Daily Archives: October 17, 2011

The economic policy debate in Washington has come down to a boxing match between two opposing remedies – ‘stimulus’ in one corner and ‘austerity’ in the other. Unfortunately, considering each so-called solution in isolation has hampered both analysis and decision-making. The proponents of stimulus argue that the losses in aggregate demand following the global financial crisis must be reversed. Their opponents say that austerity is needed to restore fiscal sustainability. But to understand how elements of each fit together, a different approach is needed, one that “connects the dots” and integrates the sets of economic logic and data employed by the two sides.

The problems of the financial crisis and economic downturn are a case in point. Leading up to the crisis, market participants and policymakers failed to understand the interconnections within the “shadow banking” system. The ensuing freeze in the repo financing markets – particularly after Lehman Brothers’ bankruptcy – had severe adverse effects on credit demand and supply, and employment. But the US economy’s structural problems predated the financial crisis. Public policy and the financial system were geared to promote excessive reliance on consumption, with inadequate support for business investment and exports. Making the right connections would have exposed this imbalance, and the role of leverage in propping up economic growth that looked solid on the surface.

Understanding these links provides a clear direction to restart growth. The US economy must shift toward promoting investment and exports. This requires a return of confidence. Businesses need a shock to ‘animal spirits’ to promote investment, and the incentives to investment should be substantial. At the same time, debt-service burdens are constraining households’ ability to respond to policy actions. Consumers need to feel more secure about their net worth. Policies should facilitate these adjustments, and offer a foundation for growth and wealth appreciation.

There are three tangible steps to boost growth. First, fundamental tax reform is essential. The US must reduce marginal tax rates on household and business earnings and on savings and investment, while broadening the tax base. By lowering tax rates on corporate profits, dividends and capital gains, equity values and household wealth will rise immediately. It will also promote growth by raising investment.

Tax reform can add between one-half and a full percentage point to gross domestic product growth each year for a decade, according to research by Alan Auerbach of the University of California at Berkeley.

Second, a viable plan for medium and long-term fiscal consolidation is needed. The most straightforward would be a gradual slowing in the rate of growth of benefits in the Social Security and Medicare programmes. Such a move would reduce the likelihood of higher future taxes, thereby raising asset prices and expectations of household incomes and wealth. The shift could be gradual, but if credible, would generate significant positive effects today.

Third, financial frictions make it difficult for households and businesses to respond positively to fiscal stimulus or to low interest rates. Policy actions need to mitigate this broken link in the chain. In particular, frictions in the mortgage market and low equity levels have restricted the ability of tens of millions of borrowers to take advantage of very low interest rates by refinancing their mortgages.

This has blunted a key channel of monetary policy and led to large numbers of foreclosures. Household balance sheet repair would be accelerated if every homeowner with a mortgage through Fannie Mae and Freddie Mac who is current on payments were allowed to refinance their mortgage at the current very low rates. It would reduce debt-service burdens and offer the equivalent of a long-term tax cut (over the life of the mortgage) of up to $70bn annually. The credit risk of these mortgages has been borne by taxpayers since 2008 anyway, so the refinancing would not increase the Treasury’s risk exposure. It should reduce it, as defaults diminish. For businesses, significant investment incentives (as part of, or as a down payment on, fundamental tax reform) can directly lower the cost of capital for plant and equipment spending.

Focusing just on monetary stimulus and temporary tax cuts misses these important links. The positive effects of low interest rates on refinancing, household incomes and wealth have been cancelled out by mortgage market imperfections that can be straightforwardly fixed. Additional fiscal stimulus for business investment can mimic very low interest rates in the cost of capital.

These three seemingly disparate steps come into focus as one connects the dots in the causes of sluggish US economic growth. Taken together, they could improve growth sufficiently to bring the unemployment rate back to pre-crisis levels within four years. The proposed plan does not imply that short-term action by the government or the Federal Reserve is useless, but it should be consistent with the steps.

Otherwise, the debate we are having about stimulus versus austerity risks being as futile as rearranging the deck chairs on the Titanic.

The writer is dean of Columbia Business School and former chairman of the Council of Economic Advisers.

You cannot remove the fragilities in Europe’s banking system without solving the sovereign debt crisis… and you cannot solve the debt crisis without stabilising the banks. This much has finally been recognised by the Group of 20 finance ministers at their meetings in Paris over the weekend. They must now move on to addressing the underlying issues at next week’s European summit and the meeting of the G20 heads of state in November.

The bank-debt dynamics that grip the eurozone have all the elements of a destabilising feedback loop. As such, the longer they persist, the harder they are to overcome and the greater the economic and social costs. It is encouraging to see policymakers searching for a holistic policy, after months of ad hoc decisions. But for this to be reflected in more than just comforting rhetoric, they must quickly overcome disagreements on three key issues.

First, they have to make more explicit which balance sheets will do the heavy lifting. Current disagreements extend well beyond burden-sharing between the private and public sectors. There is also no agreement on the public sector component, including the allocation among tax payers in creditor and debtor countries, as well as the contribution of monetary institutions such as the European Central Bank and the International Monetary Fund.

Second, regardless of how the funding is organised, there are few mechanisms to inject it effectively into the system. Traditional transmission pipes are mostly clogged. The erection of new ones is hindered by an overall architecture that never envisaged the possibility, let alone the persistence, of the current challenges.

Finally, there is the even more difficult issue of conditionality. As America’s experience demonstrates, satisfying the first two conditions will fail the test of time if it is not accompanied by visible changes in behaviour by the recipients of the aid.

To make things yet more interesting, leaders must solve these three issues while countering the detrimental impact on economic growth, limiting the drain on public finances, and safeguarding the integrity of the monetary institutions. Much sharper (and politically bolder) distinctions between solvency and liquidity, austerity and structural reforms, old debt and new flows, and bail-outs and crowding in will need to be made.

Consider Greece where, by paying insufficient attention to these issues, the approach of the last two years has failed across the board. The country’s problems have been left unaddressed, contagion to the rest of the eurozone was not contained, and the institutional credibility and balance sheets of the ECB and IMF have not been safeguarded. Officials must now shake up Greece’s adjustment programme and its funding. This means much broader burden-sharing, including a bigger haircut for private holders of the sovreign debt. New private capital inflows should also be supported by partial guarantees, to help steer the exceptional funds Greece has received towards encouraging investment and future growth. The ECB and IMF should return to their core responsibilities, replaced by fiscal support from revamped European Union facilities. In the longer term, meaningful structural reforms would allow a shift away from excessive (and unrealistic) reliance on budget austerity and privatisation.

Finally, and most controversially, the architecture of the eurozone needs to be modified to enable a country in extreme difficulties, such as Greece, to regain control over a broader set of domestic adjustment instruments, including independent monetary and exchange rate policies.

Some, but not all, of these elements would extend to countries such as Italy and Spain, where liquidity and borrowing cost concerns must be countered before they morph into solvency ones. This includes using partial guarantees (as opposed to bond purchases by the ECB) to lower borrowing costs and attract private capital, insist on joint public-private equity recapitalisations for banks, and place greater emphasis on structural reforms, rather than just budgetary austerity.

Greater clarity on whether the medium-term stabilisation of the eurozone involves a fiscal union for the current configuration or among a smaller set of countries with similar initial profiles is also crucial. Make no mistake about it; there is no escaping these issues. Hopefully, the next few weeks will see elected leaders address them from a position of leadership. If they do not, they will find it even harder to deal with a crisis that is consistently progressing from one bad outcome to an even worse one.

The writer is the chief executive and co-chief investment officer of Pimco.

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