Auto loans, part 2: options for the President

Auto loans, part 2: options for the President

In part one of this series I reviewed some background and long-term problems facing the U.S. auto manufacturers. I pointed out that General Motors and Chrysler, and the Obama Administration, face a more immediate cash flow problem. The Obama Administration is in the midst of rolling out the President’s new game plan. I’d like to walk you through the options the President faces.

Now let’s examine the benefits and costs of each option. I will soon ask you to pick your own recommendation to President Obama.

Option 1: Extend the current loan and lend additional funds from TARP

Assume a loan cost of roughly $5 B per month for GM, Chrysler, and their finance companies combined. This could be off by a factor of two either way, and can easily vary from one month to the next as external pressures on the companies change their needs.

Likely short-term outcome: 99% chance GM and Chrysler continue operating for the duration of the loan.

Benefits

  • It avoids immediate failure and the associated job loss. If GM and Chrysler both were to enter a Chapter 7 bankruptcy and shut down operations permanently, we had estimated (back in December) total job loss of roughly 1.1 million jobs, heavily concentrated in Michigan and surrounding states. This would be a significant hit to an overall weak national economy, and would devastate the region. We further estimated that U.S. GDP would be 0.5 — 0.75 percentage points lower in 2009 as a result.
  • It buys the firms time to continue working to solve the above-described long-term problems. It also buys time to allow the economy to recover, with the hope that vehicle sales improve.
  • It buys the President and his team time to focus on implementing and selling their financial plan, passing their budget through Congress, and maybe asking Congress for additional TARP funds.

Costs

  • The taxpayer would be placing at risk more funds ( ?$5 B per month), in addition to the $25 B already loaned in December and January.
  • New loans would consume scarce TARP resources, which are needed for the banking sector (their original intended purpose).
  • The December loans require the firms to prove that they are “viable” to continue receiving funds beyond March 31st. By rewriting or extending these loans, the President risks taking a political hit for explicitly relaxing or delaying the viability requirement. By providing even more taxpayer funds, he exacerbates this risk.
  • By temporarily removing the threat of a bankruptcy filing, it may delay a deal among stakeholders (labor, dealers, suppliers, creditors, and management).
  • Each time the taxpayer injects funds, it reinforces the incentive for those stakeholders to negotiate with the government (both the Administration and, separately, with the Congress) rather than with management.
  • In a competitive market, management and equity holders are supposed to face the full downside risks of their failures. By insulating them from some of that downside, the government is creating a moral hazard for the future. This is the “bailout” point, applied to management and shareholders.
  • It is harder to say no to other industries and firms that request relief. The Obama Administration already said yes to certain auto suppliers, lending them $5 B of TARP funds [last week]. This is a slippery slope.
  • It is harder to justify saying no the next time. If you lend them funds for another three months, how do you justify saying no three months from now? Each extension and additional loan increases the chance of these becoming “zombie firms” — firms which can survive only by consuming an ongoing stream of taxpayer subsidies.

Option 2: Offer to extend the current loan, and lend additional funds, but only to help a firm that attempts a restructuring by filing for bankruptcy.

This is called “debtor-in-possession” financing, or DIP financing. The firm enters a Chapter 11 bankruptcy proceeding, and then someone shows up and provides the cash for them to continue operating. In this case, that someone would be the U.S. taxpayer, through the TARP.

Assume that, as a part of this option, some of the DIP financing goes to support a guarantee of service (from third party services, if necessary) for cars bought during restructuring. This should help address the bankruptcy purchase fear.

You should assume a significantly higher initial cost to the taxpayer: $20 B up front, and $100 B total over time, if GM and Chrysler both did this. When a firm enters bankruptcy, everybody wants cash up front for everything. So the taxpayer outlay of DIP-financing is equivalent to roughly 10-12 months of ongoing support in option 1.

Likely short-term outcome: GM files for bankruptcy and takes the DIP financing. Chrysler files for bankruptcy. Maybe they take the DIP financing, or maybe their primary shareholder, the private equity fund Cerberus Capital Management, liquidates them and sells off the valuable parts.

Possible medium-term outcomes: This is where it gets tricky. The bankruptcy restructuring process creates a greater likelihood of the firm reducing its costs dramatically, at the expense of other stakeholders: labor, creditors, and dealers would all take significant hits, because the bankruptcy judge can void their existing contracts. This improves the firms balance sheet, and can improve their cost structure.On the other hand, bankruptcy means the firm defaults on payments to suppliers, which may hurt their ability to get new supplies and increase their costs. In addition, the conventional wisdom is that the word “bankruptcy” in headlines will make it harder for that firm to sell cars, as customers will be (rightly) concerned that the firm may not exist to service their car in the future. It’s unclear how these factors would balance out: will the benefit of cost savings from reorganization and reductions in legacy costs outweigh higher supplier costs and lost sales?

We guessed that there would be a high probability of a Chapter 11 restructuring leading to a Chapter 7 liquidation. This is particularly true when aggregate vehicle sales are so low — sales in 2009 are down about 38% from a year ago. GM’s sales so far this year are down 51% compared to last year; Ford’s are down 45%, and Chrysler’s are down 49%.

If, instead a restructured firm emerges from Chapter 11, it probably has a higher probability of longer-term success than if it had not entered Chapter 11, because it was probably able to achieve greater cost savings and potential future productivity improvements.

Benefits

  • It may avoid immediate failure (liquidation) and the associated job loss.
  • It buys the President and his team time to focus on implementing and selling their financial plan, passing their budget through Congress, and maybe asking Congress for additional TARP funds.
  • If the firm survives Chapter 11 restructuring intact, it probably has a higher probability of being viable in the long run.
  • If the firm survives restructuring, the taxpayer has a higher probability of being repaid.
  • Equity holders face the full costs of the firm’s failure. No more moral hazard is created.

Costs

  • There is a fairly high probability that at least one of GM and Chrysler liquidate. Chrysler’s owners might choose to do so immediately. Either firm may find that their sales loss is so great that they cannot emerge from restructuring, especially beginning from an already low level of sales. If they liquidate, then a portion of the 1.1 million job loss happens, with consequent economic and political effects.
  • This is a bigger cash outlay from the taxpayer than under option 1, at least initially. If these are TARP funds, a $100 B outlay squeezes out an element of the Administration’s financial and housing plan. If not, it dramatically increases the likelihood that the Administration has to go to Congress for more funds.
  • The President would be blamed for “allowing the U.S. auto industry to go bankrupt,” even if the firm is in restructuring and trying to emerge from bankruptcy. The word “bankruptcy” has tremendous political power. The President’s team might try to shift the blame back to his predecessor, but the failure would have occurred on his watch. This would have a national impact on the rest of his agenda, and would have a severe regional political cost for the President, especially in Michigan and neighboring states. It would also likely force some Members of Congress of his own party to attack him publicly. It is easy to imagine midwestern Democrat Members voting no on the budget resolution in protest of a Presidential decision not to provide further aid.

Option 3: Allow the loan to be called and provide no additional funds.

Likely short-term outcome: GM and Chrysler file for bankruptcy no later than mid-April.

Likely medium-term outcome: GM and Chrysler likely liquidate.

Benefits

  • U.S. auto manufacturers succeed or fail based on their own merits, and are therefore on a level playing field with most other American firms. (I said “most.”)
  • There’s no additional direct cost to the taxpayer. There would be indirect costs from higher unemployment insurance payments, higher health insurance subsidies through “COBRA”, and lost income tax revenues.
  • There’ no more moral hazard. Investors and managers face the full costs of their actions and decisions (present and past).

