Handyman Needed: Incoming Administration Strategies for a Struggling Economy

January 21, 2009

Speakers:
Bruce Kasman, Chief Economist & Global Head of Economic Research, J.P. Morgan, Inc.
Shiro Katsufuji, Chief Economist, Bank of Tokyo-Mitsubishi UFJ, Ltd.
Alex Pollock, Resident Fellow, American Enterprise Institute

Moderator:
Jim McTague, Washington Editor, Barron's

The day following President Obama's inauguration, a distinguished panel of specialists in banking, economics and financial policy discussed the challenges before the new administration and the country.

Japan's equity and real estate bubbles burst simultaneously at the end of the 1990s, whereas in the U.S. the equity bubble burst before the bubble in real estate, but the deflation of bubbles is painful regardless of sequence, said Alex Pollock of the American Enterprise Institute, a mortgage expert and former banker. "We're caught with all kinds of fixed nominal contracts written when expectations were very different than they become in the aftermath of the bubble. And how to get out of these fixed nominal contracts, otherwise known as debt, and turn them into something else becomes the overwhelming problem."

There's no mechanistic fix given "the complex set of recursive relationships" that the financial markets represent, Mr. Pollock said. When the bubble gets going and balance sheets load up with debt, many players in the market, from homebuilders to bond salesmen, make the mistake of thinking that balance sheet expansion is cash flow. By "an endogenous, intrinsic process of financial markets," prosperity begets complacency, "the greater leverage and greater use of short-term debt becomes an accepted fact," and in Hyman Minsky's phrase, "stability creates instability."

"If only it were a Minsky moment, we'd all be happy," he commented. In reality, "it's a Minsky few years that we're going to go through."

Considering private enterprise as one big balance sheet, there are only two ways to delever in the aggregate: debt deflation with asset price collapses and massive defaults, which no one wants, or shifting the debt to another balance sheet, namely the government's, Mr. Pollock said. "So the government balance sheet has been wildly expanding, and in the new administration it will doubtless continue to expand."

Better than a huge stimulus package would be tax cuts in the form of a suspension of Social Security payroll taxes, in his view--efficient, quick to take effect, progressive and, if structured to cover employer payments as well as employee payments, a way to help businesses avoid layoffs. But this won't be likely to happen given the new administration's philosophy.

Bailout operations ought to be treated "as if they were a corporation--a government-owned corporation to be sure"--with assets, liabilities, income and expense "rigorously and in a disciplined way captured in a set of accounting statements." Either there'd be a loss, in which case taxpayers at least would know what the whole thing was costing them, or a profit, in which case Mr. Pollock said he'd like to see the government declare a cash dividend "to those 60 percent of the households who actually pay taxes."

On the notion of a super-Fed or consolidated systemic risk regulator, Mr. Pollock was lukewarm. The Fed's own interest-rate policies that "triggered purposefully a housing boom, which got away into a housing bubble," and the Fed "still halfway through 2007 was pronouncing that, quote, the subprime crisis is contained, unquote," he said. "It's an idea that's arguably worth trying, but we ought to be realistic about the unknowability of the future."

Is the U.S. now condemned to a "lost decade" like Japan's? asked Shiro Katsufuji of Bank of Tokyo-Mitsubishi UFJ. His answer: no. Another three years of GDP doldrums are in the offing, but not 10.

The Fed's provision of liquidity in short-term money markets, commercial paper and mortgage credit has had good effects, Mr. Katsufuji said. "Generally, I'm very comfortable with the measures taken by the Fed so far, although there is still room to provide more liquidity, particularly in the longer-term credit market."

"Even after the economic stimulus package takes effect as intended, we need to address two major areas of the recent turmoil. The first one is financial market turmoil. The other one is toxic financial assets."

There are strong parallels between Japan's nonperforming loans problem of the 1990s and the drag of so-called toxic assets on American financial institutions today, he said. U.S. domestic debt outstanding peaked in 2005, so we are now more than three years past the peak. The last American cycle of drastic deleveraging began in 1985 and lasted seven years; if this is a rough gauge of what the U.S. can expect in current circumstances, we have another three years or so to go.

The Japanese experience of the 1990s differs in several respects from the current situation in the U.S., he said. Most corporate debt in Japan was financed through bank lending, whereas in the U.S., the capital markets provide the larger share of debt financing. Land values in Japan plunged over 50 percent, much more than in the U.S. to date. The Japanese government waited some seven years to inject capital into Japanese banks after the NPL problems first surfaced, but in the U.S. the government has acted much more quickly, within a couple of months or so after the current crisis began. However, he cautioned, we need to keep in mind that capital injections do not always have the desired effect; for as Japan's history shows, "higher bank reserves would not necessarily prompt the bank to lend more."

Deflation is a risk today, as the consumer price index maintains a growth rate near zero, unemployment rates rise, capacity falls and consumers hoard money. The key, Mr. Katsufuji concluded, is for the government to inject money directly into the credit markets and to contain deflationary expectations of the sort that plagued Japan during the 1990s and beyond.

