On September 7, Bloomberg Businessweek brought together four top economists and one eminent money manager and gave them the following tough assignment: fix the American economy. Eleven days before, at an annual gathering of central bankers in Jackson Hole, Wyo., the influential University of Maryland economist Carmen M. Reinhart had presented a paper forecasting high unemployment, low housing prices, and very low growth through 2017. That grim forecast was on the minds of our roundtable, which included Yale University professor Robert J. Shiller, author of Irrational Exuberance; Peter R. Orszag, who recently stepped down as director of President Obama's Office of Management & Budget; financial consultant and former Salomon Brothers Managing Director Henry Kaufman; and Professor Charles W. Calomiris, who is the Henry Kaufman Professor of Financial Institutions at Columbia University. Pimco Managing Director William H. Gross, who runs the world's biggest bond fund, joined the group by telephone. The discussion was moderated by Tom Keene, co-host of Bloomberg Surveillance. What follows is a condensed, edited transcript.
How do we get out of this mess?
Bill Gross: You have to ask how we got into it—and what Carmen Reinhart presented at the Jackson Hole conference was probably the best explanation: An expansion in credit, debt, and deregulating over the past 10 or 20 years got us here. It was a 10- to 20-year process moving in, and it will probably take a long time moving out. Some have suggested the Biblical seven years fat and seven years lean.
Peter Orszag, now that you are out in the real world, give us a time continuum .
Peter Orszag: I would agree with Bill that this is going to take a while. We are in the mode of years rather than quarters.
Henry Kaufman: I believe it will take time, but it need not take time. What can we do about the debt position of households, businesses, and the American government? We are unwilling to do drastic things that will improve the situation of households. You can do that by raising their income so they can meet their debt burdens. Or you can do something about the size of that debt. We don't have the capacity or the willingness to do that.
Charles Calomiris: What typically happens in these kinds of financial crises is that the problem switches from being a private-sector leveraging problem to a public-sector leveraging problem. That is the major handoff—and we are in the middle of that handoff right now. So you could look at the private sector and find some room for optimism if the growth rate of the economy could get going.
The problem is that the public-sector debt is a terrible drain on the growth rate of the economy. And what we know from history is that when you get to the point where it starts looking like you are in an unsustainable fiscal path, the tax increases and high interest rates that come from that are a threat to long-term growth. So you get into a bad equilibrium driven by the public debt problem. Without drastic reforms to entitlement programs in the United States, we are really talking about something that will feel like the 1970s—but last for 20 to 25 years.
Robert Shiller, tell us how housing links into this mess.
Robert Shiller: Housing is, for most people, the biggest part of their wealth. We went through a bubble-and-burst cycle—that was the single biggest cause of this crisis. Now we have so many underwater, and so many unemployed, that it is creating a lack of confidence. One question is, should we reinstate the Home Buyer Tax Credit in an effort to push home prices up? That did succeed, but it seems to be unraveling at the other end, and I am afraid home prices may go down [further]. We should be thinking about modernizing our housing sector, improving the kind of mortgages we offer, and encouraging innovation.
Orszag: Let me return to the out-year fiscal problem Charles raised. Over the long term, it is clearly right that entitlements are the key issue, and we should talk about health care because that is the core of the long-term problem. But if you are looking at the next five or 10 years, the nature of our problem is fundamentally different. I don't think you are going to be able to get the majority of the fiscal adjustment necessary in 2015 or 2016 on the spending side of the budget.
Social Security changes will be gradually phased in and will protect current and near-retirees, which means their impact by 2015 is very modest. Most of the politically feasible Medicare and Medicaid offsets were part of the health-care bill, so the [odds] you are going to get a lot more by 2015 are not overwhelming. If you look at nondefense discretionary spending, even if you cut 5 percent from that, that is 0.2'percent of GDP. So the majority is going to have to come on the revenue side for the medium term.
Calomiris: I disagree with Peter when he says we just can't get more than a 5 percent cut in nondefense discretionary spending. Nonsense! During the Bush Administration and in the last two years, we have substantially increased government expenditures. Government expenditures as a fraction of GDP are way too high. We need to go back and think about where we were 10 years ago and think about rolling back those programs, because we are broke.
Orszag: Can I just jump in with some facts here? The increase from about 20 percent of GDP to roughly 24 to 25 percent of GDP in government spending over the past couple years came from a set of very temporary things that are not there in 2015 or 2016.
Calomiris: I wasn't just talking about the last two years.
