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![Page 1: Sustaining U.S. Prosperity in a More Competitive World Robert M. Coen Department of Economics Northwestern University December 2, 2008](https://reader035.vdocuments.us/reader035/viewer/2022062322/56649d3e5503460f94a17a1f/html5/thumbnails/1.jpg)
Sustaining U.S. Prosperity in a More Competitive World
Robert M. CoenDepartment of EconomicsNorthwestern University
December 2, 2008
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Better title:Maintaining U.S. Prosperity in a
Shaken World
Robert M. CoenDepartment of EconomicsNorthwestern University
December 2, 2008
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Challenges for Obama• Short-run: Financial crisis and recession
Restore stability and trust in financial marketsModerate declines in employment and production
• Long-run: Slow productivity growthEnvironmental degradationEnergy inefficiencyGrowing income inequalityGrowing inequality in access to health
care
• Short-run crisis overshadowing all else
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How bad is the situation?• GDP growth: -0.5% in Q3, but +2.8% in Q2.
Modest decline thus far by historical standards.
• Employment: 10 months of decline; 1.2 million jobs lost, but percent loss not yet huge.
• Industrial production: down 4.7% from peak in Jan. 2008, but actually rose 1.3% in October.
• Stock market: major collapse, but not unmatched historically.
• Housing starts in free fall since 2006, but similar to some previous housing cycles.
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-15
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50 55 60 65 70 75 80 85 90 95 00 05
Change in GDP, 1948Q2 to 2008Q3Percent
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Job Losses in Recessions
(thousands, nonfarm)
Peak Trough m’s Loss %Loss 12-2007 ??? 10 1,179 0.9% 02-2001 08-2003 30 2,708 2.0% 06-1990 05-1991 11 1,621 1.5% 07-1981 12-1982 17 2,838 3.1% 03-1980 07-1980 4 1,159 1.3% 07-1974 04-1975 9 2,171 2.8% 03-1970 11-1970 8 1,044 1.5% 04-1960 02-1961 10 1,256 2.3% 04-1957 06-1958 14 2,326 4.4% 07-1953 08-1954 13 1,711 3.4% 09-1948 10-1949 13 2,344 5.2%
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Production Losses in Recessions
(Industrial Production Index)
Peak Trough m’s %Loss 01-2008 ??? 9 4.7% 11-2000 12-2001 13 5.8% 09-1990 03-1991 6 4.2% 08-1981 12-1982 16 9.4% 02-1980 07-1980 5 6.6% 11-1973 05-1975 18 13.0% 10-1969 11-1970 13 7.0% 01-1960 02-1961 13 8.6% 02-1957 04-1958 14 13.6% 07-1953 04-1954 9 9.5% 07-1948 10-1949 15 10.1%
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Housing Starts, 1960Q1 to 2008Q3Housing boom ends in 2006 Q1
0
500
1,000
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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Year
Th
ou
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How bad will it get?
• Credit crisis still snowballing
• Epic decline in housing prices not over, moremortgage defaults likely
• Excess inventories of houses/cars must be worked off
• Job cuts will create more mortgage/consumer credit defaults
• Falling household income and wealth will reduce spending
• Business, state-local govts can’t get short-term finance
• Auto industry bankruptcy?
