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Archive for May, 2010

“Matterhorn” by Karl Marlantes

To commemorate Memorial Day, let me recommend “Matterhorn: A Novel of the Vietnam War” by Karl Marlantes. There’s little that I can add to the overwhelmingly rave reviews over at Amazon: it’s gripping, intense, and authentic. I was particularly impressed with Marlantes’s skill in portraying the choices that confronted his characters, how seemingly irrational decisions might make sense from an individual’s perspective, and how faulty information and flawed incentives could lead to tragedy.

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Journalists, commentators, and economists often say that consumer spending makes up 70% of the U.S. economy. Indeed, it’s easy to find several examples of that claim in today’s coverage of the latest GDP data (e.g., here). And, full confession, I’ve used that phrase a few times myself.

There’s just one problem with the 70% claim: it’s wrong. Consumer spending actually makes up only 60% of the economy.

This discrepancy exists because national income accounting doesn’t always mix well with simple arithmetic. If you look at data for 2009, you will find that consumer spending totaled $10.1 trillion, while GDP was $14.3 trillion, both measured in current dollars. Put those together, and it appears that consumer spending is about 71% of the economy (= 10.1 / 14.3). (You get almost the exact same percentage if you do the calculation with real values, but that introduces other complexities.)

That calculation is so simple, it’s easy to understand why it has a fan club. But there’s a hidden problem. To see it, it helps to do the same calculation for other parts of the economy. Again using current dollar figures for 2009, you will find the following:

     Consumer Spending            71%
     Investment                            12%
     Government                          21%
     Exports                                    11%

Notice anything strange? If you add these four sectors of the economy together, you discover that they account for 114% of GDP. In other words, consumer spending, investment, government spending, and exports, when combined, are one-seventh larger than the total economy.

This apparent paradox—the components of the economy are bigger than the economy itself—is resolved when you consider how the economic data handle imports. In order to determine gross domestic production, the statisticians add up domestic purchases and then subtract imports. So the full national income accounts for 2009 show the following shares of the economy:

     Consumer Spending           71%
     Investment                            12%
     Government                          21%
     Exports                                    11%
     Imports                                 -14%

These figures add to 100%, as they should. They also demonstrate why consumer spending was not really 71% of the U.S. economy in 2009. Total consumer spending was indeed 71% of the size of the economy, but part of that spending went to imported goods (clothes, coffee, cars, etc.). If you want to know how much consumers contributed to U.S. GDP, you need to take the 71% figure and then deduct the portion that was spent on imports.

I am not aware of a simple way to do this calculation using the data in the regular GDP reports. Over at Mandel on Innovation and Growth, however, Michael Mandel provides a useful discussion of a paper that does this calculation for several recent years, including 2008. (Michael deserves credit for taking a leading role in fighting back against the claim that consumers are 70% of the economy.)

The paper, “Induced Consumption: Its Impact on Gross Domestic Product (GDP) and Employment” by Carl Chentrens and Art Andreassen (you can find it in this conference proceeding) makes exactly the import adjustment I described above. For 2008, it concludes that the relative shares are as follows

                                        Unadjusted                   Adjusted

Consumer Spending           71%                           61%
Investment                            14%                           11%
Government                         20%                           17%
Exports                                   12%                            11%
Imports                                 -17%

The authors find similar results in previous years, including 1999, 2002, and 2006.

Bottom line: Consumer spending really makes up about 60% of the U.S. economy. But you’d be hard-pressed to know that from the usual GDP data.

Note: The authors make a second adjustment for “induced activity”, that Michael Mandel also picks up on. That makes the consumer share seem even smaller. I have serious reservations about that adjustment, however, particularly when trying to answer questions about (a) the overall size and composition of the economy and (b) its long-term growth. Thus, I favor the 60% figure.

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The past few years have demonstrated that Fannie Mae and Freddie Mac, the two mortgage giants, were built on a flawed business model. One that paired private profit in good times with taxpayer burdens in bad times; created systemic risks to the world financial system; concealed the degree of federal involvement in mortgage markets; and directed many of the benefits of government assistance to shareholders and management, rather than homeowners.

The folks at e21 asked Phill Swagel and me to ponder how Fannie and Freddie ought to be restructured when they emerge from government conservatorship.

Our proposal, “Whither Fannie and Freddie: A Proposal for Reforming the Housing GSEs” has just been released.

Here’s the gist:

The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.

Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.

How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit  easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.

P.S. For a nice overview of the Fannie & Freddie situation, see this article by Nick Timiraos in the Wall Street Journal; it includes a brief mention of our plan.

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.

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I’ve enjoyed the hullabaloo over the rodent that upstaged President Obama during his remarks on financial reform on Thursday. As an animal aficionado, however, I’ve been disheartened by the number of people who believe the critter was a rat or mouse. As the photos show, that just isn’t so:

That, dear friends, is a vole. Indeed, I’m pretty confident it’s a meadow vole, Microtus pennsylvanicus (you can tell by the size, body shape, ears, tail length, and presence in the Rose Garden). According to the AP, the experts agree:

“The rodent is definitely a vole,” said Paul Curtis, a wildlife biologist at Cornell University. “It has small ears hidden in fur, small eyes and a short tail. Given that the length of the tail is longer than the hind foot, I’m 99 percent certain it is a meadow vole.”