Orszag: I understand, but go out to 2016. Half of the budget is Social Security, Medicare, and Medicaid. Take out net interest and you are at defense and nondefense discretionary spending. Defense already assumes a phasedown in the war. Nondefense discretionary spending is 4 percent of GDP. There is no plausible way you are going to get more than 0.2 percent or 0.3 percent of GDP on that.
Calomiris: We agree that entitlements are where all the action is, Peter. I am just saying, arguing that we need to raise taxes to solve our problem is not a good idea. Arguing that we are going to spend more money to solve this problem is acting like we are in an aggregate demand problem when we are in a very long-term growth problem.
Orszag: I don't think the solution is just on the revenue side. The point is, the medium-term fiscal problem is fundamentally different from the long-term fiscal problem.
Calomiris: There is only one fiscal problem, and it is long-term. If you cut entitlements, the market will reward you. It doesn't care about the next two years.
Kaufman: One of the big issues on the housing front is Fannie Mae (FNMA) and Freddie Mac (FRE). I don't think we are going to modernize Fannie and Freddie very soon. Fannie and Freddie hold the preponderance of mortgages in the United States. They provide a subsidy to households. If you turn it over to the private sector, households will have to pay more.
Gross: I almost totally agree with Henry on this one. And I take it from a market perspective: Non-Fannie and Freddie mortgages trade in the 6-to-8 percent category, as opposed to the 3½-to-4 percent category [for Fannie and Freddie mortgages]. Those that argue for a more private orientation toward housing, that may be fine 10 to 15 years out. But over the next five years, the private market can't really step in for Fannie and Freddie.
Calomiris: I understand that point, but I disagree with the conclusion. To me the problem preventing the private market from getting started taking over the burden is a lack of loss recognition. Because Fannie and Freddie are effectively government agencies, they are willing to pretend to continue the game in ways that the private sector wouldn't. Remember, the leveraging we saw in the 2000s was driven by government subsidies. Fannie, Freddie, and the FHA went to unprecedented leveraging limits. And we don't want to continue that. What we want to do is make the tough decisions to accept the losses that exist, write down mortgages. And when we do that we can restart the private mortgage [sector].
Gross: That is not sufficient. What has been recognized in the private market is that housing prices can go down and not simply up. To suggest that we recognize losses and go on our merry way is—
Calomiris: Let me clarify. I am not saying just an accounting exercise. I am talking about a fiscal exercise. I am talking about actually subsidizing the recognition of losses. So, the Mexican government in 1999 did a program where they did loss sharing with private creditors, which accelerated the recognition of losses and absorbed some percentage of the loss. It was very effective. That is the kind of program I have in mind.
Shiller: The Dodd-Frank bill calls for a HUD study of shared appreciation mortgages [in which the lender loans money in return for a share of the future increase in the property value]. Let's think about it. We got into this crisis partly because homeowners were heavily leveraged in the only asset they hold, their home. If home prices fall, they are going to be underwater and they are going to be panicking. So the HUD study, which is supposed to come out about the end of this year, will lead to a change in household mortgage financing. We could also encourage more rentals; then people could hold a diversified portfolio. That would bring us into the 21st century with more logical and sensible portfolios for households.
Kaufman: You are absolutely right. But when I listen to you, there is a timeline attached. You talk about some things that may be done, but before they begin more than a year will have elapsed.
Shiller: Roosevelt did things fast. He created the 30-year mortgage within months of his taking office. We need that kind of spirited innovation.
Well, spirited leadership and innovation, we turn to Peter Orszag. Where is it, Peter? How do we get rhetorical leadership that jump-starts us?
Orszag: Well, there is a rhetorical component, but there is also a legislative or policy component. The problem there is structural—a culture in Washington where people don't work together as well as they did in the past. Layer on top of that our political system, [which] never has been good at gradual long-term problems, and you have two structural problems facing our policy process.
Shiller: Sounds awfully pessimistic.
Orszag: We need to devise ways to overcome that, but I don't think there is going to be a knight in shining armor who rides in and fixes that.
Shiller: I thought the Dodd-Frank [financial reform bill] was an inspiration. You can criticize it, but it wasn't a dysfunctional Congress that did that.
Charlie Calomiris just fell off his chair over there.
Calomiris: Are we talking about the Dodd-Frank bill that was just passed? That 2,300-page monstrosity is the worst piece of legislation ever passed in U.S. history, and that is saying something. And I would wager that Bob hasn't really read it. I would like to talk about each section, Bob. I wonder, have you really read it?
Shiller: I can't claim to have read all of it, but I have read a lot of it, yes.
