Oregon Economic Forum 2013
Picking up a thread from the last talk, let me adopt to some degree the rhetoric of the Chinese Communist Party. Let me say that we are coming to the end of a Special Period of Struggle in the American economy. Or perhaps I should look forward to our last speaker's possible next job, and say that as far as the American economy is concerned we hope very much that we are coming to the end of the Years of Living Dangerously. This means we can start thinking about, worrying about, hoping about what a normal economy will look like in America in the future--what will be the "new normal" that will emerge from this Special Period of Struggle, from theses Years of Living Dangerously? Things will be substantially different from the "old normal" we thought we understood back so long ago, back in 2007 and early 2008.
Thus I am here to talk about what the new normal is likely to be. And because I have watched forecasters like Tim down there have to explain over and over again, year after year, why this year is not like the forecast he made last year, I am not going to make forecasts. I am simply going to set out scenarios. I am going to give some alternatives with respect what the US economy as a whole is going to look like, moving into the future, after the next couple of years, when we do get back to a position in which the economy is no longer clearly in substantial disequilibrium.
As far as this audience is concerned, the important things to focus on when looking at what the economy’s "new normal" state will be are three.
- There is the cost of capital--the level of interest rates. Because you all are in one form or another either enormous net debtors or enormous net creditors, the terms of which you borrow and lend shape what you do to an extraordinary degree.
- There’s the question of economic slack--which applies both to what you sell and what you buy. Is it the case that sellers have an awful lot of pricing power because buyers are desperate and are scrambling to get their hands on resources? Or is it the case that there’s an awful lot of slack and that it’s the buyers who get to pick and choose?
- There is the question of margins. The margins you imps and the margins that are imposed on you are of vital importance in trying to figure out how to maneuver in any particular economy.
Start with rates. Back in the 1990s I would have bet my eyeteeth and my firstborn on the belief that the United States government that had a high national debt would be one in which interest rates were bound to be high--both high real interest rates, as you have a lot of private demand for capital chasing relatively few savers left over after accounting for Treasury purchases, and high nominal interest rates, for on top of those real interest rates would come an inflation premiums because there is always the chance a government will decide to inflate its debt away.
Thus in the 1990s I was an enthusiastic, advocate, spear carrier, and supporter of Bill Clinton’s deficit-reduction initiative--raise taxes, slash spending, raise taxes and slash spending some more, and so get the debt-to-GDP ratio on the downward trajectory that Clinton got it from 1995-2001 after the Reagan-Bush explosion that had nearly doubled debt-to-GDP since 1981. We at the time thought we had no choice but do do this. We did not want to contemplate what the economy would be like, what interest rates would be like, and how difficult it would be to get funds for investment if the US debt-to-GDP ratio was up to 80% or so.
Well guess what?
Immediately after World War II we had a high debt-to-GDP ratio. But we also had an extremely tightly regulated financial system, in which financial intermediaries had few options other than to hold Treasuries. And we had a Federal Reserve taking as its principal mission the task of making sure the interest rate on Treasuries was low. Thus it seemed to us at the start of 1990s that we needed to take big steps to be able to get the debt-to-GDP ratio down or we’d face a world with extremely high interest rates and that would be bad for America. The bet was that a high debt-to-GDP ratio was not consistent with low real and nominal Treasury interest rates without substantial financial repression.
That bet turned out to be wrong.
The Reagan-Bush deficits of 1981-1992--boosting defense spending, cutting taxes, and balancing the budget didn't quite work out as his advisors had assured Ronnie that it would--the Bush II reversal of the Clinton policies that had produced a downward debt-to-GDP trajectory in the 1990s, and the effects of the Great Recession have all three tougher pushed us from having a normal American debt-to-GDP ratio of 25% of GDP or lower to a ratio of 75% or so on net debt. Yet there is no sign that this has had any effects to interest rates. We hit the world with extraordinary amounts of US Treasury bond issues. The world swallows them at absurdly high valuations. And then it begs for more.
As Harvard’s Carmen Reinhart says: that for the past decade and a half, the central banks in the world have been the equivalent for the United States of Japan’s inertial postal savers. If it’s not the central banks of the world, it's US financial intermediaries that want to hold much safer portfolios than they wanted six years ago. If it’s not US financial intermediaries, then it’s the emerging superrich of China who think that their grandchildren may be living in the United States, and thus having a large share of their portfolios in US Treasuries strikes them as a good idea.
Thus the "new normal" in which interest rates, especially interest rates on U.S. Treasuries, are likely to be remarkably low. This is going to be good for those of you who are debtors. This is going to make life awkward for those of you who are creditors--especially those of you who are financial intermediaries, and who really can’t pay your depositors less than zero. But those of you who in such positions now have a powerful advocate in the Federal Reserve board right now: Jeremy Stein.