You might wonder why I think I can identify meadow voles. When I was young I caught one in the backyard (in a live trap) and kept it as a pet for a couple of days. My sister and I quickly released the little guy, however, after it leapt straight up from its cage to sink its teeth in her index finger. It took Jennifer forever, it seemed, to shake the vole off. After which we promptly returned him to the backyard. Not, I should emphasize, because we were afraid of him or mad at him. No, we were still pretty fond of him, but we feared for his life if our parents ever found out. [Obligatory warning: Kids: If a wild animal bites you, don’t wait thirty years to tell your parents.]

So watch out Mr. President, make sure Sasha and Malia enjoy the FVOTUS from a safe distance.

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How Would You Tame the Debt?

Show of hands, please: Do you think you can do a better job with the federal budget than our leaders in Washington?

OK everyone, put your hands down. And put that confidence to the test by clicking over to the new Stabilize the Debt exercise from the Committee for a Responsible Federal Budget.

The exercise gives you a goal–getting the federal debt down to 60% of GDP by the end of 2018–and a lengthy menu of policy options that you can use to get there.

How tough is this? Pretty hard. The CRFB’s baseline has the debt at 66% of GDP in 2018, implying that we need $1.3 trillion in spending cuts and tax increases to hit the 60% target. But that’s assuming that all the 2001 and 2003 tax cuts expire at the end of the year and that discretionary spending will grow only at the rate of inflation over the next decade.

As a political matter, a more plausible baseline might be to assume that the tax cuts get extended except for high-income folks and that Congress enacts the President’s proposed levels of discretionary spending. In that case, the debt would be 82% of GDP in 2018. And you, the beneficent budget dictator, would have to find $4.6 trillion in spending cuts and tax increases.

Just for fun, here’s one way you might get there:

  • Reduce the number of troops in Iraq and Afghanistan to 30,000 by 2013
  • Make a variety of other defense spending reductions
  • Raise the Social Security normal retirement age to 68
  • Gradually reduce scheduled Social Security benefits through 2080
  • Use an alternate (i.e., lower) measure of inflation for Social Security COLAs
  • Include all new state and local workers in Social Security
  • Increase Medicare cost-sharing and premiums
  • Reduce spending on graduate medical education through Medicare
  • Enact medical malpractice reform
  • Increase the Medicare eligibility age to 67
  • Reduce Medicaid spending to higher-income states
  • Reduce farm subsidies
  • Cut assorted other spending (is anyone not going to cut “certain outdated programs”?)
  • Enact a carbon tax
  • Increase the gas tax by 10 cents [I was surprised CRFB didn’t have an option to raise it more]
  • Raise the Social Security tax cap to cover 90% of earnings
  • Index the tax code to an alternate (i.e., lower) measure of inflation
  • Sell government assets
  • Reduce the tax “gap”
  • Replace the mortgage interest deduction with a flat credit
  • Curtail the state and local tax deduction
  • Replace the exclusion for employer-provided health insurance with a flat credit
  • Limit itemized deductions for taxpayers with high incomes
  • Eliminate subsidies for biofuels

And that doesn’t leave room for any spending increases or tax reductions that you might want.

Good luck.

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Today’s housing data are again driving some optimistic headlines. Most notably, new starts of single-family homes in April were up more than 10% from March.

As I’ve noted in previous posts (here, for example), I think it’s useful to look not only at the number of housing starts, but also at the number of houses under construction (which reflects the pace of both starts and completions). Why? Because that gives us a sense of how much construction activity is actually taking place. As shown in the following chart, those figures suggest that the housing market is still moving sideways:

307,000 single-family homes were under construction at the end of April, essentially unchanged from March. The sudden spurt in housing starts in April was offset by a burst of completions.

In short, little has changed in construction of single-family homes over the past month or, as the chart demonstrates, over the past year. The number of houses under construction has remained remarkably constant over the past 12 months–ranging between 298,000 and 318,000–despite home buyer credits and the upturn of the overall economy.

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The International Monetary Fund released its latest Fiscal Monitor last week. As expected, the headline message was quite grim for the advanced economies, many of which face grueling fiscal adjustments in coming years.

One of the IMF’s most important findings is that the government financing needs of many advanced economies “remain exceptionally high.” As illustrated in the following chart, Japan will have to sell debt equivalent to 64% of GDP this year in order to rollover maturing debt (54% of GDP) and finance new deficits (10% of GDP):

The United States comes in second, needing to sell debt equivalent to 32% of GDP in order to rollover maturing debt (21% of GDP) and cover new deficits (11% of GDP).

Why does the USA come in ahead of more troubled economies such as the UK and the PIIGS? Because our debt has a much shorter average maturity. According to the IMF, the average maturity of US debt is only 4.4 years. Portugal, Italy, Ireland, and Spain have maturities that are about 50% greater (from 6.2 to 7.4 years), and the UK is almost three times as long at 12.8 years.

The short maturity of US debt is a blessing in the short run, since we can benefit from lower interest rates. But it is also poses two risks in the long-run: greater exposure to interest rate increases (if and when they materialize) and a relentless need to ask capital markets to rollover existing debts. Both good reasons why Treasury should continue to gradually extend the maturity of federal borrowing.

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