the wrong problem. Its hard to understand how that happened but one can hazard some guesses. Changes in the price of health care services would be strongly resisted by the entire health care services delivery establishment. Therefore, it is politically impossible to deal with. Social Security, which is much less of a problem, however, gets more attention because it is easier to fix with minor changes to revenue and benefits. It also seems to be a fetish among Republicans who continue to view it as a Democratic program that really works. In George Bush's recent book he said that his biggest regret was his inability to privatize Social Security. Discretionary spending receives attention because its easy to mess around with the budget and make lots of small changes that give the appearance of real effort but which have only a small impact on the outcome. Lastly, the report fits in nicely with the conservative prohibition against any efforts to pay for government services with tax revenue. Both Reagan and the junior Bush were successful in cutting taxes and paying for government services with debt.

Where Deficits Come From

Since the 2008 election much more attention has been paid to the problem of federal budget deficits and the national debt. The GOP, in particular, has rediscovered its purported passion for fiscal conservatism. They apparently, lost this passion during the Bush administration when they cut taxes substantially and increased spending considerably. They even added an expensive benefit to Medicare. They voted in an expensive drug benefit to the program just prior to the 2004 election which did not hurt their chances to win votes from the elderly. In any case, we do have to bring spending and tax revenues into greater alignment after we recover from our current downturn. The Congressional Budget Office has provided an analysis of the major sources of budget deficits, and their implication for the national debt projected into 2020. Their analysis assumes no changes to current law. This enables Congress to assess the impact of changes in policy against their benchmark. I have provided a graph of the CBO projection to help with our analysis.

The first thing to notice is the impact of lost tax revenues in 2009 and 20010 on the federal budget deficits. The loss of tax revenues due to the recession and the loss of tax revenues as a result of the Bush tax cuts are, by far, the major cause of these deficits. The economic recovery act also had an impact. The act increased spending but it also cut taxes by over $200 billion. Spending on TARP to deal with the financial crisis and the wars in the mid-east also contributed to the deficits. We should recall, however, that TARP was enacted in the Bush administration. These data indicate that lost tax revenue from multiple sources have had a far greater impact on the budget deficits than increases in federal spending. There is little support for the ranting and raving coming from politically motivated sources that the deficits are due to "out of control spending" from tax and spend liberals. In fact, to the extent that increased spending mitigated the loss of jobs, and even greater loss of tax revenue from the recession, the deficits might have been greater without the stimulus.

It also important to look out to 2020. This analysis assumes that the Bush tax cuts will not be allowed to expire as called for under current law. The loss of tax revenue from the Bush tax cuts will add $4 trillion to the national debt in 2020. It is clear that cuts in spending alone cannot restore balance to the federal budget. It seems, however, that we are in for two more years of political gridlock. The GOP will not accept changes to current law that eliminate the tax cuts to the wealthiest Americans and Democrats do not want to eliminate the tax cuts to the middle class during an economic downturn.

Reactions to Recent Actions by the Fed

Prior to the current economic downturn the Fed could shift the direction of the economy by making relatively modest purchases or sales of US Treasuries. They sold treasuries to shrink the money supply and increase interest rates when they worried about inflation and they purchased treasuries and lowered interest rates when unemployment was a concern. The Fed has played a much greater role in the economy since the banking crisis. It participated in the bailout of the banking system by purchasing assets other than treasury bills from banks and other financial institutions and it made loans to other institutions that needed cash. Its balance sheet is much larger and much more diversified than it has been in recent history.

Most recently, it has decided to purchase up to $600 billion of long-term debt from the Treasury. They hope that this will halt the decline of the price level in the economy and prevent a potential deflationary spiral like that which occurred in the Great Depression and, more recently, in Japan. It should also keep interest rates low and encourage spending that might enable the economy to recover more rapidly from its downturn. This decision is not without its critics. I have provided an overview of the issues raised by this unusual development.

The Fed has traditionally played a much different role in the economy. By prudently managing the money supply and interest rates it has done a good job of preventing price inflation and in maintaining price stability and reasonable levels of economic growth. The purchase of $600 billion of long-term treasuries will greatly expand the money supply and many worry that it will lead to price inflation. By increasing the money supply it may also cause a decline in the value of the dollar. A cheaper dollar might make US products more attractive to our trading partners and increase exports. This message has not been lost on our trading partners who fear that it might limit their exports to the US. It might also cause the prices of commodities purchased with dollars to rise and contribute to inflation. For example, oil prices are based on the dollar and a fall in the value of the dollar will cause the price of imported oil to rise. Economic growth in emerging markets, such as China and other fast growing markets, has also increased the demand for many commodities such as cotton and copper and their prices have increased substantially.

On balance, the Fed made a tough decision, with considerable risks, because it believed that the consequences of inaction were worse than those of the action that it is taking. Not surprisingly, the reactions to the Fed decision have been strong and varied. Some believe that they are doing too little to late and that the contribution to recovery will be weak. Others, have reasonable concerns about the potential for price inflation and about the potential decline in the value of the dollar. Unfortunately, there have also been unreasonable concerns raised by those who have little understanding of the economy or monetary policy in particular. Sarah Palin, gave a recent speech, intended primarily I assume for her constituents, that demonstrated her lack of understanding but also her ability to create fear and misinformation about vital issues. Our problems are many, and the answers are not easy, but they are made much more difficult when media celebrities and politicians, who worry primarily about the next election, intentionally mislead the public.

Government Bailout of GM is Success

GM reported a $2 billion profit for Q3. This was its largest quarterly profit in 11 years. Revenues were up 27% in Q3 versus previous year Q3 to $31.5 billion. Prior to reorganization GM needed to sell 4 million cars to break even. Today it can make a profit on half the number of vehicle sales.

If we had let GM fail thousands of jobs would have been lost and it would have had a devastating impact on the economy. Today it is a $120 billion firm that contributes greatly to the economy.

Libertarians, such as Tea Party members, opposed the bailout when the Obama administration proposed the rescue. It looks like the administration made the right decision. We should be glad that the administration ignored the opponents of the rescue.