The Economic Future, Debts, Lies and Cowboy Economics

Image: Kevin Lamarque/ Reuters

Like the umpteenth review of a bad film that we have already watched, the downgrading of United States debt by Standard & Poor’s was neither revealing nor surprising. The world’s largest economy has lived beyond its means for a very long time until its debt burden exploded into $14.6 trillion, more than thrice the entire wealth of all the world’s 1,210 billionaires on Forbes List.

But what is disconcerting to the rest of the world is the apparent nonchalance of the US political system. Beyond a bipartisan commitment to brinkmanship, America hasn’t offered a credible policy to dig itself out of this fiscal quagmire.

Even the world’s poorest economies have paid the price for America’s folly — in the form of elevated inflation. Violent protests are becoming common across such nations. Europe is a poor copy of the US, with all the bad borrowing habits but without the quick capacity to print currency. China’s debts have been exposed to be much higher than admitted previously. India is in the throes of widening public unrest against a regime perceived to be weak and corrupt. Growth is sagging in both emerging economies.

In other words, is America leading the world in a march towards an economic disaster not experienced by anyone living? This is the question that four leading economists with a foot on the ‘Ground Zero’ of this mayhem answer in the following pages.

Raghuram G. Rajan

Profile: Economic advisor to the Indian Prime Minister; professor of finance, University of Chicago’s Booth School of Business; advisory council member, U.S. FDIC; former chief economist, International Monetary Fund.

Key Ideas:       
Trying to inject more economic stimulus will offer diminishing returns.
Both Democrats and Republicans are unrealistic in their fiscal prescriptions.

Despite the S&P downgrade, United States bonds are safe.

The paranoia we’re seeing about a double dip recession in the United States is a little misplaced, I think. If you delete the last few days following Standard & Poor’s (S&P) downgrade, what we have is a slow recovery, but a recovery nevertheless. If there is another recession at these levels, apart from the fact that we don’t really know what these last few days have done for confidence, I would suspect it would be a mild recession where we go below zero for a couple of quarters and come back again. But it’s not anywhere near the terrible recession we had in 2008.

It’s not so much that we should be worried about another recession; we should be worried about upping growth from where it is. The real issue is why the US is not growing faster. I think we need to stop fretting continuously about needing more monetary and fiscal stimulus. Instead, we must focus on tackling problems more directly. The US needs to think very seriously about improving the skill base of its workforce. It must tackle the housing bust. Trying to inject more stimulus has diminishing returns.

Managing the debt and long-term fiscal situation is important and necessary for people to retain confidence in the US. But it’s a slower process partly because America is very divided politically. People keep pointing to Congress saying what incompetent idiots they are. The truth is the electorate itself is horribly divided. Unfortunately, one set of people is sending one set of instructions to representatives, and the other set is sending diametrically opposite instructions.

Take the standard Democrat voters’ view, which is ‘we’re going to balance this budget by taxing the rich, presumably meaning anybody earning more than $250,000 a year. But we will protect our entitlements.’ When you do the math, that doesn’t make any sense because there’s not enough money among the rich to provide for the entitlements that are going to explode over the next few years.

Similarly the math the Republicans do doesn’t make sense. Saying we’re going to shrink spending back to where the revenues are, currently 15 percent of the GDP, is not going to work. It’s an enormous amount of cutback without doing the kind of investing you have to do in some areas. Both sides have to realise that their prescriptions are simply unrealistic.

What you saw with the debt ceiling debate is politicians reiterating their playbook until the last minute when there was some compromise largely on the side of the Democrats and much less on the side of the Republicans. But that was to be expected. Even the fact that they pulled it off in the last moment is still seen as a failure by President Obama.

I hope America finds a way to deal with its fiscal problems, if not now then after the next election. After the election they’ll find nothing much has changed and they’ll have to get down to the hard brass tacks of actually negotiating some sort of compromise.

I think the S&P downgrade, which is in response to these problems, is not right in a relative sense. Let me explain. Which country would you put your money in today? The US or Belgium? Belgium is rated the same as the US, has a higher debt to GDP ratio, doesn’t have its own currency, and doesn’t even have a government because both sides don’t know if they want to be part of the same country. Are the politics there more fractured or less fractured than the US? I would guess that if you don’t have a government, you’re worse off than the US right now! So in a relative sense, it doesn’t make any sense that S&P would downgrade the US to Belgium’s level. But in a time series sense, they’re saying things are getting worse than they were and that’s absolutely right.

