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Archive for January, 2010

Key Readings on America’s Fiscal Plight

It remains to be seen whether our elected leaders have much enthusiasm for dealing with America’s troubling fiscal trajectory. But the policy commentariat has embraced the issue with relish.

If you have a few hours (or days) to ponder these issues, let me recommend the following:

  • Train Wreck: A Conference on America’s Looming Fiscal Crisis, held last Friday at the USC Law School. Conference papers addressed a host of issues, including the need to pay attention to tax expenditures, the burden of state pensions, the potential for catastrophic budget failure, and the arithmetic impossibility of solving our budget woes by raising income taxes on the highest earners. I had an unusual role in the conference, presenting a paper by Joyce Manchester and Jonathan Schwabish of the Congressional Budget Office about the role of health spending in our long-term budget challenges. I didn’t play any role in preparing the paper, but was happy to present the findings when neither of the authors could attend. My presentation is near the end of the afternoon session (video here). Bottom line? Our fiscal trajectory is unsustainable thanks to population aging and rising health spending.
  • Choosing the Nation’s Fiscal Future, released last week by the National Research Council and the National Academy of Public Administration. Weighing in at a hefty 360 pages (including appendices), this report provides a comprehensive overview of our budget challenges. More important, it then lays out strategies for addressing them. And it makes very clear the most important decisions we face: how big a government do we want and how should it balance the interests of older and younger generations?
  • Red Ink Rising: A Call to Action to Stem the Mounting Federal Debt, released last month by the Pew-Peterson Commission on Budget Reform. This report  reviews our fiscal prospects and makes six big picture recommendations: (1) Commit immediately to stabilize the debt at 60 percent of GDP by 2018; (2) Develop a specific and credible debt stabilization package in 2010; (3) Begin to phase in policy changes in 2012; (4) Review progress annually and implement an enforcement regime to stay on track; (5) Stabilize the debt by 2018; and (6) Continue to reduce the debt as a share of the economy over the longer term. This framework strikes me as reasonable, although one can always debate the exact numbers (e.g., would 60% in 2018 be that much better than 60% in 2020?).
  • The Right Target: Stabilize the Federal Debt, released last week by the Center on Budget and Policy Priorities. Another excellent overview of the budget challenge, this report agrees with the Pew-Peterson report in many qualitative ways, but disagrees on tempo: “Pew-Peterson Commission endorses sounds ideas but overly ambitious target.” The authors would like to see deficits reduced to 3% of GDP or lower by 2019. (A goal that OMB Director Peter Orszag has also mentioned.)
  • A Path to Balance: A Strategy for Realigning the Federal Budget, released last month by the Center for American Progress. This report takes a slightly different approach from the others, focusing on achieving primary budget balance (i.e., balancing revenues with spending excluding interest payments) rather than a debt-to-GDP target. Those concepts are closely related in analytic terms (each of the reports explains why), but as Stan Collender over at Capital Gains and Games notes, the concept of achieving primary budget balance may be a better talking point than stabilizing the debt-to-GDP ratio. Because CAP has close ties to the Obama Administration, Stan also suggests that its budget thoughts may offer a “sneak peek” about what to expect in the President’s upcoming budget.

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The Federal Reserve system is doing its part to cut the budget deficit (at least for now). Treasury will receive $46.1 billion of profits from the Federal Reserve profits for fiscal 2009. That’s about a third higher than the amount remitted for 2008.

According to the Fed’s news release this morning, the following items drove profits:

$46.1 billion in earnings on securities acquired through open market operations (U.S. Treasury securities, government-sponsored enterprise (GSE) debt securities, and federal agency and GSE mortgage-backed securities) [Profits on traditional open market operations plus the new credit easing operations]

$5.5 billion in net earnings from consolidated limited liability companies (LLCs), which were created in response to the financial crisis [Profits on the Maiden Lane partnerships etc.]