Costs

  • Assume roughly 1.1 million lost jobs, beginning within weeks.
  • (Same as option 2, but more intensely): The President would be blamed for “allowing the U.S. auto industry to go bankrupt.” His team might try to shift the blame back to his predecessor, but the failure would have occurred on his watch. This has a national impact on the rest of his agenda, and would have a severe regional political cost for the President, especially in Michigan and neighboring states. It would also likely force some Members of Congress of his own party to attack him publicly. It is easy to imagine midwestern Democrat Members voting no on the budget resolution in protest of a Presidential decision not to provide further aid.

Option 4: Punt to Congress. Refuse to spend additional TARP money, and tell Congress that if they want the companies to survive, they should appropriate new funds.

Given that the December loans expire within a week, the practical implementation of this option is likely a combination of this with option 1: extend the December loans for, say, one additional month, and provide additional TARP funding to cover that month. But tell the Congress and the auto manufacturers that you will not lend any funds beyond that without a new law from Congress that explicitly appropriates those funds.

Likely short-term outcome: GM and Chrysler survive for as long as you provide your last short-term loan.

Likely medium-term outcome: Completely unknown.

Benefits

  • Some argue that TARP funds were never intended for this purpose, and that Congress has the power of the purse. This is a decision, they argue, that should be made by the Legislative branch, not the Executive branch. Your decision not to spend any more (beyond, say one additional month) of TARP funds returns both the policy and political responsibility “where it belongs.”

Costs

  • Reactions from Congress will be mixed.
    • Conservatives (not usually this President’s allies) will likely relish the opportunity to try to block or amend legislation. Environmental advocates may take a similar view.
    • Members from auto states, as well as the auto manufacturers themselves, will likely try to pressure you and the President to reverse this decision, “Just as a fallback, in case Congress does not act.” This pressure will come from friends of labor and management, as well as from investors and “the markets” generally.
  • You lose control of the outcome, which is highly uncertain. In past years, the smart money would have bet heavily on the firms getting additional relief, and that’s still probably a better than 50 percent chance. But in last Fall’s debate there were signs of bailout fatigue on both sides of the aisle, and the environmental advocates had powerful friends who were not sympathetic to the industry’s views.
  • You look like a wimp who is trying to duck responsibility.

Coming soon: parts 3 and 4, comparing the Bush and Obama approaches, and part 5, in which I pose some hard questions and ask you to make your recommendation to the President.

Auto loans: a deadline looms

Auto loans: a deadline looms

The Obama Administration is beginning to leak to the press their impending decision on loans to U.S. auto manufacturers. I am writing in parallel to explain how you might think about such a Presidential decision. There’s an obvious caveat that every President and each Administration are different, but I hope my explanation will at least give you a feel for how you could think about such a challenging policy decision.

I will begin today with some background, and a presentation of four basic options and their costs and benefits. I will follow up later by describing two different approaches to the issue, and then I will ask for your recommendation. We’re going to pretend you are an advisor to the President. You can pick Cabinet (Treasury, Commerce, Budget, Energy, Labor, Transportation, EPA) or a senior White House staffer.


U.S. auto manufacturers face a set of long-term challenges. Let’s divide them up into factors affecting their future revenues, their future costs, and their balance sheets.

(Note: “Detroit 3″ = General Motors, Ford, and Chrysler)

Revenues

  • The economic slowdown means fewer vehicles are being purchased from all auto manufacturers, foreign and domestic.
  • Even apart from the economic slowdown, U.S. auto manufacturers have been losing market share over time.
  • This is in part because they made a bet on light trucks versus smaller cars. This product mix doesn’t work when gas prices are high. Think of the proliferation of SUV’s in the past 10 years. (Note that this was in part the fault of U.S. government policies. SUV’s are technically light trucks, and so they qualify for lower fuel economy requirements.)

Costs & productivity

  • The Detroit 3’s ongoing labor costs are higher than those of foreign-based firms. This is still true when you compare an American worker in a GM plant in Michigan, for instance, with an American worker in a Nissan plant in Mississippi.
  • Productivity is lower in U.S. plants of U.S. firms than it is in U.S. plants of foreign-based firms. Some of this is because of the UAW contract that mandates certain inefficiencies. Some of it is poor management.
  • The Detroit 3 have huge dealer networks that are costly to the manufacturers. These dealer franchises are often protected by state laws that make it hard for the manufacturers to make these networks smaller and more efficient.
  • Auto manufacturers face a burdensome and unpredictable legislative and regulatory environment.

Balance sheets

  • The Detroit 3 have enormous legacy costs from their retirees. Past UAW contracts provided generous benefits that continue to burden these firms. This drains profits (when they earn them) away from productivity-enhancing investments.

I have found that different people emphasize the above points differently. The manufacturers tend to stress the economic slowdown point. The Wall Street Journal editorial page likes to focus on the costs of CAFE and government regulation. Conservatives in Congress and on the outside tend to emphasize the legacy retiree costs, and the ongoing labor costs.

The Detroit 3 must overcome these challenges to survive and be profitable in the long run. GM and Chrysler, however, face a much more immediate problem. They are out of cash, and no private lender will loan them funds. They pay their suppliers on a monthly schedule, due in the first few days of a month. GM and Chrysler were going to be unable to pay their suppliers in full in early January of this year. If you cannot pay your suppliers and if they will not extend you credit, then you cannot get the parts you need to make cars and trucks, and you shut down. Ford seems to be in better shape, at least in terms of short-term cash flow.

In late December, after more than a month of wrangling with the Congress, President Bush authorized $24.9 B of three month loans to be made to GM, Chrysler, and their financing companies in late December, using funds from the $700 B pot at Treasury known as the TARP: Troubled Assets Relief Program. (If you want to dive in deep, you can find the gory details of the loans to GM, Chrysler, GMAC, and Chrysler Financial on the Treasury website.)

A March 31 deadline looms for GM and Chrysler. The Obama Administration faces its own March 31 deadline, which it can unilaterally extend to no later than April 30. So sometime within the next five weeks (at most), the President must make a decision about the fate of General Motors and Chrysler. It is, however, quite possible that GM and/or Chrysler will need funds before the end of April, which would force the President’s hand earlier.

According to the terms of the loan (bottom of page 6 for the GM term sheet),

On or before March 31, 2009, the Company shall submit to the President’s designee a written certification and report …

If the President’s Designee has not issued the Plan Completion Certification by March 31, 2009 or such later date (not to exceed 30 days after March 31, 2009) as the President’s designee may specify, the maturity of the Loan shall be automatically accelerated …

The President has four basic options:

  1. Extend the term of the current loan and loan additional taxpayer funds, using more TARP money.
  2. Same as option (1), but only if a firm files for bankruptcy. This is called debtor-in-possession (DIP) financing. If a firm does not file for bankruptcy, allow the December loans to be called, in which case the firm will go bankrupt anyway.
  3. Allow the loan to be called and provide no additional funds.
  4. Punt to Congress. Refuse to spend additional TARP money, and tell Congress that if they want the companies to survive, they should appropriate new funds.

In part two I’ll discuss the pros and cons of each option.

Parts three and four will compare the Bush and Obama approaches to this problem. Part five will ask you to make a recommendation to the President.

Is $700 billion enough?

Is $700 billion enough?

I think President Obama will soon need to ask Congress for more TARP funding, and that such a request will displace his legislative agenda for a while. Let’s do the math.

When President Obama took office, $387 B of the $700 B of available TARP funds had already been publicly committed. Here’s the breakdown.

