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Thursday, February 25, 2016

Radio Show: Looking Backward, Looking Forward

Mike Smitka
Professor of Economics, Washington and Lee University

WREL Lexington (VA) is changing its format, so today is my last regular radio show. So looking back, what have we talked about, and what then should we think about moving forward? First and foremost there's the slow but steady growth of the US economy. Because most observers are parochial, unfamiliar with the experience of other countries and of our own history, that slowness continues to be treated as a surprise. More in a moment. Looking forward I see four long-run economic issues facing the US: education, infrastructure, population aging and fiscal health. While it's a bit of a straw man, can we make America great again? More properly, will our children face a future of falling incomes and rising social tensions? I fear the answer is "no." I don't want to end my regular radio presence without a reminder that I'm a practitioner of the dismal science.

Americans are parochial. As someone who's lived at least a couple months in Munich Germany alongside my seven years in metropolitan Tokyo, there's a useful image. We call someone who is comfortable in two languages bilingual, someone comfortable in three languages trilingual, someone who only knows one language American. That's slightly unfair, because anyone who lives in a large country – say with a population over 100 million – can get advanced textbooks in their own language, and otherwise get along fine. In addition, people learn your language if they want to do business with you. That's not true if you're a Finland. Anyway, that parochial mindset means that even quite good economists really were not familiar with the experience of other economies, yet Japan for example went through a real estate bubble that peaked in 1991, from which recovery took 15 years.

The result is that both specialists and the general public thought 2008 was the start of just another recession, severe but otherwise "normal". But in post-1945 America "normal" recessions had been a reaction to an economy overheating, with the Fed raising interest rates to slow things down. Business then held back on investment projects, consumers put off buying houses and cars. Recovery came promptly once the lowered rates because that behavior reversed. If that was the case then once the financial system was stabilized recovery would be prompt. We wouldn't need any extraordinary measures, only an ordinary period of lower interest rates.

But that's not what happens when a bubble breaks, particularly a real estate bubble. Consumers have too many houses and too many cars, at least relative to incomes, and any slowdown in the economy pushes many households into their own, personal financial crisis. Lower interest rates do nothing to help them, and low rates don't eliminate the overhang of too many houses and too many light trucks (to give a nod to the "autos" side of this blog). Similarly businesses had their own overhang, too many shopping malls and office buildings, and a long period when underwater consumers wouldn't be buying their wares. So they didn't need to invest. After all, repaying debt means you as a household have to hold expenditures below income, the functional equivalent to an economist of raising your savings rate. Oh, and people lost jobs by the millions. That made everything harder. The bottom line is that – with early 2007 as the start of the down cycle – we're 9 years along. Employment remains 5.5 million below normal, after adjusting for population growth while subtracting off the impact of baby boomer retirements. Long-term interest rates remain at a post-WWII record low. Inflation is well below the target of 2.0%-2.5% consistent with a normally functioning modern economy. Construction and real estate sales, adjusted for population growth, remain below the worst of any previous recession, and a few metropolitan areas aside housing prices are below where they were 10 years ago. On the other hand since 2012 growth has been steady, we've added 12 million jobs (15 million if we add in those who'd been pushed into part-time work but now have full-time jobs). So by the end of 2017, absent a sharp acceleration in growth, we'll be back to normal. The bottom line: we will have experienced a lost decade, particularly painful to younger Americans who didn't start building up work experience and so will find it had to reach an income level that will let them start a family and buy houses. The impact of the recession will reverberate for a decade to come.

So for a couple years of my WREL show with Jim Bresnahan I've looked at the slow recovery, looking at interest rates and monetary policy, fiscal balances with the recovery of local, state and Federal tax receipts, the housing market, the auto industry, and so on. In contrast, I've spent almost no time on the stock market. Low interest rates plus uncertain corporate profit prospects make fundamental valuations volatile. In the short run companies are cash-rich as profits recovered (those job losses reflecting a trimming of costs). Will they invest those funds at some point? Of course we see frothy behavior, too, with a belief in tech that I think is largely unfounded. Tesla, for example, has no strategy that will let them earn decent profits, so their market valuation should be very low. It isn't. Explaining that is a job for sociologists and psychologists who study the madness of crowds. I as an economist can offer no insights. But one theme I did raise was diversify, another was that when returns are low, they're low and any investment that purports to offer good returns should be treated with suspicion.