• World economies slowing, reducing our exports
• Spreading gloom and doom
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Credit Crisis BackgroundFinancial Innovation/Deregulation
• Deregulation of interest rates
• Permission for branch banking
• Certificates of deposit
• Money market mutual funds
• Mutual funds, stock index investing, competitive brokers’ fees
• Flexible mortgages
• Home equity loans
• Development of futures and options markets
• Securitization of mortgage and consumer debt
• Floating currency exchange rates
• Venture capital, private equity, hedge funds
• Freer flow of money internationally
• Credit default swaps
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Where Your Father’s Banks Got Funds
(Remember those Greek Temples)
Commercial banks, billions of dollars
1952 Q4 Financial liabilities $157 Deposits 151 96% Credit markets 1 1% Other 6 4% Other securities 16 9%
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Where Today’s Banks Get Funds
(Now store fronts/counters)
Commercial banks, billions of dollars
1952 Q4 2008 Q2 Financial liabilities $157 $11,362 Deposits 151 96% 7,534 66% Credit markets 1 1% 1,394 12% Other 6 4% 2,433 21% Other securities 16 9% 4,651 40%
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How Your Father’s Banks Used Funds
Commercial banks, billions of dollars
1952 Q4 Financial assets $169 Cash 23 14% Loans 66 39% Treasury securities 64 38%
Other securities 16 9%
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How Today’s Banks Use Funds
Commercial banks, billions of dollars
1952 Q4 2008 Q2 Financial assets $169 $11,694 Cash 23 14% 79 1% Loans 66 39% 6,864 59% Treasury securities 64 38% 100 1% Other securities 16 9% 4,651 40%
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Banks Grow Riskier: Why?• More competition from non-banks
MMMFs, investment banks, hedge funds
• Equity holders unable to impose discipline
• Regulatory capital requirements not effective
• Bankers inclined to take greater risksBig payoffs to them if bets winDepositors, equity holders, or taxpayers absorb lossesCollect fees in either case
• Gramm-Leach-Bliley Financial Services Modernization Act of 1999 repealed Glass-Steagall and added to potential conflicts of interest
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Financial Innovation/DeregulationGood Effects
• Promotes competition – better deals for savers and investors
• Securitization allows lenders to expand loans
• Promotes homeownership rate (from 64% in 1995 to 69% in 2004)
• Creates insurance against many financial risks
• Improves allocation of investment and business risks
• Improves allocation of capital to most profitable uses
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Financial Innovation/DeregulationBad Effects
• Innovation often an escape from regulationHedge funds a good example
• Need for new regulation (like automobile)But can it work? Innovation runs ahead of regs
• Securitization separates debtor from creditor (cf. new mortgage market vs. old)
Spurs irresponsible lending practicesIncentive to generate commissionsComplicates recontracting for troubled debtors
• Gives false sense of security from risk
• Can lead to increased leveraged speculation
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Who Held Your Father’s Home Mortgage?
Billions of dollars, end of year
1952 Total mortgages $58 S&L, CU 24 41% Life ins, pensions 12 20% Banks 11 19% Households 8 14% Governments 3 5% Other 1 2%
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Who Holds Your Home Mortgage?
Billions of dollars, end of year
1952 2007 Total mortgages $58 11,171 S&L, CU 24 41% 1,187 11%
Life ins, pensions 12 20% 17 0%
Banks 11 19% 2,208 20% Households 8 14% 131 1% Governments 3 5% 105 1% Other 1 2% 7,523 67%
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“Other” Holders of Home Mortgages
Billions of dollars, end of year
2007 Total other $7,523 Agency, GSE backed pools 4,320 57% ABS issuers 2,163 29% Finance companies 474 6%
Govt sponsored enterp 449 6%
REITs 78 1% Other 39 1%
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Other Factors Spurring Credit Expansion
• Low interest rates (courtesy of Greenspan) encourage borrowing and leverage
• Growth in international savings seeks home in U.S.Our trade deficit builds up foreign reservesBurgeoning profits of oil exportersFinances of developing countries improves
following crises of 1997-98
• Failure to oversee lending practices, capital ratios
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Total debtMortgage debtConsumer credit
HOUSEHOLD DEBT, 1948-2007Percentage of Disposable Personal Income
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Snowball effects when credit bubble bursts
• Sharp rise in mortgage defaults and foreclosures
• Prices of mortgage-backed securities (MBS) go south
• Highly-leveraged holders of MBS’s find value of assets dwindling; their creditors want more collateral
• Liquidation of MBS’s difficult
• Turns out risk of MBS’s erroneously rated
• Hard to recontract mortgages in pools
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Snowball effects when credit bubble bursts
• Foreclosed properties further depress house prices, leading to more defaults, etc., etc.