Public commitment
Banks — Capital purchase program $250
AIG $40
Citigroup $25
Bank of Amrerica $27.5
Autos
….GM $13.4
….Chrysler $4
Auto finance
….GMAC(including $1B from UST –> GM –> GMAC) $6
….Chrysler Financial $1.5
Term Asset-backed Lending Facility (TALF)for new securities for consumer credit $20
Total $387.4

This meant that the Obama team had $313 B left to commit before reaching the $700 B limit.

Since January 20th, President Obama has made the following new commitments:

$50 B from TARP into housing subsidies — Note that this is just the TARP commitment. There’s other spending on housing, but it’s not from TARP.

$30 B more from TARP for AIG

$5 B from TARP for auto parts suppliers

$15 B from TARP to buy securities derived from small business loans guaranteed by the Small Business Administration

$80 B to further expand the TALF to consumer credit and mortgages

$75 B — $100 B for the new “Public Private Investment Plan” announced Monday, to purchase toxic loans and mortgage-backed securities from banks. They call these “legacy loans” and “legacy securities.”

That’s a total of $255 B — $280 B in new commitments.

Add that range to the $387 B we had committed, and you come up with a range of $642 B — $667 B already committed.

That leaves them $33 B — $58 B before they hit $700 B.

Uh-oh.

There’s some uncertainty around the $80 B figure to further expand TALF, because the Administration has been ambiguous about how big the new TALF would be in total. I’ll bet they’re scrambling this week trying to figure out what they actually meant.

They can create some wiggle room for themselves if they say that the $15 B for small businesses and the $5 B for auto parts suppliers are a subset of the $100 B (in total) for “consumer credit.” This uncertainty and ambiguity should not obscure the critical point: they’re almost out of money.

They have $33 B — $58 B before they hit the $700 B barrier. Let’s assume they do some hand-waving: “What we meant was …,” and redefine some of those previous commitments as overlapping and therefore non-additive. It appears to me that their best case scenario is they could have $100 B of room. My best guess is that they have less than $40 B of room.

Let’s look at what other needs they will face:

  • The banking regulators are doing rigorous stress tests on the 19 biggest banks. Some of those banks are going to need more capital.
  • The auto loans we (the Bush Administration) issued expire March 31st. If they continue those loans, then that $25 B remains committed. It looks like they will extend the loans, using at least a few billion more from the TARP. Let’s be optimistic and call it $5 B — $10 B. (If they instead provide debtor-in-possession financing, their initial outlay is probably more like $20 B.) I’ve written a separate series of posts on the Administration’s auto loan options.
  • They need “dry powder” for unexpected bad scenarios, which seem to crop up every few weeks. You always have to worry about AIG needing more money, and unpleasant surprises could come from any direction.
  • I assumed only $75 B for the direct costs of the Geithner plan. If they want to go to the top end of their range, that’s another $25 B.
  • The ambiguity on the size of the TALF is an additional $50 B — $100 B question for TARP.
  • I think the Geithner plan risks being too small to have the desired effect. Much of the informed commentary seems to agree with this judgment. If it is successful, they will want and need to put more funds into it. (I think this is their strategy.)

I would bet heavily against them being able to stay within the $700 B this year. It’s easy to imagine them approaching the limit within a few months. The auto deadline looms, and there will be pressures when the stress tests complete.

Recommendations

  1. The Obama Administration should produce an accounting of TARP commitments similar to what I’ve done above. It doesn’t have to be complex — a two-column table will do nicely.
  2. This accounting should show how the various consumer credit and TALF commitments overlap, if at all. It should also provide clarity to the markets about the sizes of various components of the TALF.
  3. The Administration should explain how much room they have left within the $700 B provided by Congress, what possible demands they anticipate, and what their game plan is for allocating the remaining resources. Secretary Geithner should be given tremendous flexibility to change this game plan as circumstances warrant, but should provide initial clarity.
  4. Congress should take the Obama Administration’s previous warnings seriously, and incorporate the possibility of a new TARP request into next week’s budget discussions. It makes no sense to build a budget and ignore that $250 B elephant over there in the corner.

I think the President will need more TARP funds soon. If he does, he’s going to have to go to Congress to get them. If this happens, it will overwhelm his legislative agenda.

In part two of this series I’ll show you that the Obama Administration has warned the Congress that this may be coming.

In part three (coming soon), I’ll give my views and recommendations.

President Bush discusses his Administration's plan to assist automakers

President Bush spoke at 9:01 AM this morning in the Roosevelt Room, announcing his plan to aid two U.S. auto manufacturers. Here are his remarks.

THE PRESIDENT: Good morning. For years, America’s automakers have faced serious challenges — burdensome costs, a shrinking share of the market, and declining profits. In recent months, the global financial crisis has made these challenges even more severe. Now some U.S. auto executives say that their companies are nearing collapse — and that the only way they can buy time to restructure is with help from the federal government.

This is a difficult situation that involves fundamental questions about the proper role of government. On the one hand, government has a responsibility not to undermine the private enterprise system. On the other hand, government has a responsibility to safeguard the broader health and stability of our economy.

Addressing the challenges in the auto industry requires us to balance these two responsibilities. If we were to allow the free market to take its course now, it would almost certainly lead to disorderly bankruptcy and liquidation for the automakers. Under ordinary economic circumstances, I would say this is the price that failed companies must pay — and I would not favor intervening to prevent the automakers from going out of business.

But these are not ordinary circumstances. In the midst of a financial crisis and a recession, allowing the U.S. auto industry to collapse is not a responsible course of action. The question is how we can best give it a chance to succeed. Some argue the wisest path is to allow the auto companies to reorganize through Chapter 11 provisions of our bankruptcy laws — and provide federal loans to keep them operating while they try to restructure under the supervision of a bankruptcy court. But given the current state of the auto industry and the economy, Chapter 11 is unlikely to work for American automakers at this time.

American consumers understand why: If you hear that a car company is suddenly going into bankruptcy, you worry that parts and servicing will not be available, and you question the value of your warranty. And with consumers hesitant to buy new cars from struggling automakers, it would be more difficult for auto companies to recover.

Additionally, the financial crisis brought the auto companies to the brink of bankruptcy much faster than they could have anticipated — and they have not made the legal and financial preparations necessary to carry out an orderly bankruptcy proceeding that could lead to a successful restructuring.

The convergence of these factors means there’s too great a risk that bankruptcy now would lead to a disorderly liquidation of American auto companies. My economic advisors believe that such a collapse would deal an unacceptably painful blow to hardworking Americans far beyond the auto industry. It would worsen a weak job market and exacerbate the financial crisis. It could send our suffering economy into a deeper and longer recession. And it would leave the next President to confront the demise of a major American industry in his first days of office.

A more responsible option is to give the auto companies an incentive to restructure outside of bankruptcy — and a brief window in which to do it. And that is why my administration worked with Congress on a bill to provide automakers with loans to stave off bankruptcy while they develop plans for viability. This legislation earned bipartisan support from majorities in both houses of Congress.

Unfortunately, despite extensive debate and agreement that we should prevent disorderly bankruptcies in the American auto industry, Congress was unable to get a bill to my desk before adjourning this year.

This means the only way to avoid a collapse of the U.S. auto industry is for the executive branch to step in. The American people want the auto companies to succeed, and so do I. So today, I’m announcing that the federal government will grant loans to auto companies under conditions similar to those Congress considered last week.

These loans will provide help in two ways. First, they will give automakers three months to put in place plans to restructure into viable companies — which we believe they are capable of doing. Second, if restructuring cannot be accomplished outside of bankruptcy, the loans will provide time for companies to make the legal and financial preparations necessary for an orderly Chapter 11 process that offers a better prospect of long-term success — and gives consumers confidence that they can continue to buy American cars.