What of the future? If as I expect the economy normalizes by 2018 – employers are holding onto their workers and workers onto their jobs at levels not previously seen – then wage growth will pick up and with it inflation. The Fed will at long last be able to raise interest rates. However, there's no sign that we will enjoy productivity growth similar to that of the past, while demographics mute labor force growth. I view 2% growth as possible, but not 3% growth – much less the 4%-5% that political hopefuls such as Bush and Sanders have trotted out. That has big implications. Our economic pie won't expand much, and that makes macroeconomic tradeoffs more contentious.

And tradeoffs we do face. First, for the long haul we need to improve our education system, particularly in the early ages. In the Rockbridge Country region about 1 in 5 children start school never having been read to, unfamiliar with books because their household has none. To improve their chances of being at grade level, we need readily available pre-K education, a longer school year, and staff for whom teaching is more than just a job. Right now, though, teacher pay remains below that which any ambitious college degree holder can earn. And in the name of quality we're asking teachers to spend an extra year in school to get a master's degree. We as a society want to educate our children on the cheap. We're getting what we pay for. Now there's plenty on the parent side, too. No one knows how to change that, but we do know how to attract staff who will go the extra mile.

A second set of challenges revolves around our aging population. While the Affordable Care Act improved access for the population below Medicare age, it's done nothing to control costs. We still don't provide good public health access for younger people, and pay a long-term cost as a society for that. But the health costs in our system are incurred mainly by older individuals. We don't consume much more healthcare services than other rich countries. We do however pay twice as much, and that gap is not shrinking. As our population ages the absolute magnitude of costs will continue to rise. International experience – and the analytics of where the costs of our system diverge from everywhere else – both suggest we need a single payer setup that can impose price ceilings. Otherwise we will either face much higher taxes, or start letting people die through some implicit equivalent of death panels as individuals simply won't be able to purchase the treatment they need. Whatever our political stripe, we ought to find that morally unacceptable. But failure to reform will lead us to starve other needs, too.

One such is infrastructure. We in the Shenandoah Valley don't see the deterioration that is affecting much of the U.S. Locally I-64 is brand new, while I-81 is comparatively new. We still have bridges that needed emergency replacement, and water systems (Goshen) that collapsed with age. We've old school buildings. Much of the U.S. is worse. And our society depends on physical mobility and access to water and electricity and communications. Given the challenge of a forested rural setting our local utilities do an amazing job. But our national grid hasn't expanded to keep up with our growing population, and the same is true of natural gas distribution. All of these are big projects, and the longer we wait, the worse the repair bills will be. We're talking trillions of dollars, big enough to matter to the economy as a whole.

Finally, we have fiscal challenges. At the Federal level are deficit is sharply down, thanks to the recovery since 2007. But the deficit remains, and it's too big to sustain. The same is true at the local and state level, though that's often hidden by back-loading expenditures by paying employees low salaries while promising good pensions and/or early retirement. Well, the baby boomers are retiring. Meanwhile pension accounting has been lax, to put it kindly, and governments have been allowed to keep their budgets balanced by putting off infrastructure expenditures and not putting money into pension funds. Management problems of pension funds don't help – the Board of CALPERS, the California Public Employee Retirement System, doesn't understand their own finances. The day of reckoning is at hand. (At the Federal level, Social Security is likewise running down its reserves, though only because the last overhaul didn't factor in the rate at which longevity would increase, amplified because it didn't foresee the revenue shortfall of the Great Recession.)

To address the above needs we need revenue enhancement at all levels of government – rhetoric aside, when they have to make actual spending decisions, no politician of any stripe can find much government left to eliminate. Raising taxes is not a popular message, and in fact establishment Republicans have built their party around constant tax cuts. Trump is not beholden to them, but there's no way to predict what he might actually do, since our primary campaign system forces candidates to take positions they must repudiate come the general election. (As I've argued on this blog, that is a greater problem for Republican candidates this time around, using economic analysis that turns to the Hotelling product differentiation.)

The numbers are big, but not so big as to give us Scandinavian levels of taxation, if we can but control healthcare costs and avoid war. So from an economist's perspective these are all problems that can be solved and still leave us a high-income, prosperous society. But solve them we must, and I see little sign that our political system is up to any of the above tasks.

Thanks for the run! It has been fun thinking through issues and being forced to learn more of my own economy. To the end I remain

Dismally yours, mike smitka

PS: I've not put in cross-links to old blog posts. Explore!