Slack. Back in 2000-2008 we had a US labor-force participation rate that was 67% or so of adults. Feminism had come to completion. American woman who wanted to have jobs could now get ones--and not be limited to jobs only as teachers, nurses, housecleaners and waitresses. Back then we expected the labor-force participation rate to decline by 1%-1½% point per decade, as the baby boom generation aged into retirement. Back then we expected there to be an unemployment rate of 5% of the labor force or so.
The new normal is different, the new normal is not an employment-to-population ratio of 63%. It’s an employment to population ratio of 59%. Out of every 15 people who we would have expected to have a job in the America of 2007 doesn’t have a job in the America of today. There is no sign that this will change. We have now seen four years without appreciable recovery in the employment-to -population ratio to what we used to think of as normal. And labor-force participation rate is now falling much much faster than we can justify from the demography. In long-run historical perspective, we are back to a labor force share of the population that we had in the late 1970s, when American feminism was at most only half-completed. An awful lot of those who are unemployed are long-term unemployed. Employers look at them askance when they apply for jobs. An awful lot more of the employment shortfall is people who have simply dropped out of the labor force, and I don't see what forces will push them to come back in. Thus we are likely to have a lot of slack in the American labor market--and a large shortfall of aggregate demand below potential supply--as far into the future as we can see.
If you are running a business, demand for your products will be low. But if you are ruining a business, it is also a fact that your margins are likely to be high. For businesses, these two effects more or less offset each other, and businesses wind up wight he operative cash flow they would have expected--and with lower borrowing costs because of low interest rates. This means the "new normal" is better for non-financial businesses than we thought we would see back in 2007. And the "new normal" is considerably worse for workers than the normal of 2007. On the labor side, it looks like jobs are going to be scarce for at least a decade to come. Few people will dare to ask for a raise. Few people will dare to quit.
That is the broadest big picture sketch of the new normal: slack demand, high margins, low interest rates.
Now what are the scenarios?
One possible scenario is that the Federal Reserve simply says "enough", stops trying to boost the economy through extraordinarily low interest rates, promises to keep interest rates low in the future, and massive asset purchases via quantitative easing. Ever since he recognized that letting Lehman Brothers go into uncontrolled bankruptcy was a horrible mistake, Bernanke has been straining extraordinary nerves to try to use the Federal Reserve to try to get the US economy moving again--to get back to a situation with higher employment and he hopes a little bit higher inflation that we have now.
Janet Yellen, should she be confirmed as Fed Chair, is likely to continue and likely to very much want to strengthen Bernanke’s policies. But there is a limit, There are worries of what the consequences of super-low interest rates are. There are worries of what the extraordinary asset holdings by the Federal Reserve are doing to the financial sector. There is a great fear that, somehow, the current policies are leading to reaching for yield on the part of shadow banks and banks, and are creating new vulnerabilities that will give rise in the future to new financial crises. There are worries that the Federal Reserve has shot its political bolt, and won’t be able to rescue everyone the next time there’s a financial crisis. That would mean that the next financial crisis would produce not just a recession but a depression. And that means that an abandonment of monetary ease and tighter monetary policy now are the right course: accept higher unemployment now in the future to make sure to prevent the growth of any bubble that might be followed by a crash.
If the Federal Reserve's Open Market Committee follows this line of reasoning, then all of a sudden our current situation with 7.5% unemployment and a 59% employment to population ratio and stagnant real wages--especially for people in the less-educated half of the population--truly becomes the "new normal" immediately, as the Federal Reserve abandons its commitment to try to push us to a higher level of activity and a lower level of slack.
Such a scenario is, at the moment, a relatively small possibility. Such a shift is a policy advocated by at most 6 of the 19 participants in the FOMC meetings--albeit the 6 include Jeremy Stein, quite probably the smartest and most eloquent of them. These arguments aren’t stupid. These arguments aren’t silly. These fears are real. The other 13 are dug-in in support of the current policies. But the dissenters may carry the day, not now, not next year, but two and three years down the road personnel will have changed and opinions may have changed. So that's one possibility: the Federal Reserve pulls the plug on its extraordinary measures to get the economy into better employment shape, and what we have now becomes the "new normal". Give it a 5% probability.
Then there are three other scenarios, in which the Federal Reserve continues its extraordinary efforts. Let me differentiate those scenarios by their paths of interest and inflation rates, and by the reasons for their paths:
- The first possibility is that we don’t deal with our national debt--that instead our national debt deals with us.
- The second possibility is we resort to more aggressive regulation to keep interest rates low--what Carmen Reinhart likes to call "financial repression".