Kaufman: That legislation leaves a lot to be desired. The most difficult issue was Too Big to Fail, and that was not dealt with. We are going to be creating even bigger financial institutions, and the role of the smaller institution will diminish. And that leads me to something that Peter said. The President now is trying to do something to help small business, to provide some additional funding. The fact is, financial concentration has increased so much that relatively few financial institutions hold a massive amount of the financial assets of the U.S.
Big institutions are not geared to finance small business. They are geared to garner savings and investments and push them out on a wholesale basis. We would have moved toward solving the problem if we had broken up the large institutions where they are not too big to fail.
So you would have broken up Pimco?
Kaufman: If it is too large, why not?
Gross: We have to recognize that there are still numerous institutions that are too big to fail, and that to allow them to fail in the current environment, and maybe even in the future environment, would simply be folly. We can pursue this fiction that regulatory changes have fixed it, but I don't think we can ever fix it.
Charlie, if the emotion of the moment is jobs, jobs, jobs, how do we jump-start that?
Calomiris: It is jobs that are affecting housing prices, not the other way around. Mainly it is the failure to generate convincing economic prospects that keep people from hiring. And there is a bigger problem out there too, and that is the prospect of a trade war between the United States and China. Let's remember, depending on how you count it, 16 percent of [Americans] would like to have jobs but don't.
That is a pretty big problem. About half of those people have been unemployed for almost two years. That we have never experienced in the United States. What is scary about that is not just the consequences for asset prices and for economic growth, but also the consequences for political backlash against global trade. So it would make sense to focus on some immediate policies that might address that. I have been advocating a payroll tax cut. It has to be long-term. It has to be big, something on the order of a 30 percent cut in Social Security taxes for four years. That would create immediate incentives for hiring.
Peter, what do you think of all these amateurs telling you we should cut the payroll tax?
Orszag: Well, if you had told me at a 9.5 percent unemployment rate there would be so little xenophobia and trade concern, I would have been quite surprised. It has been directed at Wall Street and corporate excess instead. So I am not sure that the biggest risk is backlash against China, as opposed to continued backlash against domestic institutions.
The key question is, Will a payroll tax holiday really spur hiring today?
When the Administration was floating the idea of a tax credit for hiring additional workers—which is similar in spirit to a payroll tax holiday, and ultimately a version was enacted—the pushback from corporate leaders was, "It is not really going to do very much. It is not responsive to the main reason we are not hiring." Now, I am not going to deny that changing the price of hiring workers [will] have an effect, but I don't think it is at the core of why firms are holding off. The key reason firms aren't hiring is that the economy is growing so slowly; firms don't see the need to hire more workers when they are growing at 1 or 2 percent a year.
Calomiris: I agree with you, Peter. But Tom's question was what could we do quickly right now. The bigger issues are concerns about uncertainty, marginal tax rates, health-care costs, energy taxes. There are huge unresolved issues.
Orszag: I would attack those.
Kaufman: I would favor some more public projects.
Shiller: Public projects are part of what we should be doing—New Deal, Civilian Conservation Corps-type projects—because unemployment is sapping the national morale. And we should restore general revenue sharing to state and local governments, which have to balance their budget because of their constitutions, [and] are laying off people who were doing something constructive. We have to stop that. This was a proposal initially of President Richard Nixon in his State of the Union Address in 1971. Until 1987, we had general revenue sharing in this country. We should bring it back on a temporary basis—maybe for five years.
Kaufman: We have to recognize the international dimensions of this problem. The choice is, Where do I acquire labor—in the United States or everywhere else in the world? That choice was not as great years ago as it is today. So part of this is a long-term problem: We have to enhance education from grade school all the way up so that the population becomes more competitive as a labor force.
Gross: The real problem is that the global economy faces a serious structural condition, and that is lack of global aggregate demand in which the developing countries continue to save and the developed countries no longer can finance prior levels of consumption. What is required is to rebalance some of the production that has taken place in Asian and other developing countries—and to put it back into the developed countries. The way you do that without trade restrictions is to force some type of currency realignment—which the Administration has been trying to do—but also to encourage China and other Asian countries to develop internally as opposed to simply externally for export.
Calomiris: I just don't agree with that. As much as I would like to see a redistribution of government expenditures toward infrastructure and education, the problem is we are broke. And we are not just broke once. We are broke about six times over in present value.
When a government is in an unsustainable fiscal position, spending more money does not improve the economy. And in fact, it can have disastrous negative consequences, especially once interest rates get wind of it. What we need to do is recognize that those state and local governments that Bob likes, they spent like drunken sailors during the boom. You will not tax and spend your way to high growth.