Bruce Kasman of J.P. Morgan highlighted three priorities for the new administration: one, getting out of recession, painful not just in the U.S., where the unemployment rate has been rising for a year and a half, but also in Japan and indeed everywhere; two, undoing the problems in the financial system, which will persist even when GDP begins to grow again; and three, "not messing up what makes us actually a healthy structural economy."

"Recessions are always about cleaning out the bad apples, but they're also about providing an opportunity for good credits to start growth again, and in fact get certain advantages in a world in which risk-free rates go down," Mr. Kasman said. There are some positive signs here, including a drop of about 125 basis points in mortgage rates for conforming loans since September/October.

The fiscal stimulus is of a size that "is going to start to have meaningful impact on demand directly in the middle part of the year." However, most of the direct spending, which is generally agreed to offer the biggest bang for the buck, won't come this year. Payroll-tax holidays are appealing, but tax cuts aren't all that effective. Nevertheless, "there's so much coming, even if you want to debate multipliers, it seems to me there will be a fairly decent lift to growth," about a 2 percent boost to GDP in quarters 2 through 4 on an annualized basis.

Getting house prices up isn't necessary to get growth, Mr. Kasman indicated. What is needed is a break in "the feedback loop working from the real economy being weak, home prices going down, balance sheets being hurt, and back to the financial system." Government policy must offer "clarity and comfort to where we're heading, without necessarily having to solve the problems in one fell swoop."

When recovery begins, the conditions will be daunting, he said: unemployment at around 8.75 percent; a structural budget deficit in the range of $800 billion, or over 5 percent of GDP; and a financial system "going through a workout phase where it's not going to allow the kind of leverage for growth to take place." This risks deflation, and moreover it risks a hysteresis effect, a lag in the ability of the economy to respond in terms of labor supply and capital formation. "We've seen this take place in the past, and in fact I could argue that that's part of the Japanese story over the last 10 or 15 years as well."

The remedy is growth, but "the arithmetic here is I think very unpleasant," he said. A rosy scenario would have Japan growing 3 or 4 percent, Europe the same, emerging markets 6 or 7 percent, but that's unlikely to happen. Global credit availability, which has been a key source of growth, "is not going to turn on a dime back to where it was."

So "the problem we're going to go through here is going to be more of one like malaise than it's going to be a lost decade like Japan," more like Europe in the 1980s than Japan in the 1990s, Mr. Kasman said.

In contrast to Japan during the 1990s, the U.S. nonfinancial corporate sector is healthy, and we have to be careful not to mess this up with tax or regulatory policy, he cautioned. Public debt levels and budget deficits, though "not stellar by global standards," are solid. We don't want to have the Fed "incentivized to push inflation too high," nor to "lose sight of the need over time to get our public finances in order," which will require "a higher share of revenues to GDP, probably two to three percentage points higher than we've been used to."

Some form of consumption tax, a VAT along European lines, is the better solution, Mr. Kasman concluded; "I think the idea of doing this through higher marginal tax rates on either labor or capital is a big, big mistake here."

***
Q&A from the audience followed.

Did Hank Paulson get it right in handling the financial crisis?

"We made an important step," moving "from balance sheet expansion to provide liquidity to the market to actually provide intervention in particular key areas of the credit market, which are not functioning," Mr. Kasman replied. The problems with Freddie Mac and Fannie Mae during the summer were poorly handled, which "did a lot of damage." TARP has been positive in that it provided capital, but it's been carried out in an inconsistent manner, and the ultimate cost to the institutions as well as the taxpayer is uncertain.

Bailouts by government or central banks aren't very desirable in normal circumstances, but these are not normal circumstances, and Mr. Paulson "handled it very well in the sense that he moved eventually very quickly," Mr. Katsufuji said.

"My sympathy is always with those who have to actually act and make decisions and live with the consequences of the decisions," Mr. Pollock said. "In my view the addition of capital to the banks was the right thing to do, and I shudder to think of the counterfactual situation."

Fannie Mae and Freddie Mac built up massive amounts of credit risk specifically because of government intervention, government sponsorship. Their rescues "were an intervention necessary to save an intervention--that's different in kind from the other bailouts we have discussed," he added.

If housing prices dropped 35 percent, but then fell onto a 30-year price trend line, would that be deflation? Or would it be a return to the long-term trend?

Prices are off around 23 percent from the mid-2006 peak according to the Case-Shiller national index, suggesting another 7 or 10 percent to go to get back to the trend. The issue with deflation is "you then are faced with contracts which can't be fulfilled and have to be restructured in some painful fashion or other," commented Mr. Pollock.

What's important is not a particular price but whether a deflationary psychology is emerging, Mr. Kasman said. Such shifts in expectations not only redistribute wealth from debtors to creditors, but also cut out the incentive people normally have to buy more when prices fall. This hasn't happened yet, but in the next year or two "the risk is genuine that we get into that kind of a problem."

Is Obama on the right path with the stimulus plan?

"I believe Obama is in the right direction as far as the current circumstance is concerned," Mr. Katsufuji replied. The capital injection portion is investment not spending, he added, and "there must be a certain return when the economy comes back to normal."

"If I were designing a plan right now, I would cut it in half in size and front load it," Mr. Kasman said. "I would much prefer to have the infrastructure spending designed in an environment in which we are not mixing it up with the need to get out of a recession."

--Katherine Hyde