Because Congress failed to make funds available for these loans, the plan I’m announcing today will be drawn from the financial rescue package Congress approved earlier this fall. The terms of the loans will require auto companies to demonstrate how they would become viable. They must pay back all their loans to the government, and show that their firms can earn a profit and achieve a positive net worth. This restructuring will require meaningful concessions from all involved in the auto industry — management, labor unions, creditors, bondholders, dealers, and suppliers.

In particular, automakers must meet conditions that experts agree are necessary for long-term viability — including putting their retirement plans on a sustainable footing, persuading bondholders to convert their debt into capital the companies need to address immediate financial shortfalls, and making their compensation competitive with foreign automakers who have major operations in the United States. If a company fails to come up with a viable plan by March 31st, it will be required to repay its federal loans.

The automakers and unions must understand what is at stake, and make hard decisions necessary to reform, These conditions send a clear message to everyone involved in the future of American automakers: The time to make the hard decisions to become viable is now — or the only option will be bankruptcy.

The actions I’m announcing today represent a step that we wish were not necessary. But given the situation, it is the most effective and responsible way to address this challenge facing our nation. By giving the auto companies a chance to restructure, we will shield the American people from a harsh economic blow at a vulnerable time. And we will give American workers an opportunity to show the world once again they can meet challenges with ingenuity and determination, and bounce back from tough times, and emerge stronger than before.

Thank you.

What caused this financial mess?

What caused this financial mess?

President Bush spoke today about the financial crisis to the U.S. Chamber of Commerce.

I’m going to use the President’s speech as an opportunity to explain to a non-financial audience what the Federal government did this week and why. I will oversimplify in many cases, and will gloss over many details. I don’t claim that the description below is comprehensive. But it is, we think, a good starting point for discussion.

This is a story that evolves over time as we learn more, and will be debated by economists and historians long after we’re gone.

  • We begin with a global credit boom. A dramatic increase in worldwide saving outside the United States, and especially in Asia and the Middle East, meant there was a lot of money to lend. Fed Chairman Ben Bernanke referred to this as a “global savings glut.” The U.S. has a productive economy and a strong legal framework that protects investors, so a lot of this capital was attracted to the U.S. This lowered interest rates here, creating abundant and inexpensive credit. This was particularly true for riskier borrowers – as the supply of loanable funds increased, the interest rates charged to these borrowers came down a lot, making it easier for them to get loans. In many cases this was a good thing – many low-income people who had previously been unable to buy a home were able to do so. At the same time, an economist would say that “credit spreads narrowed dramatically,” and many would say this led to an underpricing of risk. Lots of lenders seeking higher yields made increasingly risky investments.While most of the focus has been on housing, and I’ll use housing to explain the rest of the story, the underpricing of risk existed in other markets as well (e.g., commercial real estate). Also note that the credit boom was not confined to the U.S. – Australia, the U.K., France, and Spain also experienced housing or credit booms.
  • We then look at a domestic housing boom. Cheap credit and low interest rates contributed to a building boom, soaring housing prices, and ultimately an excess supply of housing. Normally you’d expect about 1.6 million homes to be built each year. At the peak of this boom, about 2 1/2 million houses were being built each year. At a normal time, there’s about a 5 1/2 month supply of unsold inventory of homes; now there’s about a 10 month supply. When there’s excess supply, prices drop and construction of new homes plummets. This last factor meant that the “residential construction” component of GDP was shrinking, and caused an overall drag to economic growth beginning in early 2006.
  • Risky mortgages proliferated. Low interest rates combined with relaxed lending standards, a new model of mortgage origination, and innovations in mortgage products to dramatically expand the number of Americans who could get mortgages and buy homes. At the same time, these factors also expanded the universe of people who purchased mortgages and homes they could not afford.In an imperfect lending system, you’re always trading off between helping too few deserving people, and too many really bad risks who will never be able to pay off their loans. The expansion of credit and innovation in mortgage markets moved the pendulum toward a lot more people being able to borrow and buy homes than had previously occurred. Many of these people who previously would not have been offered credit are now living in their homes, paying their mortgage every month. This is a good thing. At the same time, these changes allowed others to purchase mortgages and homes that they could not afford.
  • You can try to minimize this tradeoff by doing things like fixing the lending disclosure rules, and changing requirements on lenders to make sure that a borrower will be able to afford the highest interest rate of the mortgage, and not just the teaser rate. But even after you’ve made these kinds of fixes (which the Fed did late in 2007), there will still always be a tradeoff and a value choice to make: do you want to help more higher-risk low income people own homes, at the cost of having more defaults and more bad lenders and borrowers abusing the system? Or do you want fewer abuses of the system, at the cost of fewer responsible low-income and high-risk people owning homes?
  • We then move to the secondary market for mortgages. Mortgages were bundled, guaranteed, securitized, and sold to financial institutions (especially banks). DETOUR: What is a mortgage-backed security?You get a mortgage from Bob’s Bank. You will make monthly mortgage payments to Bob’s Bank for the next 30 years. 99 of your neighbors get similar mortgages from Bob. Bob then sells the 100 mortgages to the company Fannie Mae (or Freddie Mac, or a fully private securitization firm). Fannie collects a fee from Bob and slaps a guarantee onto each mortgage – if you default, Fannie will pay the rest of the mortgage due to Bob’s Bank, or whoever owns it.Now imagine that each of your monthly mortgage payments is a pancake, and so your mortgage is a big vertical stack of 360 payments/pancakes (30 year mortgage X 12 monthly payments per year). Fannie Mae lines up the 100 stacks of pancakes/payments side-by-side, and then takes a slice of the pancake/payments stacks (e.g., the bottom pancake/payment from each stack, or in the usual case with Fannie Mae, a vertical slice of each stack). That slice is a mortgage-backed security (MBS) that consists of a portion of the payments from all 100 mortgages. Fannie Mae then sells the MBS slices back to Bob, after charging him a fee for the service. Bob then sells those mortgage-backed securities to investors for cash, which he can turn around and use to offer new mortgages to other homebuyers.Fannie Mae and Freddie Mac did the bulk of this guarantee and securitization business, while other firms securitized lower quality subprime and Alt-A loans. A deeper analysis could explain how this securitization contributed to problems in these secondary markets. Creative financial engineers further sliced and diced these mortgage-backed securities, breaking risk apart into little pieces and combining them in interesting, creative, and almost completely incomprehensible ways. (Imagine flipping and swapping some pancakes around before slicing them and you’ll have a feel for it).
  • Many banks and other large financial institutions, including some insurance companies, and Fannie Mae and Freddie Mac themselves, bought and held these mortgage-backed and other complex securities. These investors all made the same incorrect assumption: they assumed that anything mortgage-related would be safe and yield a good return. While most mortgages are safe investments, investors did not correctly understand that some of these assets were quite risky. They didn’t really know what they were buying for two reasons: (1) the underlying information about some of the mortgages was bad, because some of the loans were based on poor information (e.g. “no documentation loans”) or were made to people who were higher credit risks; and (2) many buyers of complex securities did not understand how the sophisticated financial engineering affected the risks built into these securities. In some cases, investors relied on the Fannie/Freddie brand name and didn’t do their own homework. Others relied solely on credit rating agencies that later turned out to be wrong in their risk assessments.
  • Banks and other financial institutions that bought mortgage-backed securities (and other mortgage-related investments) lost a lot of money when these securities later declined in value. Because many of these institutions (especially large investment banks) were highly leveraged, they faced a greater risk of failure from a bad bet, and the consequences of that failure were much greater. Many of those banks that did not fail still lost a lot of their capital. Some of these large financial institutions were so big and so interconnected with other institutions, that their failure would create a domino effect. This is what we call “too big to fail,” which should more precisely be called “too big and interconnected to fail suddenly.”