When you look at how the markets react, they’re basically trying to look at what is safe relatively. And so far they’ve clearly voted for America. But places like France have blown out, relative to the US. So in that sense I think the market still seems to think that US bonds are safe and I would agree with the market.

The thinking that the US model has failed and economic policy has failed is a little extreme. In a balance sheet recession and recovery of the kind that we’re having, you have to focus on where the problems are and try and tackle them. The broad-based macro stimulus that typically works in a classical recession is not as effective.

When people say this is the worst they’ve seen, I think they exaggerate. It’s always fun to say we live in a hotter world, a colder world, a more horrible world where children don’t treat their parents as well as they used to and so on. US corporations are among the healthiest in the world. The US is a large diversified country, has a strong economy, and until they really mess up politically, it’s unlikely we’re going to see defaults in the US debt.
(As told to Sujata Srinivasan)

Allan H. Meltzer

Profile: Professor of political economy at Carnegie Mellon University. Author of A History of the Federal Reserve and frequent advisor to White House on economic affairs. Chaired a commission that reviewed the role of the Bretton Woods institutions. Meltzer also founded the Shadow Open Market Committee.

Key Ideas:
The current European Union should be replaced by a new union comprising only responible countries.

The world needs a new monetary system with only the major currencies floating and all other currencies pegged to them.

China will not be the economic engine of the future.

Image: Courtesy American Enterprise Institute for Public Policy Research

I worry all the time about US President Barack Obama. All his measures to revive the economy and create jobs have failed. But he has nobody else to blame. His administration has reached this outcome with the help of its own policy mistakes.

One of those mistakes is that the administration has created an enormous amount of uncertainty and lack of confidence. Today the businessman who thinks about making an investment doesn’t know what his tax rates are going to be because the President is demanding higher rates of tax. Neither does the businessman know what his energy or healthcare costs are going to be or what regulation is going to be. This is what is holding back investment in projects that could potentially create jobs and pull us out of this mess.

In fact, the President doesn’t have a policy. Short-term attempts to create jobs for the next quarter are not going to be useful. The United States has, for a long time now, lived with too much consumption and too much debt. It has to make a transition. And that transition has to be via exports. America has to become an export-oriented country. That’s happening to some extent but it needs more investment. For that, we need stable and clear policy.

A Five-Point Agenda For America
We don’t have a monetary problem but a growth problem. There is nothing that monetary policy can do at this moment. We have, at the present time, $1.5 trillion or more in excess reserves. The idea of adding to them through quantitative easing is foolish. That money will sit there and do nothing because of the lack of confidence in the economy. This is a problem that requires the government to do a set of things that unfortunately this government doesn’t seem to be willing to do.

And what are those solutions? The first thing, of course, is to do something about this enormous deficit. It has to be a long-term solution because we don’t want a draconian cut right now. We want to have a plan that aims to lower expenditure, especially for entitlements, over time.

But that won’t happen with this administration. This President plans to run for re-election as the ‘Defender of the Welfare State’. So we are just going to have to wait till the elections to decide whether we want to have more social spending or growth.

Second, I would have corporate tax cuts paid for closing the loopholes in tax policy. Third, I would also have a moratorium on new regulation except for national security. Fourth, I would sign the pending free trade agreements  (with South Korea, Colombia and Panama). Fifth, I would give people the confidence that they are not going to have a large inflation (which is now possible because of the huge amounts of excess reserves and money growth we have). I would adopt an inflation target with some enforcement to make sure this promise is kept. But I see none of these solutions coming from the current administration.

I think the US will avoid a recession, but will have a slow growth. There is a lot of pessimism at the moment and that could drive the economy down for a while. But I also believe that there is enough stimulus in the economy to avoid a recession.

But the 2012 Presidential Election is going to be one of the most important in modern American history. There are going to be two visions of the future for America. One is the Welfare State, or much more than the Welfare State. The other vision is much more about what the US has always been. It is up to the voters to decide which kind of country they want for the future.