$2.9 billion in earnings on loans extended to depository institutions, primary dealers, and others [Profits on the new loan facilities]

[$2.6 billion in] net earnings from currency swap arrangements, which have been established with 14 central banks, and investments denominated in foreign currencies

Additional net earnings of $1.5 billion were derived primarily from fees of $0.7 billion for the provision of priced services to depository institutions

Those $58.6 in gross earnings were slightly offset by the following expenses:

[$3.4 billion for] operating expenses of the twelve Reserve Banks, net of amounts reimbursed by the U.S. Treasury and other entities for services the Reserve Banks provided as fiscal agents

[$2.2 billion in] interest paid to depository institutions on reserve balances [As noted previously, the Fed's still-new ability to pay interest on reserves is a big deal for monetary policy; this is the cost side]

[$0.9 billion in] Board expenditures, including the cost of new currency

The resulting $52.1 billion in new profits were then distributed as follows: $46.1 billion to the Treasury, $1.4 billion as dividends to member banks, and $4.6 billion retained to “equate surplus with paid-in capital.”

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Treasury is Issuing More TIPS

As noted by the Wall Street Journal this morning (“U.S., in Nod to Creditors, Is Adding TIPS Issues“), Treasury is issuing more Treasury Inflation-Protected Securities (TIPS). Today’s auction involves $10 billion 10-year notes; one estimate suggest that total TIPS issuance this year will be $80-85 billion. Still small compared to our nation’s overall borrowing needs (somewhere in the $1 trillion range, not including rolling over existing debt), but a real boost to the TIPS world.

As I discussed in two earlier posts (here and here), many observers have recommended that Treasury increase TIPS issuance. The WSJ piece emphasizes one particular set of advocates: our creditors who are beginning to worry about inflation:

TIPS, which account for less than 10% of the $7 trillion Treasury market, offer investors a way to hedge against inflation as their value rises along with the increase in consumer prices. The fixed returns on nominal Treasurys, in contrast, can be eroded over time by inflation, which especially affects long-term bonds.

The small size of the market for inflation-protected securities means many large investors who want to be able to sell easily still prefer other ways to hedge against inflation risk, such as commodities.

But in the past year, China and other large foreign investors have become vocal about their concerns that the large U.S. fiscal deficits and the Federal Reserve’s ultra-loose monetary policy will lead to a spike in inflation. That would hurt the value of their large holdings of nominal Treasurys.

U.S. officials reassured China in late July that the Treasury remained committed to its TIPS program and would take investors’ views into account when drawing up its issuance plans. That pledge was seen as a commitment to increasing TIPS sales.

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On Thursday, New York Times columnist Nicholas Kristof had a wonderful piece about Costa Rica, home of “The Happiest People“) (ht Catie).

Kristof reports that Costa Ricans are the happiest people in the world, at least according to three broad surveys. Why? Kristof offers the following hypothesis:

What sets Costa Rica apart is its remarkable decision in 1949 to dissolve its armed forces and invest instead in education. Increased schooling created a more stable society, less prone to the conflicts that have raged elsewhere in Central America. Education also boosted the economy, enabling the country to become a major exporter of computer chips and improving English-language skills so as to attract American eco-tourists.

I’m not antimilitary. But the evidence is strong that education is often a far better investment than artillery.

In Costa Rica, rising education levels also fostered impressive gender equality so that it ranks higher than the United States in the World Economic Forum gender gap index. This allows Costa Rica to use its female population more productively than is true in most of the region. Likewise, education nurtured improvements in health care, with life expectancy now about the same as in the United States — a bit longer in some data sets, a bit shorter in others.

I like this hypothesis, but being an empirical guy, I should note another possibility: maybe one of the keys to happiness is whatever allowed Costa Rica to eliminate its military in the first place?

Over the holidays, I did some field research (aka vacation) in Costa Rica and am happy to report that the area we visited (the Guanacaste province) is indeed lovely. I won’t torment you with my travelogue here–my wife and I have another blog for that–but here are a couple photos of the local fauna:

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Today’s jobs report invites both negative and positive interpretations.

The positives are fewer, so let’s start with them:

  • With job losses of 85,000, December was the second-best (or, if you prefer, second-least-bad) month since January 2008.
  • With today’s revisions, November actually showed job gains of 4,000, the first increase since December 2007.
  • Put that all together, and job losses averaged 69,000 per month in the last quarter of 2009. That’s unwelcome, but much better than the average of 691,000 jobs lost in each of the first three months of the year.
  • Employment in temporary help services–often viewed as a leading economic indicator–increased by 46,500 in December.