Example of low leverage

If an investment bank has $10 of capital and makes $50 of loans, it is leveraged 5 to 1. (The other $40 to lend comes from deposits or borrowing.) If that $50 of loans loses 10% of its value and pays back only $45, then the bank has lost $5, which is half of its $10 of capital.

Example of high leverage

The same bank with $10 of capital makes $200 of loans, and is leveraged 20 to 1. If that $200 of loans loses 10% of its value and pays only $180, then the bank has lost $20. All of its capital is gone (the bank is bankrupt), and the bank is $10 in the hole. Because this bank was highly leveraged, it took on greater risk of failure.

The major investment banks were levered 25 to 1. That’s like buying a house with only 4% down – if your home price declines by 5%, you’re “underwater.” And since many of these large financial firms relied on short-term financing to run their operations, when lenders started to get nervous and pull back from their short-term loans to these large firms, things rapidly spiraled downward.

That story gets us up to the point of a large bank (we’ll call it Big Bank) ending up in a bad position in two ways:

  1. Big Bank lost a lot of capital because the mortgage-backed securities (MBS) it bought have declined tremendously in value.
  2. Big Bank is still holding the MBS on their balance sheet. Nobody wants to buy these MBS. And if housing prices or market conditions get even worse than expected, those MBS will decline in value even more. So Big Bank has a security that is illiquid and contains the downside risk of further losses.

Big Bank’s problems show up in any combination of three different ways:

  • Capital – Because Big Bank has too little capital, they can’t lend as much. This hurts everyone in the economy who needs to borrow – students who want student loans, drivers who want car loans, small business owners who need credit to operate and to expand, farmers who borrow for seed and fertilizer, and others.
  • Liquidity – Banks normally loan money to each other for short periods of time. But now Large Bank doesn’t want to lend to Big Bank, because Large Bank fears Big Bank might be insolvent and not be around to pay them back. So Large Bank charges Big Bank more (a higher interest rate) for this short-term borrowing. We have seen this in dramatic fashion as the interest rate that banks charge either, called the London Interbank Offerer Rate (LIBOR) has spiked up. Large Bank may shorten the term of their lending – being willing to loan to Big Bank overnight, but not for 30 days. In an extreme case, Large Bank may not lend at all to Big Bank. To oversimplify, banks don’t trust each other enough to lend. This breakdown in trust/confidence among large financial institutions is a core problem in our financial system.
  • Solvency - At the extreme, a bank could lose so much capital that it is clearly insolvent. In less severe cases, either depositors or lenders to that bank might lose confidence that the bank was viable. Depositors might withdraw their funds from the bank, or lenders to that bank might stop lending. Either one of these could cause a “run on the bank” that could ultimately force the bank to shut down.

Conclusion

Many banks and other financial institutions, and especially big ones, lost a lot of money on bad mortgage-related investments. This caused them to lose a lot of their capital, and in many cases some of their assets are illiquid and pose additional downside risk to their balance sheets. This hurts those banks’ ability to lend, it hurts their ability to remain liquid and borrow short-term cash from other banks, and in extreme cases it can lead to a run on the bank (of depositors, lenders, or both) and insolvency.

I am indebted to Eddie Lazear and Donald Marron of our Council of Economic Advisers for their help with this note. All mistakes are my own.

Rose Garden Statement by President Bush on financial markets

President Bush spoke at 8:02 AM this morning in the Rose Garden.

Good morning. I just completed a meeting with my working group on financial markets. We discussed the unprecedented and aggressive steps the federal government is taking to address the financial crisis. Over the past few weeks, my administration has worked with both parties in Congress to pass a financial rescue plan. Federal agencies have moved decisively to shore up struggling institutions and stabilize our markets. And the United States has worked with partners around the world to coordinate our actions to get our economies back on track.

This weekend, I met with finance ministers from the G7 and the G20 — organizations representing some of the world’s largest and fastest-growing economies. We agreed on a coordinated plan for action to provide new liquidity, strengthen financial institutions, protect our citizens’ savings, and ensure fairness and integrity in the markets. Yesterday, leaders in Europe moved forward with this plan. They announced significant steps to inject capital into their financial systems by purchasing equity in major banks. And they announced a new effort to jumpstart lending by providing temporary government guarantees for bank loans. These are wise and timely actions, and they have the full support of the United States.

Today, I am announcing new measures America is taking to implement the G7 action plan and strengthen banks across our country.

First, the federal government will use a portion of the $700 billion financial rescue plan to inject capital into banks by purchasing equity shares. This new capital will help healthy banks continue making loans to businesses and consumers. And this new capital will help struggling banks fill the hole created by losses during the financial crisis, so they can resume lending and help spur job creation and economic growth. This is an essential short-term measure to ensure the viability of America’s banking system. And the program is carefully designed to encourage banks to buy these shares back from the government when the markets stabilize and they can raise capital from private investors.

Second, and effective immediately, the FDIC will temporarily guarantee most new debt issued by insured banks. This will address one of the central problems plaguing our financial system — banks have been unable to borrow money, and that has restricted their ability to lend to consumers and businesses. When money flows more freely between banks, it will make it easier for Americans to borrow for cars, and homes, and for small businesses to expand.

Third, the FDIC will immediately and temporarily expand government insurance to cover all non-interest bearing transaction accounts. These accounts are used primarily by small businesses to cover day-to-day operations. By insuring every dollar in these accounts, we will give small business owners peace of mind and bring stability to the — and bring greater stability to the banking system.

Fourth, the Federal Reserve will soon finalize work on a new program to serve as a buyer of last resort for commercial paper. This is a key source of short-term financing for American businesses and financial institutions. And by unfreezing the market for commercial paper, the Federal Reserve will help American businesses meet payroll, and purchase inventory, and invest to create jobs.

In a few moments, Secretary Paulson and other members of my Working Group on Financial Markets will explain these steps in greater detail. They will make clear that each of these new programs contains safeguards to protect the taxpayers. They will make clear that the government’s role will be limited and temporary. And they will make clear that these measures are not intended to take over the free market, but to preserve it.

The measures I have announced today are the latest steps in this systematic approach to address the crisis. I know Americans are deeply concerned about the stress in our financial markets, and the impact it is having on their retirement accounts, and 401(k)s, and college savings, and other investments. I recognize that the action leaders are taking here in Washington and in European capitals can seem distant from those concerns. But these efforts are designed to directly benefit the American people by stabilizing our overall financial system and helping our economy recover.

It will take time for our efforts to have their full impact, but the American people can have confidence about our long-term economic future. We have a strategy that is broad, that is flexible, and that is aimed at the root cause of our problem. Nations around the world are working together to overcome this challenge. And with confidence and determination, we will return our economies to the path of growth and prosperity.

Thank you.

A "second stimulus?"

We are frequently asked whether there should be a “second stimulus” bill. Unfortunately, what is being considered on Capitol Hill is a very different animal from what we did earlier this year.


10-second macroeconomic review

GDP = Consumption + Investment + Government spending + Exports – Imports

= C + I + G + X – M


In January the President proposed, and in February Congress enacted, a bill that was short-term macroeconomic stimulus. We wanted that stimulus policy to be big, fast-acting, an efficient use of taxpayer dollars, and an effective stimulus to broad-based economic growth. We let taxpayers keep more of their wages, assuming that they would spend some of those refunds, thereby increasing consumption (C). We also temporarily cut taxes on business investment in an attempt to increase investment (I). The idea is that these two actions would quickly increase GDP. Millions of American workers and families and thousands of firms can react quickly to a change in their financial status.

