We're OK! We're Really OK! Well--Probably

Tuesday lunchtime:

2006 Washington Economic Policy Conference: Policies to Boost Economic Growth and Security--What's Needed?March 13-14, 2006. Marriott Crystal City at Reagan National Airport

The current draft:

Giving a luncheon talk is always an interesting task, a kind of verbal high-wire act. Normal conference sessions are set up for the speaker's convenience: to try to force you to pay attention: to make everything else in the room as boring as possible, so that you have little choice but to focus your attention on the podium.

That's not true at meals. The people at your table who you're looking in the eye aren't boring. The coffee isn't boring. There's lots of motion as the waiters work back and forth. And I've tried all my life to convince myself that deserts are boring--and conspicuously failed.

If this were fifteen or twenty years ago, I would be standing up here ready to give my "Age of Diminished Expectations" talk. I would have talked about the collapse of American productivity growth--that we were, collectively, getting rich at a much slower pace than anyone back in the 1960s would have believed possible. I would have talked about intractable short-run budget deficits, the combination of overoptimism on the part of Reagan administration policymakers and the collision of limited resources with expansive demands for government nurtured in the fast productivity growth first post-WWII generation. I would have talked about how Social Security as we knew it was unsalvageable: that the resources simply would not be there. I would have talked about how Medicare and Medicaid were in even greater long-run trouble. I would have talked about slow growth and rapidly-rising inequality were together political poison.

I would have, fifteen to twenty years ago, talked about how very, very hard decisions needed to be made about resources and their uses--and how the American political system seemed to be incapable of making them, politicians being eager to tell Americans pleasing lies about how all kinds of benefits and goodies could be provided with "read my lips, no new taxes."

But then things changed. We were fortunate enough to elect some politicians who understood enough macroeconomics to know that if the government does not set out to raise the revenue to meet its spending commitments, then the market will do it and do it in a way you don't like--witness Argentina in 2001. The government shifted from being a source discouraging investment and productivity growth through the crowding-out of productive investment to being a source encouraging investment through crowding-in. We caught the leading edge of the wave of technological revolution to give us the best macroeconomy seen in a generation--and caught the leading edge of the wave in a way that neither Japan nor western Europe has managed to do.

But today--since 1995--our private sector-wide rate of productivity growth is back up to nearly 3% per year, with no current signs that it is going to fall back down to "Age of Diminished Expectations" levels. We once again look forward to our standrds of living and levels of productivity doubling every generation or so. The Social Security system no longer looks way out of whack--relatively small, marginal changes should keep it from being a problem for generations. And there is great, huge news abroad: the world-changing economic revolutions in India and China.

Even Medicare and Medicaid and the long-run fiscal crises of America's public health-care programs and the employer-funded health-care system... Let me put it this way: it's not a crisis, it's an opportunity. If technological progress in medicine were to stop tomorrow--if what doctors and nurses and druggists and researchers do and how they do it were to freeze--then we wouldn't be looking forward to a health-care funding crisis. We would have no difficulty funding Medicare and Medicaid, as underlying economic growth boosted tax revenue by more than a stagnant health care system could spend, even with the aging of America. It is only because we--rationally--expect that our doctors, nurses, druggists, and researchers will learn how to do new things, marvelous new things, incredibly expensive new things, that we project health-care spending into the future and blanch in terror. And I do blanch in terror. But it is important not to forget that this is an opportunity: how many wonderful, medical things will we as a society decide to purchase, in how egalitarian a fashion will we as a society distribute them--will only the rich be offered clone-eye transplants when macular degeneration sets in in our nineties--and how will we pay for them? We may fail to grasp this opportunity, or fail to grasp it well. And to miss this opportunity would be a catastrophe. But it is an opportunity, not a crisis.

So why are things now going so--relatively--well? From a public policy standpoint, is it due to good luck or good skill? If it's good luck, it's good luck that we haven't shared with the other major post-industrial core areas of the world economy. Japan and Western Europe are, largely, still mired in their own Ages of Diminished Expectations. And there have been important acts of public-policy skill:

1. The 1986 Baker-Bradley-Rostenkowski tax reform--the true pro supply-side tax bill of the past thirty years
2. The 1990 Bush-Mitchell-Foley deficit-reduction bill
3. More important, the PAY-GO changes in congressional procedures that George H.W. Bush's aides like Richard Darman demanded as a price for the 1990 deficit-reduction deal.
4. The 1993 Clinton-Mitchell-Foley deficit-reduction deal.
5. Yet more important, enormous payoffs from generations of government support for education and research--especially computer and medical research.
6. And most important of all: we are still immigrant-welcoming entrepreneur-loving upward-mobility-seeking America. We care about the startup of the builder of the better mousetrap much more than about the fortunes of established old-technology mousetrap producers.

Nevertheless, there have been lots of acts of public-policy non-skill as well:

1. The Reagan administration did not intend to destabilize America's government finances, turn the federal government into a capital sink, and thus become a drag on investment, manufacturing production, and economic growth. Some hoped for a more growth-promoting tax bill than they managed to pass in 1981, others for a burst of inflation to give one last episode of bracket creep to offset the tax cut, others that it would be easier to cut spending. All were wrong.
2. The Bush I and Clinton administrations--we spent $20 trillion of today's dollars fighting the Cold War. We spent about 2% of that on the post-Cold War recontruction of Eastern Europe. A hideous waste of opportunity.
3. The collective fumbling of our last attempt in the early 1990s to fix the funding of health care in America.
4. Alan Greenspan advised George W. Bush in 2001 that tax cuts should contain provisions that would reduce their magnitude should forecasts be overoptimistic and deficits reemerge. George W. Bush ignored him.
5. Ex-HHS Secretary Thompson says that he warned George W. Bush that a drug benefit that did not allow Medicare to bargain over drug prices would be much too expensive to be a good deal. George W. Bush ignored him.
6. Ex-Treasury Secretary Paul O'Neill warned George W. Bush that flirting with protectionism--whether Chinese-made bras or imported steel--was not just bad economics but bad mercantilism and counterproductive politics as well. George W. Bush ignored him.
7. His entire National Economic Council warned George W. Bush that the 1990 BEA PAY-GO procedural restrictions on congressional spending were extremely valuable and important and should not be allowed to expire. George W. Bush ignored them.
8. Secretary of State Powell and Staff Chair Shinseki warned George W. Bush that stabilizing and rebuilding Iraq would be much harder than conquering it. George W. Bush ignored them.