And here are the negatives:

  • December’s job losses were much larger than most forecasters had predicted.
  • The upward revision to November job growth happened only because October jobs were revised down, making November look better. The actual level of November jobs was also revised down (by 1,000).
  • Although the unemployment rate was steady at 10.0%, the details beneath that figure were horrible. Household-reported employment fell by 589,000; the only reason that the unemployment rate stayed constant is that even more people–661,000–dropped out of the labor force.
  • The labor force participation rate thus fell to 64.6% and the employment-to-population ratio fell to 58.2%, the lowest since 1985 and 1983, respectively.
  • The underemployment rate (U-6) increased to 17.3%.

Bottom line: The economy is growing (as suggested by other data), but that growth is not yet translating into new jobs.

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The Budget Deficit Keeps Rising

The federal government racked up a $389 billion deficit during the first three months of the fiscal year (October through December), according to estimates released by the Congressional Budget Office yesterday. That’s $56 billion more than during the first quarter of last year, almost a 17% increase. (A portion of that increase is due to the timing of weekends and holidays, but even controlling for those, the deficit is up 8%.)

Two factors have been driving the increase:

1. Tax revenues continue to plummet. Revenues fell to $489 billion during the quarter, down $58 billion or 11% from last year.

2. Spending continues to grow rapidly in most programs. For example, Medicaid has grown by 25% since the same period last year, Medicare spending has grown by 8%, and Social Security spending has grow by 10%. After declining last year, interest payments are now on the rise, up more than 17%. Excluding the three programs most closely related to the financial crisis (TARP, the GSE bailout, and the FDIC), federal spending is up about 13% over the same period last year. (All these figures have been adjusted to control for timing differences due to weekends and holidays.)

The one piece of good news, budget wise, is that spending on the three financial programs has declined significantly. CBO estimates that TARP spending during the first quarter fell by $85 billion (from $91 billion to $6 billion), and spending on the GSEs fell by $1 billion (from $14 billion to $13 billion). Net spending by the FDIC fell by $45 billion, primarily because FDIC receipts have increased sharply (and are accounted for as a reduction in spending). Together, those three programs have cost $131 billion less than at this point last year.

Bottom line: Tax revenues continue to fall, most types of spending continue to increase, but spending on the financial rescue has declined.

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Every January America’s economists gather for their annual conference. There are far more papers than one could ever read (or want to read), so you need a strategy to choose the most important.

In recent years, your optimal strategy should have included the papers by Carmen Reinhart and Ken Rogoff (see, e.g., this prescient paper from 2008). And so it is again in 2010.

This year’s installment is a paper that examines how government debt levels relate to economic growth and inflation. Their key finding? High levels of government debt have a substantial economic cost. In developed economies, that cost is weak economic growth. In emerging economies, that cost is weak economic growth and high inflation.

The growth findings are nicely illustrated in the following table from their paper:

Developed economies that have high levels of government debt (90% of GDP or more) have much lower rates of economic growth; for example, their median rate of growth has been a mere 1.6%, much less than the 3 to 4% growth of countries with lower debt levels. The same pattern holds for emerging economies, as well. (The third panel shows that high levels of public and private external debt also reduce growth, but the sample there includes only emerging economies.)

As R&R note, these results are particularly important today given the rapid growth in government debts around the world. In the United States, for example, debt will probably end the year around 60% of GDP, with no sign of stopping. The good news is that we are still relatively far from the 90% level that R&R identify as problematic. The bad news is that current policies will get us close to that level in less than a decade. For example, the Peterson-Pew Commission on Budget Reform recently projected that current policies would lift the debt-to-GDP ratio to 85% by 2018.

That’s too close for comfort.

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The House and Senate appear to be on a collision course about how to pay for a new jobs bill (aka a stimulus bill). The issue? Whether Congress can pay for new jobs programs by cutting back on TARP.

The House embraced that approach in the bill it passed before Christmas. That bill–H.R. 2847, the Jobs for Main Street Act–would cut TARP authority by $150 billion. For reasons I’ve discussed before, the Congressional Budget Office scores that cut as generating $75 billion in net budget “savings.” The House bill then uses those “savings” to offset $75 billion in new spending on transportation infrastructure, support to state and local governments, and other measures.

