“The Good, the Bad and the Ugly”

Some of the Economic Challenges

Our Next President will Face

Outline

To be discussed in reverse order:

“The Ugly” - the current financial crisis

“The Bad” – inequality, health care, social security

“The Good” – productivity growth

“The Ugly”or

What Just Happened?

Events Leading up to the Financial Crisis

1977 Carter signs the Community Reinvestment Act. Designed to provide credit to “under-served populations,” i.e. those with poor credit

1995 Clinton Administration amends CRA to increase access

Amendments provide for the securitization of “subprime” mortgages

1996 Clinton Administration directs Fannie Mae and Freddie Mac to allocate 42% of mortgage financing to borrowers with income below the median for their area.

This is later raised above 50% by Bush Administration

Events Leading up to the Financial Crisis

Late 1990s- early 2000s

Low interest rates and large foreign inflows help fuel the housing bubble.

2004-2006 Few realize the real risk. The risk premium on sub-prime mortgages is just an extra 1.3 percentage points

Credit agencies give the mortgaged backed securities good ratings.

2005-2006 40% of all home purchases are for speculation or as vacation homes

Timeline of the Last 14 Months

8/9/07 Liquidity crisis – Fed and European Central bank begin injecting capital

3/08 Fed rescues Bear Stearns

9/8/08 Treasury nationalizes Fannie and Freddie

9/15/08 Lehman Brothers files for bankruptcy – largest in U.S. history ($600 billion in assets)

9/16/08 Fed makes bridge loan to A.I.G., the largest insurance company in the world.

10/3/08 Government passes bailout – authorizes Treasury to spend up to $700 billion

10/31/08 Dow is down 34% since its peak last October

Didn’t Any Officials Foresee the Crisis?

From the NY Times September 11, 2003:

The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago. Under the plan, a new agency would be created within the Treasury Department to assume supervision of Fannie Mae and Freddie Mac… Fannie Mae and Freddie Mac have been criticized by rivals for exerting too much influence over their regulators.

Among the groups denouncing the proposal today were the National Association of Home Builders and Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing. ''These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis,'' said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ''The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.''

The Lesson for the Next President:

Good intentions are not enough

The best of intentions (extending home

ownership to low income individuals) has led

to the worst of crises. Everyone, especially

low income individuals, will be much worse

off as a result.

The Fallout

The Bubble Bursts

1 in 6 homeowners owes more on mortgage than the house is worth

Foreclosures have climbed dramatically, jumping 71 % in the 3rd quarter of 2008 relative to year earlier

Worldwide credit markets have seized up

– no one trusts anyone else’s balance sheet

The stock market has plunged

The Effects Spread

Credit Markets Seize Up

Source: Shiller, updated to Oct. 24, 2008

050

010

0015

00

1880 1900 1920 1940 1960 1980 2000year

S&P 500 Stock Price Index

The Stock Market Crashes

01

002

003

004

00

1880 1900 1920 1940 1960 1980 2000year

S&P 500 Stock Price IndexAdjusted for inflation, in percentage terms

- 34%, 2 yrs to recover peak

- 67%, 20 yrs to recover peak

- 81%, 29 yrs to recover peak - 53%, 16 yrs

to recover peak

- 46%, has not recovered peak

- 27%, 4 yrs to recover peak

- 39%

Source: My calculations based on Shiller’s data.

Employment has been declining since Jan. 2008

Employment is expected to plummet in the October report.

What can the government do?

•The attempts by the Treasury and the Fed to provide liquidity to financial markets and recapitalize banks are the best hope.

•The potential effects of more fiscal stimulus are uncertain. Consider the effects of the recent tax rebate:

The Effects of the Recent Tax Rebates

9000

1000

011

000

2006 2007 2008month

01

23

45

savr

t

2006 2007 2008month

After-tax income

Consumer expenditures

Tax rebate

Saving rate

We will probably have a moderate to severe recession

because of the fallout from the subprime mortgage

debacle.

If government feels compelled to try a stimulus

package, infrastructure investment would be best. At

least spending on infrastructure would have some side

benefits, even if it didn’t stimulate the economy.

Bottom Line on Current Crisis

Income Inequality

Health Care

Social Security and Medicare

Global Warming (I won’t have time to discuss)

Some Long-term Economic Challenges

There has been a dramatic increase in income inequality in the U.S. since the late 1970s.