I could go on. There is a certain pattern here.

When I look at the economic policies of the Bush administration, I--well, with respect to Republican economic policy, I understand small-government trim-back-the-social-insurance-state-and-cut-taxes policy, and there's a case that that's the right thing to do. I understand cut-taxes-and-then-starve-the beast policy, but the case for policies based on the hope that your political adversaries will be less cynical and more public-spirited than you are is very weak. I understand dish-the-whigs-let's-do-what-Democrats-do-but-do-it-better policy. But this administration's policies... There's an exchange from the movie "Apocalypse Now": "I hear you disapprove of my methods." "I see no methods at all here, sir."

Nevertheless, we are--still--OK. Yet more evidence that, as my grandfather used to say, the Lord protects dogs, children, fools, and the United States of America. We all mourn at the opportunities that have been wasted by the George W. Bush administration, but--so far at least--they are opportunities wasted, nothing much worse. The big cost from Bush policy mistakes so far would have been the drag on economic growth and the crowding-out of investment produced by the swing back to large structural budget deficits. But--so far--that crowding-out has been offset by larger and stronger crowding-in, as Asian governments anxious to continue export-led growth buy up as many U.S. government bonds as the Treasury can issue.

But part of my job here is to warn. How could lack of feck produce something worse than missed opportunities? What steps should we be taking now to minimize dangers in the future?

The first big danger is a long-run danger. Up until 1900 or 1930 we were--for English-speaking white guys--the country of upward mobility and opportunity that we think we are. Since 1930 measures of upward mobility have declined: we are no longer a society in which it is materially easy for families to move from class to class across the generations. And we are returning to Gilded-Age levels of income inequality: differences in class matter more. Everything we have seen from the history of Europe and Latin America over the past century tells us that immobile societies with large class differences produce a uniquely poisonous and destructive brand of politics.

To guard against this, we need to do a number of things. Increase mobility: the University of California at Berkeley alone has more students from families with incomes under $50,000 a year than the entire Ivy League--a thing that my friend and patron Larry Summers of Harvard was trying to change. Make class differences matter less: more progressive taxes, a stronger safety net, more public provision of public amenities from parks to schools. What's called for isn't a single megainitiative, but a lot of pressure on a lot of margins to make sure American society remains a place for consensus rather than conflict politics.

The second big danger.... Well, you all know it, it's been growing for the past eight years or so. This year we in the United States may import $1 trillion more of goods and services than we export. Since American citizens and residents are going to buy perhaps $400 billion of assets abroad this year, that means that our current configuration of trade and asset prices can last only as long as foreigners are willing to buy $1.4 trillion gross of American assets each year. How long will they want to do this? How long will we let them do this? Certainly everybody thinking of acquiring assets in America is thinking harder after the recent episode of the Peninsular and Oriental Steam Navigation Company. When foreign asset purchases fall back to sales, our exports have to be priced to be as attractive to them as their exports are to us--which means a dollar 40% lower in value than it is today.

What form of compensation are foreign investors demanding in exchange for running dollar-decline risk? What form of compensation will foreign investors demand in the future for running dollar-decline risk? If you all leave here, and this afternoon convince your organizations that now is the time to be first out the door as far as hedging dollar-decline risk is concerned, and if all your organizations convince their clients, then:

1. All of you are big heroes, because your organizations and clients are first out the door and avoid loss.
2. The dollar at the end of the month is 40% lower than it is today.

Consequences in this scenario, in which all of you sprint for the phones and are unusually persuasive? Ten-year Treasury up by 200bp from the end of foreign net demand, plus 200bp for inflation compensation premium, plus an unknown x bp for financial crisis risk.

We here in the United States have to move--and move now--ten million workers out of construction and consumer services and supporting occupations and into export and import-competing and supporting occupations.

The Federal Reserve will multiply a 40% decline in the dollar by a 1/6 import share of GDP by a 50% passthrough and get an impact effect on the price level of 3.5%, and will start raising rates further to reestablish its inflation-fighting credibility.

Asian countries will have to move 40 million workers out of export and supporting occupations and into occupations fueled by domestic demand--and Asian countries have not, historically, been too good at figuring out how to do this.

Now, we are probably going to be OK. You all are not going to run for the phones. While a run on the dollar is possible--the bad equilibrium is out there--runs on banks or currencies are often possible, yet rarely occur.

So what would a prudent U.S. government be doing right now?

1. We're in the up-phase of the business cycle, so we should be running a budget surplus in any event, considerations only reinforced by the unsustainable current-account deficit.
2. We should be making it very clear that as a deficit country we value foreigners who want to invest in us--that we are grateful rather than xenophobic when we think about foreign capital.
3. The Federal Reserve should be making it clear that it is more interested in stabilizing measures of domestic prices than of measures that have a high weight on import prices.
4. International consensus on what to do should market prices move, and should demand for the products of 40 million Asian workers in export industries and 10 million American workers in construction and consumer service industries disappear.

Are any of these things happening?

Still, we're probably going to be OK. Opportunities, not crises.