- The third possibility is that we have a prolonged worldwide global savings glut.
Call this first scenario "fiscal dominance". This is the scenario foreseen by the people who tell you that you need to move your wealth into gold as fast as possible--and that you need to pay them a healthy commission to make that happen--if they don’t go further, and say that you need to move your assets into something else. After all, having his portfolio in gold would not have done Mel Gibson much good in Mad Max: Beyond Thunderdome: what he really needed was, instead, bottled water, sewing needles, and ammunition--plus the goodwill of Tina Turner.
The idea is: when you have a high national debt, you have to finance it. If the interest rates are that the market demands are relatively high because the market doesn’t trust you not to inflate away the debt, then you have to collect substantially more in tax revenue than you spending on programs in order to keep the situation stable. But our political system is not terribly good at generating those necessary primary surpluses. And so we could have a big inflation--a tripling of the price level in less than a decade that writes down our debt, and that is then followed by a period of low interest rates and stable prices, but getting to that low interest-rate stable-price "new normal" is a wild ride with lots of chaos, instability, and trauma.
This too is a small probability--probably even smaller than the Fed pulling the plug on its extraordinary policies. But it is a scenario that is out there. Give it a 3% probability
In scenario two, the U.S. government takes a look at the size of the debt it has built up, and decides that the easiest way to manage it is not to raise general taxes to pay off the debt but rather raise implicit taxes on the financial sector. The government then requires financial institutions to hold Treasury bonds in large amounts. This greatly diminishes the chance of a future crisis: there is then no chance that people will discover that their AAA-rated derivatives are in fact worthless because people won't be holding AAA-rated derivatives: they will be holding Treasury bonds. And if people have to hold lots of Treasury bonds by law, the interest rate that the federal government will have to pay to make them want to hold Treasury bonds will be low. Two birds. One stone.
There has been a long current of thought in economics that this is the things should be. Milton Friedman was only one of the people who said: if the US government was going to offer to insure financial institutions' deposits--which we do--then it needs to make sure that financial intermediaries don’t gamble with those insured deposits, and the best way to do that is to require that they hold Treasury bonds against those insured deposits.
This strategy for managing a high national debt--financial repression under the flag of macroprudential regulation--was adopted by practically every North Atlantic economy in the years after World Wars I and II, when debt-to-GDP ratios were high. It worked. Or, rather, I think it worked.
Other economists think it imposed a substantial growth cost on high-debt economies, but I do not see those conclusions as solidly grounded. There is considerable discussion among economists about whether in fact such policies of financial repression do wind up having a large negative impact on growth, or whether it is only when interest rates are pushed up to high levels that you find debt having a substantial effect reducing economic growth. It’s been a tremendously instructive debate. I’ve learned a huge amount from it. It’s been an ill mannered debate: economists are not known for their social skills--if they had social skills, after all, they wouldn’t be economists, would they--and that lack of politesse shows; moreover, the stakes are high and people sincerely believe that their positions are the ones supported by reason; everybody believes that if only they could express their a little more loudly and sharply and if their opponents would only stop deliberately closing their eyes to evidence, their positions would carry the day.
I don’t have time to run through that debate now. I will put up one piece of evidence created by Berkeley graduate student Owen Zidar that I found to be relatively convincing. This shows what happened to the growth rate of G7 economies after World War II, depending on their debt-to-GDP ratio. You see the extraordinarily large negative slope? Higher debt: lower growth.
But what Owen did was to label the points. The top-left countries are the defeated Axis powers after World War II. Our air force bombed their factories and cities into rubble. Then we bombed them again. Then our army marched over them--and that is when they were lucky. Of course they had very low national debts after 1945: we the occupying power weren’t interested in their honoring Axis debt. And of course they had fast growth: they were rebuilding devastated economies.
The bottom-right countries are (i) Italy and Japan recently, where we know that it wasn't policy changes that produced high debt that generated low growth, but rather that growth slowed and then unchanged policies led to high debt; and (ii) post-World War II Britain. Post-World War II Britain was an exhausted society with a lot of institutional rigidity. It was thus bound to have a low growth rate. Post-World War II Britain also had a very high debt. Roosevelt did not start up the Lend Lease Program train until Britain had already borrowed as much as it could, and spent it buying war material from the United States.
It's not high debt driving low growth. Rather, it's other things driving both high debt and low growth, or low debt and high growth.
Give this scenario a 32% chance of happening over the next 10 or 15 years: the government taking steps to try and prevent any future crisis and also keep its borrowing costs low by loading larger and larger regulatory requirements to hold Treasuries on US banks. We won’t go as far as China--which has which has done truly magnificent things in terms of persuading banks to hold utterly unbelievable amounts of government bonds at utterly unbelievable interest rates. But our Federal Reserve does not have the power to send bank executives to re-education camps if they displease it, thank God.