Economists attribute the increase to factors such as technological change and globalization.

Income Inequality

Real Wage Growth by Education Level - Males

From Autor, Katz, & Kearney (2005). Composition-adjusted full-time weekly earnings.

Real Wage Growth by Education Level - Females

From Autor, Katz, & Kearney (2005). Composition-adjusted full-time weekly earnings.

Caveats

(1) Recent research suggests that the real wage growth of low income households has been faster than we think.

The price of goods bought by low-income people have increased much less than the general rate of inflation. Adjusting for this effect eliminates 2/3 of the increase in inequality.

(2) Time use studies show that those with higher education levels now work longer hours and have less leisure than those with less education. On average a high school dropout has 9 hours more leisure per week than someone with a graduate or professional degree.

Historical Perspective: Income Share of the Top 10% of the Income Distribution, 1917 - 2006.3

.35

.4.4

5.5

1920 1940 1960 1980 2000

excluding capital gains including capital gains

Comparison of France and US

How Did France Prevent the Rise in Income Inequality?

•High minimum wages

•Highly regulated labor markets

•Generous unemployment benefits

•Powerful unions

But at what cost?

46

81

01

2

1980 1990 2000 2010Year

US France

Unemployment Rate Trends in France vs. the U.S.

Wage inequality has risen significantly since the 1970s

However, the well-being of lower wage individuals may be understated.

Trying to decrease wage inequality through labor market restrictions might lead to higher unemployment.

Obama’s tax reforms do more to reduce inequality than McCain’s reforms.

Bottom Line on Wage Inequality

The U.S spends more than 15% of GDP on health care

For the privately insured: in 1960, 62% of expenses were paid out-of-pocket; in 2006, only 22% were paid out-of-pocket

16% of the population is without health insurance

27% of the population is covered by government health insurance

Health Care

0 5 10 15

United StatesUnited Kingdom

SwitzerlandSweden

SpainPortugal

OECDNorway

NetherlandsJapan

ItalyGermany

FranceDenmark

CanadaBelgium

Health Expenditures as a Share of GDP, 2006

Public Private

Source: OECD

Source: OECD

Would we be better off with a national health insurance system?

Some Comparisons of U.S. and Canada

Current spending per person on health care:

U.S. $5,700 Canada $3,000.

All evidence points to gross inefficiencies in the U.S. health care system.

Other countries have flaws in their systems,

but they seem to be able to produce similar health outcomes at much lower cost.

Reforming health care is one of the most difficult challenges facing our next president.

Neither candidate has suggested the overhaul

we really need.

Bottom line on Health Care

The basic problems:

Too many retirees per worker (due to longer life expectancies and reduced fertility)

- In 1960, 9 workers paid the bill for each retiree’s Social Security Benefits- By 2030, there will be only 2 workers available to pay the benefits for each Social Security recipient

Medicare costs are rising dramatically

Social Security and Medicare

Social Security and Medicare have dramatically cut the poverty rates of the elderly.

A SUMMARY OF THE 2008 ANNUAL REPORTS

Social Security and Medicare Boards of Trustees

A MESSAGE TO THE PUBLIC:

“The financial condition of the Social Security and Medicare programs remains problematic. Projected long run program costs are not sustainable under current financing arrangements.”

Projected Tax Income Shortfall, Percentage of GDP

Source: Social Security and Medicare Board of Trustees

Either taxes must be raised or benefits must be cut.

The problem with raising taxes is that it could discourage work.

One way to cut benefits is to raise the retirement age.

McCain has indicated that entitlements must be cut, Obama hasn’t indicated that he will try to address this problem.

Bottom Line on Social Security and Medicare

The U.S. is still a leader in

productivity, which is the ultimate

source of increases in standards of

living.

The “Good”

Recent US Productivity Growth has Outperformed

Other G-7 Countries

Relative Labor Productivity, G-7 in 2007

Country Productivity

(US = 100)

Canada 81.4

France 100.9

Germany 91.8

Italy 73.7

Japan 71.0

UK 81.2

US 100.0

Conclusion – the next president faces many economic challenges

The Good – The US continues to lead in productivity.

The Bad – Income inequality, the health care system, and the future of Social Security and Medicare are major challenges

The Ugly – the current financial crisis