A New European Union
Europe is in a far worse situation than the US. Let us take Greece. That is the situation that started the crisis and that is being mishandled. The solution for Greek’s problems is that either they have to deflate for five or six years — that doesn’t seem politically likely — or they have to devalue. They can’t devalue while they are the members of the European Central Bank (ECB). So they have to leave the ECB.

So what I would say the next proper step should be is for countries in the north of Europe—those that want to pursue correct policies—to join a different union with responsible countries and leave out the irresponsible countries so that they won’t affect the union.

I don’t think the present ECB can last this crisis. I think the longer they wait to try to make it work, the less likely it will be good for Europe.

So what will be the future of the euro? In my opinion, the euro has always been an agreement between France and Germany that the French would adopt Bundesbank rules in exchange for having a seat at the table. And I don’t see that agreement coming to an end.

So the Dutch, French, Germans, Finns and probably Belgians and Luxembergers must join in a monetary union outside of the ECB. It is a radical solution, but it is only one that can bring back growth in Europe and prevent some of the problems we see today. Other countries outside of this porous union must depreciate their currencies and start all over again. They must qualify afresh for the union. The Europeans have tried it many, many times before. So it won’t be news to them.

A New Global Currency Order
The US has exported inflation to the rest of the world through its easy money policy. The excess reserves have caused inflation everywhere threatening growth in countries like India and China. It is an irresponsible policy.

What we need now is a new monetary system. Under this new system, the leading currencies such as the US dollar, euro and yen (and eventually perhaps renmimbi as well) would float and all other currencies including the Indian rupee could peg to them should they choose to do so. The major countries should independently choose an inflation rate of 0-2 percent in their economies.

This is the only way to get the twin benefits of fixed exchange rates and low inflation. Countries like India will benefit from low inflation and the major countries would have fixed interest rates with them. This will be good monetary policy all around.

Of course, we must remember that productivity differences exist across regions of the world. So the pegged currencies will have to adjust periodically to reflect that.

China And India
I don’t think the Chinese are going to be the dominant economic system in the world. I just don’t believe that. China has multiple problems. Most of its export growth is dependent on critical inputs coming from other countries such as Korea and India.

On the other hand, India has been a wonderful example of how remarkable economic growth can be achieved if you remove some of the regulations that hold the economy back. There has been a tremendous productivity increase and there is political consensus that this must continue.

So India should strive for internal development. And that is a good thing. India will still be a major export power in addition to a healthy domestic economy. And given that it is an English-speaking country, India is clearly in an advantageous position in the global economy.
(As told to S. Srinivasan)

Image: Phil McCarten/ Reuters
A. Michael Spence

Profile: Nobel laureate in economics (2001). Winner of John Bates Clark Medal (1981), professor of economics, Leonard N. Stern School of Business, New York University; senior fellow, Hoover Institution; professor emeritus of management, Graduate School of Business, Stanford University.

Key Ideas:
            A slowdown in China is likely and that will reverberate through emerging economies.

            Investors, wary of the high risk in developed economies, may shift some weight to emerging economies.

            Beware of the illusion of fiscal balance in an economy driven by a consumption boom.

The US’ stature is diminished by the crisis, the slow and fragile recovery, the ability to focus on fiscal stabilisation, growth and employment. It is probably fair to say there are more questions about the American system as a benchmark. In a way, the S&P downgrade was an affirmation of these underlying difficulties.

Slow growth in the West is the result of an unbalanced growth pattern that existed before the crisis, with excess private and public sector debt and asset bubbles. The US and much of Europe need structural changes and supporting policies to restore growth and employment. Right now they are focussed mainly on fiscal stabilisation, which is part, but not all of the problem.

Political gridlock or paralysis will have a large negative effect on growth and employment. And that will adversely affect the fiscal situation. It is very hard to reduce the debt-to-GDP ratio without growth.  

Some economists still expect a U-shaped recovery with an extended bottom, but the sentiment is shifting. There are those who thought the ‘new normal’ was and is real and never believed in the normal cyclical recovery view.
 

Emerging Worries
India will probably not be able to sustain eight plus percent growth rates, at least in the short run. If America or Europe or both have another major downturn, it would have a negative effect on major emerging economies. This is because emerging markets would have to generate the demand — to replace lost demand from industrialised countries — to sustain growth. I doubt that is possible.

