Sustaining U.S. Prosperity in a More Competitive World Robert M. Coen Department of Economics Northwestern University December 2, 2008

Better title: Maintaining U.S. Prosperity in a Shaken World Robert M. Coen Department of Economics Northwestern University December 2, 2008

Challenges for Obama Short-run: Financial crisis and recession Restore stability and trust in financial markets Moderate declines in employment and production Long-run: Slow productivity growth Environmental degradation Energy inefficiency Growing income inequality Growing inequality in access to health care Short-run crisis overshadowing all else

How bad is the situation? GDP growth: -0.5% in Q3, but +2.8% in Q2. Modest decline thus far by historical standards. Employment: 10 months of decline; 1.2 million jobs lost, but percent loss not yet huge. Industrial production: down 4.7% from peak in Jan. 2008, but actually rose 1.3% in October. Stock market: major collapse, but not unmatched historically. Housing starts in free fall since 2006, but similar to some previous housing cycles.

Housing Starts, 1960Q1 to 2008Q3 Housing boom ends in 2006 Q1

How bad will it get? Credit crisis still snowballing Epic decline in housing prices not over, more mortgage defaults likely Excess inventories of houses/cars must be worked off Job cuts will create more mortgage/consumer credit defaults Falling household income and wealth will reduce spending Business, state-local govts can’t get short-term finance Auto industry bankruptcy? World economies slowing, reducing our exports Spreading gloom and doom

Credit Crisis Background Financial Innovation/Deregulation Deregulation of interest rates Permission for branch banking Certificates of deposit Money market mutual funds Mutual funds, stock index investing, competitive brokers’ fees Flexible mortgages Home equity loans Development of futures and options markets Securitization of mortgage and consumer debt Floating currency exchange rates Venture capital, private equity, hedge funds Freer flow of money internationally Credit default swaps

Banks Grow Riskier: Why? More competition from non-banks MMMFs, investment banks, hedge funds Equity holders unable to impose discipline Regulatory capital requirements not effective Bankers inclined to take greater risks Big payoffs to them if bets win Depositors, equity holders, or taxpayers absorb losses Collect fees in either case Gramm-Leach-Bliley Financial Services Modernization Act of 1999 repealed Glass-Steagall and added to potential conflicts of interest

Financial Innovation/Deregulation Good Effects Promotes competition – better deals for savers and investors Securitization allows lenders to expand loans Promotes homeownership rate (from 64% in 1995 to 69% in 2004) Creates insurance against many financial risks Improves allocation of investment and business risks Improves allocation of capital to most profitable uses

Financial Innovation/Deregulation Bad Effects Innovation often an escape from regulation Hedge funds a good example Need for new regulation (like automobile) But can it work? Innovation runs ahead of regs Securitization separates debtor from creditor (cf. new mortgage market vs. old) Spurs irresponsible lending practices Incentive to generate commissions Complicates recontracting for troubled debtors Gives false sense of security from risk Can lead to increased leveraged speculation

Other Factors Spurring Credit Expansion Low interest rates (courtesy of Greenspan) encourage borrowing and leverage Growth in international savings seeks home in U.S. Our trade deficit builds up foreign reserves Burgeoning profits of oil exporters Finances of developing countries improves following crises of Failure to oversee lending practices, capital ratios

Snowball effects when credit bubble bursts Sharp rise in mortgage defaults and foreclosures Prices of mortgage-backed securities (MBS) go south Highly-leveraged holders of MBS’s find value of assets dwindling; their creditors want more collateral Liquidation of MBS’s difficult Turns out risk of MBS’s erroneously rated Hard to recontract mortgages in pools

Snowball effects when credit bubble bursts Foreclosed properties further depress house prices, leading to more defaults, etc., etc. Venerable financial institutions brought down Sellers of default insurance on MBS’s face huge payouts (AIG) Panic spreads to other financial firms, even healthy ones E.g., MMMF’s -- some “break the buck” Others suffer withdrawals, become conservative Unload commercial paper, drying up credit in that crucial market Lack of business, political leaders to calm waters

Auto Industry Bailout? Output down 20% since 2005 Q3 peak Sales down 25% from 2005 Q3 peak Sales of more profitable trucks down 37% Losses every year since 2000 “Good year” 2005: $4 billion loss Cumulative losses : $46 billion Employment down sharply 1,319,000 in ,000 in 2007

Auto Industry Bailout - Pro Huge job loss if bankruptcy 2007 employment levels, vehicles & parts Manufacturing 994,000 Retail1,969,000 Total2,963,000 Finance groups afflicted by credit crisis Domestics disadvantaged by health and pension costs Default would create CDS bombshell

Auto Industry Bailout - Con Job loss overstated New owners will continue some operations Demand for parts won’t disappear Merge finance arms into healthy finance companies Bankruptcy only way to reduce costs (break contracts) CDS writers need to be disciplined

Policies to Mitigate Recession Is monetary policy “spent”? Interest rates already low Loan demand weakening - can’t “push a string” Lower rates could weaken $, grow exports Provide capital and liquidity to financial institutions to prevent “runs on the bank” Greater govt regulation, ownership role In Sweden in early 1990s, banks socialized!

Fiscal Policies to Mitigate Recession Refinance failing mortgages: little long run cost? Extend unemployment benefits Stimulate spending with tax cuts or new govt spending Tax cuts less potent: partly saved, spent on imports Govt spending can be directed to productive investments Infrastructure, education, energy, environment Problems:Takes time to plan and execute Political waste (e.g., Japan in the 1990s) But fiscal actions add to budget deficits and national debt

Burden of National Debt: A Concern? National debt is sum of past deficits Deficits of about 3% of GDP don’t raise debt burden, because GDP grows at that rate (see 1970s) No need to balance the budget Larger deficits do not add to burden if they finance productive public investment U.S. debt not out of line with other nations Not a burden if we owe to ourselves Government can tax or print money But are tax rates already too high? Not in perspective

Government Debt as Percent of GDP, 2006 France 71 Germany 69 Italy 118 Japan 191 Sweden 53 UK 55 US 62 Source: OECD

Tax Receipts as Percent of GDP, 2006 France 44 Germany 35 Italy 41 Japan 27 Sweden 51 UK 37 US 27 Source: OECD

Concerns About Long-Run Economic Leadership Deteriorating infrastructure Weak math and science education Financial crisis undercuts trust, leadership Heightened security, xenophobia limit talent pool Growing business concentration, monopoly Large-market advantage threatened by EU, China, India Lag in important technologies – energy, environment Growing inequality limits opportunities for many No room in present federal budget to address needs

Important Reasons for Optimism Most open, flexible society Economic adaptation our hallmark Example, floating of $ in 1971 Ready funding for new ideas, risks Tolerance of nonconformity fosters creativity, originality Protection of intellectual property assures incentives for innovation