This strategy appears to be working. We’ve got evidence from multiple sources suggesting that people are spending some of their stimulus checks, and that this is helping to support increased consumption. It’s harder to tell how much firms are taking advantage of the investment incentives, because it’s hard to measure that in real time.

In yesterday’s Wall Street Journal, Professor Martin Feldstein writes that the stimulus was a “flop.” Specifically, he argues that the recent GDP data show that the boost to consumer spending from the rebates was small relative to the overall size of the rebates. He estimates that $12 billion was spent out of a total of $78 billion in rebates paid out by the end of June. The core of his argument is that we didn’t get a lot of bang for the buck – only a small bump to GDP for a large loss of revenue for the government.

We disagree with this analysis. First, we think the stimulus bang is bigger than $12 B. Prof. Feldstein assumes that the growth in consumer outlays would have been flat had there been no stimulus. He then observes that consumer outlays actually grew by $12 billion more from Q1 to Q2 than they did in the prior quarter, and attributes that to the stimulus. Many observers think that, without the stimulus, consumer outlays would have grown more slowly in Q2 than in Q1. If this is the case (and we believe it is), then the effect of the stimulus is bigger than $12 billion.

In addition, we have felt only part of the bang so far. The stimulus enacted in February will have ongoing impacts in the upcoming months. Almost all the cash to consumers is out the door, but the resulting boost in consumer spending has not yet reached its full effect. We anticipate that the past stimulus law is continuing to increase GDP in the 3rd quarter, with a diminishing amount in the 4th quarter of this year. Monetary policy works with an even “longer lag” – the evidence suggests that when the Fed cuts interest rates, it takes about a year for half of the economic effect to take hold. So there’s more bang left in the remainder of this year from past actions on both the fiscal and monetary sides.

Allowing people to keep more of their money for one year is better than not doing so at all, so the loss of government revenue is actually a good thing if that money stays in the hands of the taxpayers who earned it, even if we can only get Congress to agree to do that for one year. We agree with Marty that the stimulus would be more effective if we had been able to enact a permanent tax cut, rather than a temporary one. Legislative realities forced it to be temporary. Permanent is better than temporary, and temporary is better than nothing.


On the second stimulus question, the following interchange from May 19th is instructive. Our deputy press secretary Scott Stanzel talked with a White House reporter at the “daily gaggle”:

Q: Scott, is the administration looking any more closely at a second economic stimulus package? The Commerce Secretary was on Late Edition over the weekend, and didn’t directly and definitively shoot that idea down.

MR. STANZEL: Well, what’s in the second stimulus package that you’re talking about?

Q: Well, just — I’m saying that many in Congress say we need a second economic stimulus package.

MR. STANZEL: Right, but what’s in that? That’s the thing. The idea of the second stimulus has become sort of this catch-all phrase for adding a lot of additional government spending, or doing things that Democratic leaders in Congress may have wanted to do previously, but are now — would want to sort of put under the umbrella of a stimulus package.

Before last Thursday, there was no second stimulus proposal. Now there’s a proposal from the Chairman of the Senate Appropriations Committee, Senator Byrd (D-WV), but we have seen no indications that House or Senate Democratic leaders have signaled support for that proposal.

For more than two months we were asked to comment on something that did not exist. What does exist is pent-up demand in Congress to spend more money, and then to label that spending as a “second stimulus.” We anticipate that demand will only increase as we get closer to an election.


Congressional advocates for increased government spending this Fall have been arguing, in effect, that we should expand (G) in the equation above, and that doing so will increase economic growth.

But trying to stimulate short-term economic growth through increased government spending has a few problems:

  1. It’s slow. – Construction projects take years to plan and build. History shows that only about 27 cents of each dollar is spent in the first year.
  2. It’s often funneled through States. – Infrastructure spending and increased federal funds for programs like Medicaid result in transfers from the Federal government to State governments. This transfer doesn’t actually increase GDP, it just shifts money from one level of government to another. It’s more like putting in motion 50 potential stimulus packages, each of uncertain efficacy and speed. Some States might try to spend the funds quickly. Others might shift money around and use the Federal dollars to pay down debt, or wait until their State legislature convenes next year to allocate the funds. There’s also a danger that providing States with aid during challenging economic times will encourage states to spend irresponsibly during boom years, counting on Federal bailouts when times are tough.

You can make other arguments for spending more taxpayer funds on roads and bridges, but it’s a highly inefficient tool to stimulate immediate economic growth. Many of the advocates for a so-called “second stimulus” know that spending taxpayer funds on roads and bridges is popular with voting constituents.

There’s an important philosophical difference between the first stimulus (which was overwhelmingly bipartisan) and current Congressional attempts to increase government spending. The first stimulus proposed by the President looked at the economy as a whole, and tried to design a package that would help spur growth across the entire economy. Ideas being bandied about for a so-called “second stimulus” tend instead to take a constituency-based approach: they try to identify who is hurting, or who is politically powerful, and funnel government funding to them. Advocates then claim that these funds will stimulate broad-based economic growth.

We think that the first stimulus was both more fair and more effective by providing taxpayer rebates to more than 100 million Americans and broad-based business investment incentives to thousands of firms. And we think that there’s more economic bang still left from those recently implemented policies.


In summary:

  • We think the stimulus is working and increased Q2 consumption and GDP.
  • The effects of the first stimulus are not yet complete. Most of the cash is out the door, but we think there will be increased consumption effects this quarter, and a diminishing amount in Q4.
  • For many, “second stimulus” is code for “allow Congress to increase politically popular government spending shortly before Election Day, and call it macroeconomic stimulus.”
  • Increased government spending is slow and ineffective macroeconomic stimulus.

Thanks to Donald Marron, the newest Member of the Council of Economic Advisers, and to the CEA team for their help with his note.

USA Today op-ed: Keep taxes low

USA Today editorializes today against making the tax cuts permanent, and includes an opposing view from me.

I’ll include both here. I’ve learned that he who writes the opposing view is at a disadvantage, in that they get to see what I wrote, but not the reverse. I thought I had anticipated their attacks, but I only got one of them.

Here’s the USA Today editorial:

Our view on fiscal responsibility: Dr. Bush’s economic cures begin and end with tax cuts
Extension will drive up the deficit, won’t heal nation’s financial woes.

President Bush responded to Friday’s barrage of bad economic news – oil prices and unemployment soaring, the dollar and Dow sinking – with yet another call for extending his tax cuts. “In this period of economic uncertainty, the last thing Americans need is a massive tax increase – so Congress needs to send a clear message that the tax relief that we passed will be made permanent,” Bush said.

This little act of political theater isn’t just misguided. It’s also destructive. For one thing, Americans struggling to buy gasoline and pay next month’s mortgage are unlikely to be focused on tax cuts that might or might not expire in 2011. For another, these cuts – absent matching reductions in spending that Bush has never proposed – were irresponsible when enacted during Bush’s first term, and they are even more irresponsible now that the resulting deficits have added to the nation’s mountainous debt.

Despite inheriting a budget surplus, Bush has not presented a single balanced budget during his presidency, which coincided with the top earning years of the baby boom generation, a time when the government should have been preparing for the coming fiscal tsunami of the boomers’ retirement.

The fact that these tax cuts – which include reductions in marginal rates, repeal of the estate tax and a 15% rate on dividends and capital gains – are set to expire over the next several years reflects qualms that even a compliant Congress had when they were passed. The members who voted for them knew that they could not make them permanent without making a mockery of the budgetary rules. What’s more, they saw the boomers’ retirement approaching.

