In Need of Rescue

The headlines read like the beginnings of a summer blockbuster, with U.S. Treasury Secretary Timothy Geithner telling CNN's State of the Union : “We're almost out of runway.” The clock was ticking and if someone didn't step in and raise the debt ceiling, the world was going to end. Or at least, that was the picture being painted.

If this were a summer flick, a hero would swoop in and save the day. No more debt, no more recession. But no hero is coming to America's rescue and there doesn't seem to be an end in sight for the United States' economic woes. So we enlisted four of the most brilliant minds in economics to solve America's problems.

For the second year, Margo Thorning, chief economist at the American Council for Capital Formation, gathered expert economists for Forward's economic policy roundtable and asked them to tackle today's hottest and most complex issues. These economists may not be superheroes, but their ideas may indeed rescue the distressed economy.

Let's start with the role of the U.S. dollar as the world's currency. What do you think the future is for the dollar? Will it still be the world's currency a decade from now?

Robert Hall (RH): The issue's not really currency; it's securities. The question should be, “Will the central banks of the rest of the world continue to hold treasuries as their primary form of reserves?” That raises the question, “What other way to hold reserves is there?” And basically, the worldwide answer to that is euro-denominated government debt. With some clouds over the euro, the answer is that there's no satisfactory alternative to the dollar and it'll remain [that way]. The security of denomination and the claims will be on the U.S. government for better or for worse.

Mark Zandi (MZ): I agree. I think that roughly two-thirds of reserves are held in dollars and, if you told me 10 years from now that two-thirds of reserves will be held in dollars, I'd say that sounds about right. There's no good alternative, at least not one that's obvious for the next 10 years.

John Graham (JG): I'm surprised a little bit about this because you would think in the course of history, that the United States has never been in a more fiscally precarious position, with a lot of people questioning whether we were going to have our fiscal house in order. And you would think this would be a time when people would be looking at other places for their dollars. Is the answer suggesting that everybody else is in deep trouble like we are?

MZ: Basically, yes.

What about the question of monetary policy? Is there any reason to expect—or do we need—any further push for monetary policy? Could there be any positive impact, given the very poor jobs report for the last few months? What can or should be done? Or do we need some more fiscal stimulus?

RH: There's really not much the [Federal Reserve Board] can do at this point. Research on QE2 (the second round of quantitative easing) has been pretty clear. First of all, there's been no net change in the maturity structure of the federal debt because the Treasury has started issuing more long-term debt at the very same time the Fed has been buying and substituting its own short-term debt. So the Fed's really out of the picture as far as stimulus goes. There's no question, it seems, that some stimulus would be desirable, but the current environment is not favorable to any fiscal stimulus, so the economy has to take care of itself—which eventually it will do, but it's proving to be a very slow process.

If we have a stimulus, what should it do?

MZ: It would be helpful to have some additional fiscal stimulus; one [way] would be to extend the current payroll tax holiday for another year through 2012. That would cost about $110 billion to $120 billion. But the politics are quite difficult to interpret and I don't know how much appetite there is for that kind of additional fiscal stimulus. So, bottom line, I would agree that the economy is on its own and it's got to figure its way through this without much additional policy support.

Kevin Hassett (KH): In terms of managing risks, there is an upside risk in the sense that significant fiscal consolidation that was tied to a significant tax reform would produce growth benefits almost surely, especially if the consolidation achieved its spending reductions in the medium and long term through entitlements. So, I don't think it's rocket science to figure what you can do to stimulate medium-term growth. There are tax codes that are such a mess, so many easy things to do, and we don't seem to have the political will to do it. But if we continue with this terrible unemployment, people will look for those solutions. With the Keynesian approach, the timing problem of getting the boost in the period that you know is bad doesn't seem hard. But then there's also the timing problem of getting the hangover from the boost in a time that you know is good. That's the challenge right now for policymakers. I don't have a lot of confidence that if we jacked up growth this year, that when we pull back that stimulus next year, the negative from that would be received at an opportune time.

JG: I'm not sure that the political outlook for the broader base tax reform is that bleak. You can imagine scenarios where you can get politicians to broaden the base and lower rates in this kind of environment. I think the other part of the problem on the fiscal side is that if we could get some concrete demonstration of long-term spending restraint first, then maybe there would be room to consider some short-term fiscal stimulus. But the politicians almost always want to do the reverse—they want to do the short-term stuff without doing the long-term stuff—and I think right now, that kind of action would actually be a net harm.

