The Lubar School of Business sponsored a lunch presentation by Dr. Martin Feldstein at the University Club on Thursday, October 4th. Martin Feldstein has served as President Reagan’s chief economic adviser and, among other intervening high profile appointments, served on President Obama’s Economic Recovery Advisory Board. He is currently the George F. Baker Professor of Economics at Harvard University and serves as President Emeritus of the National Bureau of Economic Research. A summary of his current thoughts on Europe and the United States is presented below.
Europe: sowing the seeds
The establishment of the Euro currency bloc was always part of a larger effort to unite Europe politically. However, European leaders are now confronted by mounting obstacles that are undermining this effort and, in particular, one of their own making. The establishment of the Euro itself has created a series of traps for European citizens early on, and for European leaders today.
In its first decade, the currency was a boon to the weaker, higher inflation economies that are now labeled ‘peripheral'. Governments binged on easy financing as did households, particularly via mortgage debt, as inflation and interest rates approached German levels. But the competitive disparities among national economies did not improve as planned. Alarmingly, they have diverged further in recent years. Financial markets “missed it all” in Feldstein’s analysis. Europe’s wake-up call came in 2010 when Greece could no longer hide its fiscal emergency.
Four challenges face Europe today:
1. Fiscal deficits and the difficulty financing them
2. Weak banks in Spain and Italy. Pan-European financial markets have collapsed into national financial markets. Wholesale credit is now restricted between banks and depositors have expatriated their balances to stronger countries
3. A deep, Euro-wide recession
4. And the most serious in Feldstein’s assessment; trade deficits. How can you finance them?
Today, the trade surplus is $250 billion in Germany while the rest of Europe combined has a $150 billion trade deficit. Unemployment ranges from 4.5% in Austria to 25% in Spain. No doubt, trade, employment, GDP and other vital economic statistics are interrelated. Pre-Euro, weaker countries could restore trade balances by devaluing their currencies. The underlying problem today is that currency devaluation is now an all or nothing proposition- a one-size-fits-all wealth transfer that punishes savers and rewards debtors which, within Europe, falls largely along national lines.
The European answer to date is “More Europe”, meaning, greater fiscal union. More Europe allows more time to sort out the structural issues in weaker economies. The Stability and Growth Pact was a first attempt at harmonizing fiscal policies among member nations, an agreement that was regularly flouted by even stronger members of the Eurozone. The latest iteration of this idea is the Fiscal Compact, set to take effect in 2013. Feldstein suggests its firewall of restricting budget deficits to 3% of GDP already looks threatened.
Meanwhile, ECB President, Mario Draghi, has won a major victory in expanding the influence of the ECB over deep opposition from the Bundesbank, buying time for fiscal reform. Known as Outright Monetary Transactions, the ECB will buy Italian and Spanish bonds with maturities of less than 3 years without limit of magnitude. Draghi hopes to force compliance on member countries via the ECB’s purse strings. However, election politics continue to loom large in Europe. Feldstein wonders what policy options will be available if and when member countries fail to comply. Draghi may be trapped in a deeper hole after the program has run its course.
Feldstein sees the U.S. economy deteriorating. His earlier-year forecasts of 2% GDP growth for 2012 seem nearly impossible now, in his assessment. Recent manufacturing readings across the ISM, NY Fed and Chicago Fed are weak, and durable goods orders have recently fallen a staggering 13%. Regarding employment, the U.S. would need GDP growth of about 4% annually for five years to reach the long-term unemployment rate of 5.5%. 150k jobs per month are required simply to absorb new entrants to the labor force. Feldstein attributes the entire decline of the U3 unemployment rate from 9.1% to 8.1% (at time of his presentation) to declines in the participation rate. Combined, these are dismal stats.
One bright spot is the rebound in housing. However, Feldstein puts its importance into context. The 8% rebound in residential housing in the second quarter contributed only about 0.2% to Q2 GDP growth. Moreover, readings have been deteriorating here as well.
What about policy? “The Fed is being aggressive without being helpful.” Despite historically low mortgage rates of 3.5%, underwriting terms remain very tight. Small businesses without access to capital markets have also felt the effect of tight credit. More broadly, the business community is reluctant to invest. Feldstein believes that Bernanke is attempting to inflate the stock market to raise wealth and encourage spending. Quantitative easing worked well in the fourth quarter of 2010, but completely collapsed in Q1 2011. Feldstein suspects that any growth from future easing will be ephemeral.
Despite a strong showing by Romney in his first debate (the prior evening), Feldstein believes the odds still favor an Obama victory. Continuing on present course, the financing of entitlements will drive external debt as a percentage of GDP from 70% today to 100% within 10 years. Interestingly, Feldstein believes that both Obama and Romney are open to Social Security reform. He believes this could be on the docket within a year in either election outcome.
A need for tax reform is evident. Including state income taxes, the US has the highest corporate tax rates of all OECD countries, stymieing incentives to invest. Furthermore, unlike other OECD countries, the US is the only country to penalize the repatriation of foreign assets.
Feldstein says there is a false dichotomy between cutting spending and raising revenues. Continuing a wonkish theme from the first presidential debate, Feldstein suggests that reductions in tax credits and deductions (technically known as tax expenditures) should be considered spending cuts via the tax code. The difficulty in execution is that each tax subsidy has its own political constituency that protects it. Imagine the difficulties involved in reducing the mortgage interest subsidy.
Feldstein’s solution is to leave tax expenditures in place, but put a cap on itemized deductions to limit their use by upper income households to, say, some percentage of AGI. Alternatively, he pointed to Romney’s $25,000 or $50,000 cap on the dollar value of such deductions, which would have similar effects. By phasing out tax expenditures, revenue is raised. In addition, more people will opt for the standard deduction, thereby simplifying tax preparation for a large portion of the tax base.
In the Q&A, several interesting questions came up.
On the future of Europe, Feldstein believes that Greece, Portugal and, perhaps Finland, may exit the Euro within 5 years. However, the core of Europe is too dedicated to fiscal union to allow a complete breakup of the Euro.
On the absence of bond vigilantes for US Treasuries, Feldstein believes they are lying in wait. Currently, there is too much purchasing power from the Fed and from China. The Fed will buy $40 billion of mortgages per month while China will continue to take in Treasuries. However, China’s five year plan entails increasing consumer spending which, if effective, will result in the reduction of its trade surplus and, correspondingly, its need to finance a US trade deficit. At that point, bond vigilantes may make their presence known in the Treasury market.
On inflation. Commercial banks have accumulated vast deposits in interest paying accounts with the Federal Reserve. If and when the Fed begins to see inflation, it may have to raise rates on these deposits to restrict money supply to the banking system. When this happens, Feldstein believes unemployment will still likely be over 7%. Nodding to how the Fed has become more politicized, he suggests that Congress may not allow rate increases necessary to hold inflation to acceptable levels –via this scenario, higher inflation is a real possibility in the intermediate term.
The CFA Society of Milwaukee would like to thank the Lubar School of Business for the opportunity to report a summary of this timely economic outlook to its membership.