The situation has been compounded by the spree of spending and borrowing that followed these tax cuts. The wars in Iraq and Afghanistan, the creation of a Medicare drug benefit and other initiatives have ballooned the national debt from $5.7 trillion in June 2001, when the first tax cuts were enacted, to $9.4 trillion today. That’s $3.7 trillion in new debt just as Medicare and Social Security are reaching crisis proportions.

It is easy, of course, for Bush to call for the permanent extension of these tax cuts. He won’t be around to deal with the consequences. Democrat Barack Obama or Republican John McCain will be, yet neither presidential candidate looks to be a model of fiscal prudence. Obama has called for rolling back the Bush cuts for wealthy taxpayers but proposes a bevy of new spending programs. McCain, meanwhile, voted against the 2001 cuts but now supports extending them without suggesting credible, offsetting reductions in spending.

At least McCain’s top domestic adviser, Douglas Holtz-Eakin, appears to recognize that there’s more to economic policy than cutting taxes. “Sadly,” he told Bloomberg Television on Friday, “it seems that is all President Bush understood in the economy.”

In opposing the extension of all these tax cuts, we do not mean to suggest that this nation can rely solely on tax hikes to bring the budget into control. Overspending is a bigger problem than undertaxation.

But the Bush tax cuts have aggravated the nation’s fiscal problems. And, to be realistic and blunt, if the country is to avoid a financial crisis much bigger than today’s appears to be, it will need both painful curbs in benefit programs and hikes in taxes.

This is not a particularly pleasant message, particularly in a presidential election year when the economy is faltering. But it is one that needs to be heard.


Here’s my piece.

Opposing view: Keep taxes low
Allowing Bush cuts to expire will slam families, strangle investment.

By Keith Hennessey

In 2001 and 2003, President Bush led a Republican Congress in cutting tax rates and the marriage penalty, increasing the child credit, eliminating the death tax, and reducing capital gains and dividend taxes. Without action by this Democratic Congress, those laws will expire in January 2011, and Americans will face the largest tax increase in history. Congress should make the tax relief permanent.

If Congress fails to act, a typical family of four earning $50,000 a year will pay $2,100 more in taxes. The marriage penalty will return in full force, and the death tax will return to life. Expensive gasoline is painful; imagine if your family also had to pay $2,100 more in taxes.

Raising taxes on work leads to less work. Americans will have less incentive to enter the workforce, work and earn more, and invest in education.

When you hear that we should raise taxes on the rich, remember that most small businesses pay taxes as individuals. Raising the top tax rate will harm these small business owners, from restaurants and dry cleaners to shopkeepers and repairmen.

Raising taxes on capital gains and dividends will strangle business investment.

If Congress instead keeps taxes low and cuts spending, firms will invest more, productivity and wages will rise, and our economy will grow.

When you hear that dividends and capital gains relief helps only fat-cat investors, remember that half of American households are invested in the market, including seniors living on dividend and pension income, and families invested in prepaid college tuition plans.

If America raises taxes on capital, that capital and the better jobs created by it will go elsewhere.

Some say we can’t afford more tax cuts. It is important to remember that our deficit challenge is a long-term problem driven by future increases in Social Security and health care spending. Washington should cut its spending so American families don’t have to cut theirs.

Future tax increases will impede further economic growth if the Democratic Congress stalls. American workers, consumers and entrepreneurs are doing their part to keep our economy growing. It’s time for members of Congress to do theirs.

Keith Hennessey is assistant to the president for economic policy and director of the National Economic Council.

The Economic Report of the President

On Monday Dr. Edward Lazear, Chairman of the President’s Council of Economic Advisers, released the Economic Report of the President for 2008.

This traditionally is released a week after the President’s Budget. It describes the state of the U.S. economy, and also discusses in more detail a range of economic policy issues. As the ERP is written by professional economists on the CEA staff, it’s quite substantive. Topics covered this year include the U.S. macroeconomic picture, credit and housing markets, export growth, health care, tax policy, the Nation’s infrastructure, alternative energy, and improving economic statistics.

In addition, Dr. Lazear spoke to reporters yesterday about the ERP, and about the Administration’s economic forecast. Here are some of the most significant quotes from that press briefing. While normally I try to explain our policies, I can’t do better than Eddie has done for himself, so I present his quotes without further ado.

On the economy

CHAIRMAN LAZEAR: Going forward, most forecasters expect the first half of 2008 to have slow, but positive, growth, followed by a pick-up in the latter half of the year. The stimulus package just passed by Congress that will be signed by the President shortly should help ensure against risks in the economy.

This year’s most significant economic events revolved around housing and credit markets. An apparent under-pricing of risk was revealed first in mortgage markets, and later in a variety of credit markets. The President was quick to respond to these issues by focusing on borrowers through programs like FHA Secure, suspension of the tax liability on mortgage write-downs, and HOPE NOW programs. Additionally, the Federal Reserve acted to pump liquidity into the market. Some credit markets have become more stable since the acute tightening that occurred in the summer.

Are we in a recession?

Q: [D]o you think we’re going to go into a recession or are in a recession right now?

CHAIRMAN LAZEAR: The answer is, I don’t think we are in a recession right now, and we are not forecasting a recession. We are forecasting slower growth. There’s no denying that the growth that we had in the fourth quarter of last year was significantly lower than the growth that we had in the third quarter. Now I just remind you that we had similar growth rates in the first quarter of last year, and those similar growth rates were followed by two very strong quarters. So these things are somewhat volatile.

I am not suggesting that we expect that in this quarter we’ll see the same kind of growth that we saw, say, in the third quarter of last year — we’ve had some issues, obviously, in terms of credit tightening, in terms of the housing markets. And that’s the reason why the President was very active in pushing through the stimulus package, which we’re very pleased about. I think we got that in record time. We think that’s insurance against risks on lower economic growth, and we think that will help a good bit. We think it should help immediately, because businesses will build those expectations into their plans, and we expect that will help the economy even in the very near term.

Should people be worried even if we’re not in a recession?

Q: I know you’re not forecasting a recession, but a lot of Americans look at the fourth quarter figures, they look at the stock market, they look at the shrinkage in the job figures in the fourth quarter, and they say, well, I’m worried about it. Are they wrong to be worried about it?

CHAIRMAN LAZEAR: Well, we look at those numbers too, and that was the motivation, of course, behind the stimulus package, because of the concerns out there — and it wasn’t just the public’s concerns, it was our concern that there are some factors that suggest some potential weakness in the economy. We were worried about lower growth, and as a result of that, we decided that it was the right time to act.

We believe that the stimulus package that was voted on last week will be quite effective in ensuring against these downside risks, and we think that they will keep the economy from slipping into lower levels of growth. And again I think that our forecasts are realistic, they’re consistent with what you’re seeing out on the street, as well. I think this is — we’re moving in the right direction.

I should also mention, by the way, that the Federal Reserve has also acted to change their monetary policy stature over the last few weeks, and in a pretty aggressive way, and that will also contribute, we think, to the economic picture.

Is the Administration willing to consider a second stimulus bill?

Q: Congress is planning to advance a second stimulus package in a few weeks. First of all, given the timing, would you even agree that it would be a stimulus package? And whether or not it has a stimulative effect, is the administration willing to consider additional measures?

CHAIRMAN LAZEAR: We think the proposal that we put out a few weeks ago, and it was acted on last week, is the right thing to do. We think 1 percent of GDP is about the right number — it’s slightly higher than 1 percent, but we think that’s an effective stimulus. We think it will have the desired effect. And that was the policy that we thought was appropriate. We still think that policy is appropriate and we’ll stick with that.

Does your forecast assume spillover from the housing problems into other financial markets or economic sectors?