KH: Well, [Robert] is the author of probably the best such tax reform proposal, so I wonder what you have to say about this.

RH: A movement to a consumption tax, essentially a value-added tax, made progressive by rebating it on the weight side, remains the best tax structure. But no one is talking, at the moment, about starting over in the tax system. We have the structure, it's a proven structure and we know how to make it progressive, which is the thing that has inhibited movement toward a value-added tax historically in the United States. Currently there's no politician who's putting any effort into it, and the arguments raised against it, although incorrect, seem to be pretty persuasive. I'm afraid we're stuck with more of piecemeal. If the things we have now—which make it more like a concession tax, which are write-offs for investment—are attacked as loopholes and tax expenditures, then we're just moving in the wrong direction.

KH: The reason I was wandering in this direction is that we're saying that it seems like policymakers are out of ammo; that there's probably not going to be an opportunity for another Keynesian stimulus. Monetary policy has had this quantitative easing that has sort of mixed results but certainly is politically unpopular. So then the question is, “Are we totally out of ammo?”

One thing that might be politically feasible is if you did the same thing with the corporate tax and reduced it gradually over time. You'd get that same kind of effect, where people would want to have their deductions today. It'd be kind of like having an investment tax growth.

There's been a lot of talk, even from the president, about reducing the corporate rate. If they did that and phased it in, they could really have quite a stimulus effect.

RH: Right, but they see that as a competitiveness issue, that the United States is being out-competed by the low-corporate-tax countries in the world. I didn't realize that it was also being considered a stimulus.

JG: Well, it's not too long from now where we'll have an election and the mathematics say that the Senate is probably going to be tilted even more toward the Republican side, maybe even in Republican control. So there's going to be a lot of active interest in Congress in doing something on the tax side. Of course, we don't know if it will be Obama in a second term or a Republican president, but I think in either scenario, major tax reform is going to be a big part of the discussion.

I don't know how any of it will get passed if it doesn't have the rate reductions. How can the Republicans in the House possibly vote for such a thing? That would be suicidal for them. So the only scenario to me is some combination of broadening the base and lowering the rates. I think that's something you're going to see Obama wanting to find. Obviously, he would love it even more if he could get a little “revenue enhancing” out of it, and we'll see how that negotiation goes.

MZ: Doesn't that also possibly address the issue of raising marginal rates on folks at the top of the income distribution? You could scale back deductions and credits that they benefit from, raise their effective rate but not raise their marginal rate. And you accomplish what Democrats want and address what Republicans want as well.

JG: That's quite hard for the Republicans to vote for. It's more likely they stay at the corporate tax side and get the corporate rates down and broaden the base on the corporations. Though Obama seems to be very determined on this high income rate question, so I'm not sure where the zone of agreement is there.

KH: You're right about the corporate tax reform rate because the administration has been talking about that for quite some time. But to solve the current fiscal logjam—and if we're debating the top marginal, personal income tax rate—maybe one way around it is to focus on the tax expenditures and deductions that folks in the top part of the income distribution benefit from, scale those back and then you achieve what you want. You keep the marginal rates down. Or even lower them, depending on what you do with the deductions and credits.

JG: One thing is clear, the [George W.] Bush administration made a big mistake in starting with Social Security instead of tax reform. Right after [the 2012] election is a really good time, if we can get the right players to work seriously.

The next question is about economic growth in developing and developed worlds. What are the implications as economic growth in developing economies continues to exceed that in the United States and NATO countries?

RH: Isn't that something we've hoped for for decades? That the previously low-income countries would finally get their act together and figure out what it took to be an advanced country? It can only be good.

MZ: We're counting on it. The key source of growth going forward will be our ability to sell what we produce to the rest of the world, particularly the emerging world, and if the emerging world isn't growing fast, that kind of strategy isn't going to work. It's to our great benefit if they're able to continue to grow strongly. Now obviously, they're currently bumping up against capacity, inflationary pressures are developing and speculation's creeping up into different real estate markets and asset markets, leading to slow growth. Broadly, we need to cheer their growth; it's a big plus for them and for us.