Then there’s scenario three. That is the dominant and most likely scenario. Give it a 60% chance. It is that the U.S. never has to worry about paying off its national debt because interest rate "normalization" on US government and also high-quality business bonds never comes. The interest rates we see now are the "new normal". Maybe they go up by a percentage point or two. But that they never rise back to levels we would have thought as normal in the 1990s let alone what we saw in the 1980s and the 1970s.
The reasons for this are threefold:
First, there is the reemergence of the equity return premium. Two stock market crashes in the decade of the 2000s shocked people into understanding that equities really are risky. And when people are less confident about equities, they are willing to hold debt at lower interest rates. The fact that we had two stock market crashes in one decade was quite a shock. We used to think that you would see a stock market crash in real terms like 1929 or 1974 or 2001 only once in a generation.
Second, there is the global saving glut. A large number of countries abroad with very many people are becoming richer faster. Their rich want to diversify their portfolios globally. Buying US assets is one very important way to do this.
Third, the United States has an extraordinary and exorbitant privilege: the liabilities of our government are today's gold standard for assets--in fact, they’re better than gold because they pay interest. Almost everybody would rather have a 30-year US Treasury bond to hypothecate and re-hypothecate and use to grease the wheels of all kinds of financial transactions, if offered a choice between it and a lump of gold. The fact that we’ve gotten ourselves into this extraordinary situation as the lynchpin of global finance means that unless the US government actively threatens to default, anything that increases risk means that the interest rate on US treasury bonds would go down.
That looks like the most likely future possibility. In a way, the United States government would then look like the Medieval Medici Bank. The Medieval Medici Bank doesn't pay you interest. It charges you fees. You don't lend it money in order to boost your wealth. You lend it money in order to keep your wealth safe--so that if the Pope excommunicated you and you had to flee the city of Lucca in the dead of night with only the clothes on your back, when you got to Paris you could draw on the local Medici bank. In a similar way, since 1990 the average growth rate of the economy has never been lower than and has often been much higher than the average interest rate the US pays on its debt. The US can simply borrows, roll over the borrowing, and watch, as time passes, the debt it owes shrink relative to the size of its economy. No reason to fear inflation. No policy changes required in order to make people hold Treasury debt at low interest rates. It just happens.
Now I’ve come to the end of my time. So let me simply summarize.
The new normal for the American economy is likely to see:
- a lousy labor market if you’re a worker
- a relatively good labor market if you’re an employer
- lower demand relative to the size of the economy’s productive potential than we would have expected
- higher margins than we would have expected.
We are looking forward to a world with high slack, high margins, and low interest rates. The Federal Reserve is likely to continue its extraordinary policies for a number of years. But they are unlikely to return the economy to "old normal" levels of boom. Exports and business equipment investments are back to normal levels. But government purchases are low and austerity is going to continue. Construction spending is also low, and without major reforms that are not going to take place is going to remain low. So where is the demand to push the economy into a large boom going to come from?
One final thought: one thing I haven’t mentioned. On January 1st, 2014, the Affordable Care Act's main provision will take effect. We are changing the regulatory and financial framework of 18% of the economy. Now on the one hand this possibly means good things if you’re a small business or individual on your own--you all of a sudden have a benefits department in the form of the exchange-marketplace to help you buy insurance and to negotiate with insurance companies for you. On the other hand the performance of the federal exchange does not make you think it’s a very good benefits department--Oregon's exchange is doing much better.
But, then, which of us really thinks that we’ve ever had a very good benefits department?
If you run a small business, you will no longer have to do all the work of managing benefits yourself--and you will no longer be trying to bargain with insurance companies that say: Why do you want to buy insurance? Are you sick? How sick are you? There must be something wrong with you or you wouldn’t want insurance given the unconceivable prices we’re charging! If the Affordable Care Act works, it means freedom: freedom for people to move and change jobs and start businesses, as they will no longer be locked into their current jobs with their current bureaucracies by fear of losing affordable health insurance.
The Affordable care Act means that we’re shifting 2% of spending out of other stuff--we’re not sure what stuff yet--and into healthcare stuff. It's a major boost to the health care sector: the equivalent of adding an extra 25 million customers to the health sector, with the federal government picking up the tab, for people with health insurance go to the doctor about twice as often as people who don't. So don’t be surprised if anything that you have that is all tangentionally connected with health booms over the next two or three years. But also don’t be surprised if anything you have that requires employing medical professionals becomes more expensive: there has been little thought on where the doctors, nurses and orderlies to provide treatment for this extra 25 million people's worth of customers are going to come from.
Thank you very much.