I put “savings” in quotes because no one believes that the TARP reduction would help taxpayers by anything close to $75 billion. Back in December, Treasury Secretary Geithner estimated that TARP would use at most $550 billion of its $699 billion in existing authority. As a result, Congress can cut at least $149 billion from TARP without having any effect whatsoever on the budget. In other words, the House’s TARP rescission would reduce TARP activities by at most $1 billion (and, in practice, probably by $0). So there aren’t any real budget savings here.

But that’s not the only problem with using TARP as an offset. As I noted in another post, the drafters of TARP tried to prohibit future Congresses from using TARP rescissions to pay for new spending. That prohibition is spelled out in Section 204 of the law:

SEC. 204. EMERGENCY TREATMENT.

All provisions of this Act are designated as an emergency requirement and necessary to meet emergency needs pursuant to section 204(a) of S. Con. Res 21 (110th Congress), the concurrent resolution on the budget for fiscal year 2008 and rescissions of any amounts provided in this Act shall not be counted for purposes of budget enforcement.

The House vs. Senate debate comes down to the interpretation of that section. The House apparently does not believe that Section 204 applies. As a result, it believes that TARP rescissions can be used to “pay for” other spending increases. The Senate, however, disagrees. It believes that Section 204 forbids the use of TARP rescissions to pay for other spending.

That conflict hasn’t flared up in public yet, but it is apparent in a carefully-worded footnote in CBO’s cost estimate of the House bill:

The House Committee on the Budget does not consider the original TARP authority to have been designated as an emergency requirement. Persuant [sic] to Sec. 204 of the Emergency Economic Stabilization Act of 2008 (Division A, P.L. 110‐343), the Senate Committee on the Budget does consider the TARP authority to have been designated as an emergency requirement.

Under congressional budget rules, emergency spending gets special treatment: it doesn’t need to be paid for (a fact that the House bill uses, by the way, since it designates about $79 billion as emergency spending that needn’t be offset). To avoid some obvious abuses, the budget rules therefore specify that rescissions of emergency spending can’t be used to pay for increases in regular spending (or regular tax cuts). Based on Section 204, the Senate believes that TARP is emergency spending and therefore can’t be used to pay for new jobs programs. For reasons I don’t yet understand [readers?], the House disagrees.

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Happy 2010, everyone. To kick off the new year, I am in Atlanta at the annual meeting of the American Economic Association. As Paul Kedrosky notes, there are lots of sessions on the financial crisis and its aftermath. Perhaps not surprisingly, many presentations have a pessimistic tone. But there are pockets of optimism, including Robert Shiller’s luncheon speech about the potential benefits of continued financial innovation.

One of Shiller’s ideas is that the federal government should issue a new kind of security that would pay quarterly dividends based on the nation’s gross domestic product (GDP). More specifically, each security would entitle its owner to one-trillionth of America’s gross domestic product (GDP). These “Trills” would be perpetual, like common stock in a private company, and would be backed by the government’s full faith and credit.

I will leave to others to argue the pros and cons of Trills. What caught my attention was Shiller’s estimate of how much they would be worth. With GDP around $14 trillion, each Trill would pay about $14 in annual dividends this year. That dividend would then increase (or, of course, decrease) as the economy grows (or contracts) in the future.

How much you would be willing to pay for a Trill? In principle, that should depend on your expectations of future GDP growth and your choice of what discount rate to apply to cash flows that track GDP. Oh, and if you worry about the U.S. government defaulting (still a very low risk), you might include a discount for that as well.

Shiller’s own answer is $1,400. In other words, he thinks Trills would be priced with a yield of about 1%. Trill owners would be willing to accept that low yield because they would expect future economic growth to boost dividends–and, therefore, Trill values–in the future.

That figure feels a bit high to me, but not unreasonable. For example, you could justify a $1,400 per Trill valuation if you believe that nominal GDP growth will be 4 percent and that an appropriate discount rate would be 5 percent.

If you take Shiller’s estimate seriously, it is just a short step to placing a value on the U.S. economy as a whole. If one trillionth of the economy is worth $1,400, then the entire economy would be worth $1.4 quadrillion.

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