JG: In that sense, we have to be a little concerned about a couple percentage points of decrement in Chinese growth. I don't have a lot of confidence that we know exactly what the pace of that growth will look like. We know it's going to be growing, but the couple percentage points makes a huge difference in terms of how it affects everybody around the world. There are some potential adjustment issues, which we've been seeing in recent years and that's the impact on commodity prices, on energy prices specifically. So, this process has to be managed well, otherwise it could torpedo the growth in the developed world and the United States. The recent run-up of energy prices is a good case in point. In the long run it's a big plus, but there are some short-term adjustment issues that need to be carefully watched and managed well.

Well that's a good segue into a question about energy and climate and environmental policy. Which direction are we heading? How important is it that we make some changes to enhance security of supply? What would be your preference among the available policy options for energy policy?

RH: Congress is disposed to eliminate the domestic ethanol subsidy and also remove the tariff on Brazilian ethanol, both of which would be big improvements on energy policy, but not a big deal in terms of the total picture of world energy prices.

KH: When we were pursuing cap and trade, it was the worst of all worlds. Politicians [hoped] they could hand these permits out like candy, and the [Congressional Budget Office (CBO)] estimate was something like a trillion-and-a-half and the first 10 permits were going to be allocated by politics. Economists prefer the carbon tax. A carbon tax could be part of a fiscal consolidation that reduces rates on other things. You don't get a true double dividend, but economic harm from the carbon tax could be significantly muted by using the revenue to reduce other rates.

RH: Do the Republicans have a position?

JG: I would be very surprised. Public opinion is too polarized on this kind of issue. It's gotten highly partisan. The economy would have to get a lot better before you could see any serious entertainment of a carbon program, whether it be tax or cap and trade. Certainly, if you're going to do it, wrapping it in with other tax reform is a sensible way to do it. But the economy is going to have to get a lot better before we'll be talking about a major piece of social engineering like that. I don't think there's enough confidence in the politicians to have them design a program like that.

There's a lot of government [entities] and venture capitalists [that] have a bunch of money in green technology. I think it may prove to be a really risky investment. With the discovery of natural gas, and oil possibilities, and the technology to get this out at a reasonable cost, it's not clear what that investment's going to look like. There's going to be a lot of pressure on politicians to save all these investments, which I think would be very unfortunate. So, in the energy policy area, there's a chance that more money's going to go after bouts of bad money.

Would it be more helpful if we had more access to onshore and offshore reserves? The energy industry is trying to make the case that, with the limited access that exists now and the slow permitting process, it's very difficult to enhance supplies.

MZ: I don't know if that's a long-term solution, although it is reasonable to start looking at our natural gas reserves; that does seem to be an area of promise. There are some questions about the size of the reserves and whether we can bring them into our transportation network in an efficient way.

JG: Keep in mind that on the electric power sector side, virtually all the investments in the United States are being made with natural gas. [There is very little activity going on in either] the coal-fired power plants or the nuclear plants. There is some growth in wind. A lot of people are putting a lot of money in natural gas, and there needs to be a regulatory framework. That's the big uncertainty that sits over a lot of those investments right now.

KH: But in terms of oil, there's not enough in the United States to have much of an impact on prices.

If you had the chance, how would you change the treatment of entitlements? The president's National Commission on Fiscal Responsibility had a full set of recommendations, as have many of the other deficit plans that have been put forward. Of course, that's going to be central to getting a handle on the debt. How would you approach that?

RH: We have to approach it by rethinking many things. First of all, the issue is health care; entitlement just means health care. [Social Security] is not a big issue, but health care is a huge, all-consuming issue. The problem with health care entitlements is how many of them go to people who are perfectly capable of paying their own bills through an insurance system. The other thing is the importance of getting the employer out of the story. The employer got into health care entitlement as an accident of war-time wage controls, and it's time to reverse that error and try some kind of rational non-employer-based system. All the attempts to reform health care, so far, have been focused on trying to beef up the employer side. Certainly that was true of Obama's plan. Ultimately, that's just not going to work. Health care has become such a big fraction of spending that trying to finance it through employers is going to be a non-starter.