• Venerable financial institutions brought down
• Sellers of default insurance on MBS’s face huge payouts (AIG)
• Panic spreads to other financial firms, even healthy onesE.g., MMMF’s -- some “break the buck”
Others suffer withdrawals, become conservativeUnload commercial paper, drying up credit in that
crucial market
• Lack of business, political leaders to calm waters
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Auto Industry Bailout?• Output down 20% since 2005 Q3 peak
• Sales down 25% from 2005 Q3 peakSales of more profitable trucks down 37%
• Losses every year since 2000“Good year” 2005: $4 billion lossCumulative losses 2000-2005: $46 billion
• Employment down sharply1,319,000 in 2000 994,000 in 2007
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ALL VEHICLES AUTOS TRUCKS
Domestic Vehicle Output, 1990Q1 to 2008Q3Down 20% from 2005Q3 peak: trucks down 33%
Bill
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0 d
olla
rs, S
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AUTOS TRUCKS
Domestic Vehicle Sales, 1990Q1 to 2008Q3Autos down 15% from 2005Q3, trucks down 37%
Bill
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Auto Industry Bailout - Pro
• Huge job loss if bankruptcy2007 employment levels, vehicles & parts
Manufacturing 994,000Retail 1,969,000Total 2,963,000
• Finance groups afflicted by credit crisis
• Domestics disadvantaged by health and pension costs
• Default would create CDS bombshell
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Auto Industry Bailout - Con
• Job loss overstated
New owners will continue some operations
Demand for parts won’t disappear
• Merge finance arms into healthy finance companies
• Bankruptcy only way to reduce costs (break contracts)
• CDS writers need to be disciplined
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Policies to Mitigate Recession
Is monetary policy “spent”?
• Interest rates already low
• Loan demand weakening - can’t “push a string”
• Lower rates could weaken $, grow exports
• Provide capital and liquidity to financial institutions to prevent “runs on the bank”
Greater govt regulation, ownership roleIn Sweden in early 1990s, banks socialized!
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Fiscal Policies to Mitigate Recession
Refinance failing mortgages: little long run cost?
Extend unemployment benefits
Stimulate spending with tax cuts or new govt spending
Tax cuts less potent: partly saved, spent on imports
Govt spending can be directed to productive investmentsInfrastructure, education, energy, environmentProblems: Takes time to plan and execute
Political waste (e.g., Japan in the 1990s)
But fiscal actions add to budget deficits and national debt
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Burden of National Debt: A Concern? • National debt is sum of past deficits
• Deficits of about 3% of GDP don’t raise debt burden, because GDP grows at that rate (see 1970s)No need to balance the budget
• Larger deficits do not add to burden if they finance productive public investment
• U.S. debt not out of line with other nations
• Not a burden if we owe to ourselves
• Government can tax or print moneyBut are tax rates already too high? Not in perspective
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ReceiptsExpendituresBudget Surplus
Federal Receipts, Expenditures, and Budget Surplus, 1952 Q1 to 2008 Q3Percent of GDP
Per
cent
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Government Debt as Percent of GDP, 2006
France 71 Germany 69 Italy 118
Japan 191 Sweden 53 UK 55
US 62
Source: OECD
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55 60 65 70 75 80 85 90 95 00 05
Effective Personal Income Tax Rate, 1952 Q1 to 2008 Q3
Per
cent
Personal Income Tax Receipts as Percent of Personal Income
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55 60 65 70 75 80 85 90 95 00 05
Effective Corporate Profits Tax Rate, 1952 Q1 to 2008 Q3
Per
cent
Corporate Profits Taxes as Percent of Corporate Profits
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55 60 65 70 75 80 85 90 95 00 05
Effective Tax Rate on Products and Imports, 1952 Q1 to 2008 Q3
Per
cent
Product and Import Taxes as Percent of GDP
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4
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55 60 65 70 75 80 85 90 95 00 05
Effective Social Insurance Tax Rate, 1952 Q1 to 2008 Q3
Per
cent
Social Insurance Taxes as Percent of Personal Income
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Tax Receipts as Percent of GDP, 2006
France 44 Germany 35 Italy 41
Japan 27 Sweden 51 UK 37
US 27
Source: OECD
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Concerns About Long-Run Economic Leadership
• Deteriorating infrastructure• Weak math and science education• Financial crisis undercuts trust, leadership • Heightened security, xenophobia limit talent pool• Growing business concentration, monopoly• Large-market advantage threatened by EU, China, India• Lag in important technologies – energy, environment• Growing inequality limits opportunities for many• No room in present federal budget to address needs
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Important Reasons for Optimism
• Most open, flexible society
• Economic adaptation our hallmarkExample, floating of $ in 1971
• Ready funding for new ideas, risks
• Tolerance of nonconformity fosters creativity, originality
• Protection of intellectual property assures incentives for innovation