With very low or even zero growth in advanced countries, emerging economies could sustain high growth, but not with a large downturn. However, a slowdown in India does not mean a complete loss of growth. Much will depend on whether China sustains its growth. I expect some slowdown in China and that will reverberate through the emerging economies.
 

Growing Risk Aversion
I expect investors to reduce foreign currency holdings in US treasury bonds, but at a measured pace. Especially the large reserve holders will be cautious, as they would not want to destabilise the global financial situation. China will continue to hold dollar denominated assets, but will diversify away from government bonds and into a wider range of assets, including risk assets.

International investors will adopt a wait-and-see attitude on diversifying their exposure to assets denominated in BRIC currencies. They are exiting risky assets. They don’t know about the double dip and they do not know about the scope of the global growth slowdown including the emerging markets. But I expect the weight will shift toward emerging markets.

China’s strategy of sterilising its currency by buying US treasury bonds, which enables consumer debt in the US, is an important issue for the G20. Imbalances of this type create unsustainable growth. Developed and emerging economies should be careful not to run sustained and high current account surpluses and deficit.

These need to be rectified by structural change. This is the case in China, which needs to reduce the surplus without damaging growth, and the US, which needs to reduce the current account deficit by expanding the scope of the tradable sector.

Lessons for India
I doubt American-style credit-driven consumption can drive India to debt. The Reserve Bank of India and other regulators are well aware of the dangers. Indians save more and use less debt in buying real estate. Thus far, except for a recent upward blip in the current account deficit, India has invested at high and rising levels and financed that from domestic savings. A lesson India can learn from the US is that what appears to be a balanced fiscal situation when the economy is running on consumption caused by an asset bubble, really isn’t so. Fiscal policy needs to include an assessment of the balance and sustainability of growth of the real economy.
(As told to Sujata Srinivasan)

Robert s. Kaplan

Designation: Professor of management practice, Harvard Business School. Former vice chairman of the Goldman Sachs Group, Inc.

Key Ideas:
There will be a continued shift of economic power to emerging economies in the East.

The US must learn from China in talking in one voice through times of crisis.

Politicians should not make pledges about taxes or spending cuts even before they have seen the facts.

Emerging market economies, particularly in the East, don’t have the de-leveraging problem of Western economies, and have better prospects for economic growth. As a result, it is not surprising that we’re seeing a continuing shift of wealth from the Western economies to developing ones. This will be manifested in currencies, in debt markets and in equity markets.

While the US is going through de-leveraging and fostering growth, it is not going to have as much global economic power as it did before. It has to get through this period and improve its balance sheet and deal with some structural problems.

The Importance of Leadership
The people watching the US [during the debt ceiling debate] knew it would be tough. But everybody was surprised that it was this contentious. Part of the problem is candidates making pledges to not raise taxes or not cut spending. It’s the antithesis of what I recommend. Before you’ve even seen the facts, you can’t make a pledge. It’s very destructive.

If a politician asks how he can get re-elected, that’s the wrong question. The question needs to be “How do I do the right thing for the country, even if I don’t get re-elected.” But it takes a lot of strength and a lot of faith for a leader to do that.

Business leaders are asking the right questions. The best capitalists know if they add value, they will make money. So, their first question is how to make value.  

China’s political system allows them to speak with a consensus and in one voice at the government level. The US political system takes a while for us to get to a consensus. In the meantime, we speak with a lot of different voices. So, in a period of global turmoil, China speaks very clearly. But I’m confident that the US will eventually come up with a plan and we will speak with one voice.

Boosting Growth via Spending
We have seen results. But it has not been sufficient to generate high GNP (gross national product) growth. When the Obama Administration came in, I think they may have underestimated the challenge of reducing unemployment and restoring significant levels of growth. The good news is that the corporate sector — the non-financial firms — is in good financial shape compared to before the crisis. But the government and household sectors still have a lot of de-leveraging to do.

Cost to Taxpayers
Plans from the Federal Reserve and programs like TARP [Troubled Assets Relief Program, spearheaded by former US Treasury Secretary Henry M. Paulson, Jr., former chief at Goldman Sachs] played a critical role in helping big banks and the financial sector de-leverage. The financial sector is in a dramatically better shape. The country had gone into a cardiac arrest and had to do things that it really didn’t want to do and taxpayers certainly would not have wanted. But TARP and the government bailout were necessary to stabilise the country.

As told to Sujata Srinivasan