No one is even slightly realistic about what the burden of health care looks like 50 years from now. The notion that we can maintain tax revenue in the 20% of GDP range flies in the face of any reasonable prediction of what health care is going to look like, unless we figure out a way to get people to spend their own money on health care. Calling it entitlement reform in my view invites tinkering in the short term, which is certainly what's happened so far. And everyone has to consider what an economy looks like that's spending 40% of its GDP on health care, which is where we're headed.

JG: I agree with that entirely. We clearly have to get a total mindset shift in our country. People [need to] think of themselves as consumers of health care rather than as beneficiaries of health care programs. The starting point is introducing a lot more co-payment and higher deductibles in a wide range of health [care] programs. In a sense, we're inverted: over-insured on the first couple thousand dollars of health care that we spend every year and under-insured on the low-probability, high-consequence events, where people face very substantial and household-demolishing health care expenses. That shift has to be gradual, because this country politically can't take something like this overnight. It's got to be a gradual introduction of a lot more out-of-pocket expenses that induce people to think of themselves as consumers. And then a lot more information to the consumers about different physicians, different hospitals, different medical technologies so that they can begin to act like a consumer in the marketplace.

KH: There are a number of simple steps one can take to move in the right direction. The best idea is to just start having an annual deductible. Imagine if we started by adding $2,000 to everybody's Social Security and then having a $2,000 deductible for Medicare. You wouldn't exactly break even, but that's what has to happen. You have to move stuff to out-of-pocket in a way that it gets people to have skin in the game and to make choices to conserve when it's appropriate, but still have catastrophic insurance that is probably merited on social welfare grounds.

MZ: One other idea would be to scale back the deduction that employers get from providing health insurance, particularly for higher-income workers. That would move in the direction that Bob has proposed, and may also force folks like me who benefit from these gold-plated plans to start shopping.

RH: It is remarkable how, if you look 30 years, or 40 years or 50 years in the future rather than just 10, the whole federal government is just completely nonviable. And yet, people buy 30-year Treasury securities at 4% yields. So there's a big disconnect between what securities markets think about what's going to happen to the federal government and what any reasonable spreadsheet for the federal government looks like. There's obviously a belief that we're going to solve this problem. It's going to be very interesting to see how we solve it.

You said Social Security is not a big issue; the solution was pretty obvious to you. Can you define that?

JG: People are living longer lives [and] the period of morbidity is being compressed later and later in the life span. People have a lot more productive working years left than they did 30 or 50 years ago. Clearly there has to be some adjustment in terms of the expectation of how long people are going to work and contribute to their retirement income.

RH: In other words, [further extending] the postponement of benefits is part of the story. But if you kept the current schedule, with a gradual advancement, which is already built into the system in retirement, it would only take a few percentage points of increase in the payroll tax to solve the retirement side, even if you didn't change the structure. So, there's just not the same urgency that the unending rise in Medicare and Medicaid is going to be.

MZ: You could do other simple tweaks: You could change the inflation index to an index that most would consider more accurate, and that by itself would save a fair amount of money in the Social Security system. It wouldn't solve Social Security's problems, but it would get you a big step in the right direction.

What about the question of U.S. productivity growth? Studies recently suggest that the U.S. productivity growth rate is going to fall behind that of several of our competitors. What should we do in order to try and keep up with the rest of the world?

RH: It's unambiguously a good thing for us when the productivity of other countries rises, because rising productivity means they're making goods cheaper. Since we consume a lot of those goods and they become cheaper, that's to our benefit. We shouldn't think of there being a productivity race, in which we lose and somehow that makes us less beneficial. On the other hand, it would be better for us if our productivity could rise faster.

You shouldn't credit forecasts for productivity growth very much, because they've been completely and utterly wrong in the past. Nobody anticipated the decline in productivity that occurred starting around 1980. Nobody at all forecasted the dramatic increase in productivity in the 90s, and we don't know where it's going today. Productivity [growth] has been extremely rapid in the last year, but that's mostly making up for the decline that occurred the year before.

MZ: Our productivity performance has been pretty good over the last 15 years. In fact, during the recession, productivity jumped quite significantly. American companies—and I think you need to make a distinction between the big companies and the smaller companies—are quite competitive. Actually, unit labor costs have gone nowhere in about five years in dollar terms. If you put it in euro terms or yuan terms, they've actually declined. So I think U.S. companies are actually in pretty good shape.