Q: Back in March, the great debate was, will this housing crisis spill over into any other sector, and economists were divided, and of course by August we knew it was spilling into the financial sector. Now, if you pick up the papers you’re reading about corporate debt market seems to be under pressure. Is your forecast assuming no more spillover, or have you actually taken into effect possible spillover into corporate debt and other marketplaces?

CHAIRMAN LAZEAR: Well, when you say “spillover,” I guess I would say that’s still a debatable point. The fact that we saw some distress in other credit markets does not necessarily mean that it was a spillover from the housing market. It could have been, but it could also be a reflection of the same underlying phenomenon. I think most market observers believe that most of what we’ve seen in terms of credit markets reflects the under-pricing of risk that occurred over the past couple of years, that happen to have shown up first in mortgages.

Okay, so it showed up first in subprime. That doesn’t mean that subprime necessarily was the cause of what we saw in other markets. It’s just a reflection of the same forces perhaps showing up there first. And my guess is that will be something that will be debated by academics for the next 10 years to come.

Is it over? You know, who knows whether it’s over. I think the good thing that has happened in credit markets is that many firms have recognized their losses and, in addition to that, they’ve been able to raise capital. I think that’s the most encouraging sign — that firms have suffered some distress and financial markets, no question about it, but after they’ve declared those losses they’ve been able to go out and raise capital and to start again. And that’s what’s most important, I think, going forward.

Debt and the real threat

Debt and the real threat

Monday the President proposed his budget for Fiscal Year 2009. This is the first “e-Budget” – it was transmitted electronically as an official document to the Congress, and was digitally signed by the Executive Clerk.

At a press conference Monday, Senate Budget Committee Chairman Kent Conrad (D-ND) said:

But let me emphasize to you what I see in almost no stories: That is a four-letter word called debt. Nowhere do I see mentioned of what’s going to happen to the debt. It never leaves the administration’s lips. I have never seen it in a single story. I hear a lot of focus on the deficit.

No mention of what happens to the debt.

And I would suggest to you the debt is the threat. Why? Because if you look at what is scheduled to happen in this next year, according to the administration’s own estimates, while the deficit goes up over $400 billion, the debt will go up over $700 billion in one year. The big difference, of course, is Social Security money that is being used to pay other bills. It doesn’t get included in any deficit calculation, but every penny of it gets added to the debt.

The result is, under the Bush administration proposal, they are building a wall of debt. At the end of his first year, the gross debt of the United States stood at $5.8 trillion. We don’t hold him responsible for the first year because he wasn’t in charge the first year. The budget, as you know, is presented by the president outgoing.

If you look at the end of his eight years of responsibility, we see the debt as being over $10.4 trillion. That is almost a doubling of the national debt on his watch. You will recall, he said paying down the debt was a high priority. And we see the debt further escalating to more than $13 trillion by 2013.

One of Chairman Conrad’s charts says “The Debt is the Threat.” Let’s look at a chart, which purports to show the Federal debt under President Bush’s tenure. Looks pretty bad, no?

graph - building a wall of debt (Conrad)

This is easiest to analyze if we look at the simplest statement made by Chairman Conrad: “That is almost a doubling of the national debt on [the President's] watch.” The chart above purports to make that same point, as gross federal debt increases from $5.8 Trillion in 2001, to $10.4 T in 2009. (By the way, that’s a 79% increase, which is a bit far from “almost doubling.” But I’ll set that aside.)

I’m going to disprove the statement: “That is almost a doubling of the national debt on his watch.” I don’t dispute the factual accuracy of the numbers, but instead the presentation and the conclusion.

This presentation misleads in three ways.

  1. nominal $ vs. % of GDP – You can’t compare $1 in 2001 to $1 in 2009, for two reasons. Inflation has made the $1 in 2009 worth less than the $1 in 2001, and economic growth since 2001 increases our economy’s ability to carry the burden of any given amount of government debt. What we care about as an economic matter is not our debt, but our debt burden relative to our ability to support it with our income. As an example, someone with $50K of annual income who takes out a $500K mortgage is borrowing 10X his annual income – that’s nuts. But someone with $1M of annual income who takes out the same $500K mortgage is borrowing 1/2 of his annual income. That’s much more reasonable. Serious analysts look at federal debt over time measured as a share (%) of our national income (GDP), not measures of nominal dollars over time.
  2. gross debt vs. debt held by the public – (this is the hard part) What we care about is how much the U.S. Government owes to the American public and the rest of the world (meaning how much we owe to those who buy Treasury bonds). This is commonly known as “debt held by the public.” To this amount, the Chairman adds debt that one part of the government owes to another part of the government, to get what budgeteers call “gross federal debt.” If you use funds from your savings account to pay down a credit card, you have decreased your personal “debt held by the public.” For comparison, if you borrow from your savings account and put it into your checking account, and leave in your savings account an IOU from you to you, Chairman Conrad’s metric would say that you have “increased your gross debt.” This is economically meaningless.
  3. no comparison to the historic average – It’s relevant to compare our federal debt [held by the public] with historic averages, to see if we’re in a lot of debt relative to where we’ve been in the past.

So here’s a new graph, using the same data source (OMB’s Historical Tables), which corrects for these three problems.

debt held by the public

Now that we’re looking at a fair analytic presentation, we can draw a few conclusions from this new graph:

  • Yes, the federal debt is higher than when the President took office. Debt in 2001 = 35.1% of GDP. Projected debt in 2009 = 37.9% of GDP.
  • The claim that the debt is “almost doubling” under this President is absurd. Measured as a share of the economy, it’s about 8% higher than it was when the President took office. (37.9 – 35.1) / 35.1 = 8%
  • This debt increase comes in the context of: an inherited recession, a stock market crash, corporate scandals, a terrorist attack, war, and a huge increase in the price of oil.

The President’s budget is merely the first stage in the annual Congressional budgeting process. The next step is for Chairman Conrad, and his House counterpart Chairman John Spratt (D-SC), to each propose his own budget. If their budgets raise taxes more than they increase spending, as was the case last year, then they would show lower debt held by the public than in the President’s budget. But since they so far have not tackled the Social Security challenge, we would still expect those budgets to show significant increases in Chairman Conrad’s preferred metric of “gross debt.”


I want to more fundamentally disagree with Chairman Conrad’s claim that “the debt is the threat.” (He has another chart that says this.) His statement focuses entirely on what has happened to the debt (using a misleading measure) over the past seven years. His focus is: (1) backward-looking, (2) short-term, and (3) focused on debt.

This is trivial compared to what we call “the real fiscal danger”: the projected long-run future growth of federal government spending.

  • Where the Chairman’s focus is backward-looking, the real fiscal danger is in the future.
  • Where the Chairman’s focus is on the past seven years, we face the real fiscal danger over the next several decades.
  • The Chairman focuses on the debt. This is incomplete – our problem is debt driven by projected future spending growth.

To make the first two of these points, let’s recreate the above graph, but I’m going to expand the timeline to cover the next several decade. Same graph, longer timeframe:

real fiscal danger

Now compare the part of this graph between 2000 and 2010, which is identical to the data in the graph above it, with what happens to the debt beginning in about 2025. On our current long-term policy path, the federal debt would explode beginning in about 20 years. Note that while this chart purports to go out to 2080, we would never make it that far on the light blue line on our current long-term policy path. Financial market pressures would force a change long before our federal debt got to 200 or 250% of GDP.

The real threat is not the additional 2.8% of GDP of debt we have accumulated since the President took office, during a time of recession, war, terrorist attacks, high oil prices, and burst stock market bubbles.

The real threat is that steady and steep upslope in the blue line – the explosion of future debt over the next several decades, if we don’t do something about it. The President has proposed to do something about it, and Congress has failed to act.

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