I'd also point out that our service-based industries are not nearly as productive as the goods-producing side of the economy. But they are much more competitive than service-based industries almost anywhere else in the world.

KH: It's even kind of astonishing how good it's been in manufacturing. If you look at the difference between productivity and unit labor costs in manufacturing then there's been a massive change going back to '09.

What about financial reform? Maybe some of you have seen Sheila Behr's comments suggesting that policymakers really haven't gotten to grips yet with what needs to be done in terms of financial reform. Do you think the Dodd-Frank legislation is adequate or should we be doing more, and did it address the right issues?

RH: It's certainly true that, so far, little has actually been put in place that would have provided regulators the tools they should have been using in the last decade to prevent the explosion of debt and the weakening of financial institutions. Whether the regulators are prepared to adopt a suitably more aggressive view [remains to be seen].

The main thing we learned in the last decade was that regulators frequently collaborate with shaky financial institutions in order to prevent them from being brought down, which just weakens them further and makes catastrophe more likely a year from now. And there's a widespread acceptance that banks were adequately capitalized in 2007, when they really weren't because they had not faced up to the decline in value of their assets. The tools were available to deal with that situation at the time, but the regulators were reluctant to raise the issue because they thought that would just further destabilize the system. That's a mentality that's very, very difficult to get out of the regulatory process. The legacy of events in 2008 and 2009 is a very widespread expectation that every financial institution that ever gets in trouble is going to be bailed out. And that, of course, creates problems everywhere.

One of the things that [the Dodd-Frank Act] did was to create the systemically important financial institution. We used to think that's what a bank was, but then we learned in '08 that it's not just a bank, it's a myriad of financial institutions. We've created a very, very challenging system for the future.

KH: A lot of what has been done is going to lead to the financial sector looking more like the traditional telecom sector, where the Fed serves the role of the [Federal Trade Commission (FTC)]. If something's too big to fail, well then it's too big. Maybe the solution is to try and make it easier for new financial institutions to enter and compete. This does the opposite and creates a kind of a gain from doing what everybody else does. Ideally, financial institutions would take their own idiosyncratic risks—so if one guy goes down, he's uncorrelated with the other guys, so we would potentially have a stronger system.

MZ: I have a different perspective. In aggregate, the mentality of the reform will lead to a better financial system. I'm not saying we'll have fewer financial crises, but the odds that we'll have a severe financial crisis are lower. There are a couple things in Dodd-Frank that made me feel that way. One is just it's going to require more capital. The system was over-leveraged. The kind of capital ratios that regulators, because of Dodd-Frank, are coalescing around are 10% capital asset ratio—and that's real capital. That's appropriate in the context of historical numbers. There's also a clearer resolution authority being defined by Dodd-Frank. That's one of the reasons we had such a severe financial crisis and panic: because that was not clear, how you resolve institutions like [Lehman Bros.] and AIG. There's still going to be a lot of uncertainty in the next crisis, but less so, giving the FDIC authority to resolve all institutions. And there are other elements to the reform that will be helpful. Stress-testing: a very therapeutic exercise. Living wills: I know there's a lot of concern and criticism about that, but I think that's a good idea too, in terms of resolving troubled institutions.

Having said that, there's a lot in it I don't like. At the end of the day, it did not solve “too big to fail,” although I'll have to say I don't think there's any reform that would. We're competing in a global financial system, the rest of the world has very large “too big to fail” institutions and they don't seem to be hand wringing about it. If we're going to compete in a global financial system, there's just no way not to have big institutions that are complex. Why not just have capital rules and liquidity requirements that scale according to size and complexity? And the bigger you are, the more complex you are, the more capital you have to hold in liquidity form. The Volcker Rule, I'm not sure that makes any sense at all. You're just lopping off the risk into that side of the banking system where you can't monitor it carefully, and so I think that was a step in the wrong direction. And, of course, risk retention: In theory it's a very nice idea, but in practice, very impractical. That's not going to help revive securitization and I think that's vital to a well-functioning financial system. I have many complaints, as you can see, but if you take it in its totality, it was a step in the right direction. It's not going to solve our problems, but I think it'll make them less severe in the future.