Kaufman: Let me just put this again in financial terms. The household sector is not a net new borrower. The business sector is not a net new borrower. State and local governments are nearly incapacitated as borrowers. The only one that has the capacity to borrow in sizable amounts is the U.S. government. And if the U.S. government for the near term is not going to borrow, we have a very serious problem.
Gross: To agree with Henry, what we have seen over the past year or two is a substitution of the government balance sheet, the government checkbook for that of the household. And to suggest that the government now contract fiscally in terms of reducing its deficits to me is simply going in the wrong direction.
Calomiris: I didn't say that. In fact, I agree. The deficit has to expand. I said cut spending and cut entitlements. Freezing discretionary, nondefense spending growth would be a great idea.
Orszag: That is what the Administration has proposed.
Calomiris: The key issue is not the next two, three years of deficits. I agree that those have to increase because of the state of the economy. The key issue is making the tough decisions about medium- and long-term entitlement spending and not raising taxes to choke off the little growth we have.
Bob, I get mail 30 to 1 saying, Just bring back a form of pay-go. People are starving for discipline out there. To jump-start confidence, how about a simple solution: Three years out, institute a more rigid form of pay-go. Would you get a confidence jump-start?
Shiller: There are many dimensions to trying to restore confidence. A plan to reduce the national debt is a relatively small part of it at this point. The really big thing is, people are very upset. They feel that the country is not theirs, and that a small group of wealthy people who get bailed out and bribe the government are in charge.
Orszag: There still is a lot of anger out there, no question about it. And just looking at the facts, it is not surprising. Our government stepped into a situation that was imploding. The shift in private-sector borrowing from plus 28 percent of GDP in 2007 to minus 17 percent of GDP in 2009 is stunning. It is not surprising that people are upset. In some sense, they should be. This is a traumatic thing to live through.
Kaufman: Underneath that was the effort to reform financial markets and institutions. And we still have to see how that is going to unfold. The legislation has contributed to uncertainty because we don't know yet what will be done with proprietary trading and securitization—what will the exact details be?
Shiller: The Congress isn't to be blamed for that. They had to do something, and they couldn't fix it all.
Calomiris: I disagree. They are to be blamed completely for it. They created such a mess of possibilities rather than addressing in a surgical way the problems that needed to be addressed.
There is a political mandate of "just do something," of FDR in 1932.
Kaufman: Well, he did do something. The separation of commercial banking from investment banking. FDIC insurance. A whole series of specific issues that everybody clearly understood. The issues are not that clearly understood today. The system is more complex. What has been legislated is a Rube Goldberg contraption. And that is wrong.
Bill, there is a tendency here to talk dismal. What is optimistic right now as we enter the autumn of 2010?
Gross: Two big things. First, in terms of the global economy, there is a portion that is doing relatively well. The developing countries have an under-consumed economy, and they offer a more complex financial system going forward. The engine of global growth is shifting from the United States to other countries, but there is an engine—and that is helping to keep us above the line in terms of 1 to 2 percent economic growth.
Secondly, interest rates are extremely low. They haven't done much in terms of positive economic growth, but to the extent that they stay low for a long time, then ultimately the ability to borrow—not just by big corporations but by smaller businesses and consumers alike—[should lead to a] regeneration of growth.
Kaufman: I would add that Americans are beginning to save more. And that is part of a readjustment process.
Orszag: I actually see a few things that are optimistic. Bill alluded to growth in the rest of the world. Export growth has reflected that. You are also seeing a pickup in equipment and software investments. Firms are not buying new buildings, but they are buying new computers. There are a bunch of sectors that are reflecting those forces—transportation equipment, for example.
So there are positive signs, but let me take a step back. The most important thing we have going for us is our entrepreneurship and flexibility. If our political system can help overcome a few of the problems we face, it will help unleash that underlying sense of optimism.
Shiller: I was going to list some of the things in the Dodd-Frank bill, which Charlie thinks is the worst. We are creating a Financial Oversight Council which will be worrying about systemic crises, and an Office of Financial Research, which is going to be collecting data. When we had this crisis we didn't know what was happening. We didn't have research on it. We have an Office of Housing Counseling that will help homeowners not get into the wrong mortgages. We are putting derivatives and swaps onto exchanges. All of these things are moving ahead.
Calomiris: I am going to short the stock market big time if the best Bob Shiller can come up with for optimism is the Housing Counseling Office.
What is the immediate to-do list?
Gross: It is jobs, jobs, jobs. And it is important to create jobs for the future, as opposed to jobs for current consumption that aren't competitive in a global environment. And so the President and the next Congress have to focus on making the economy competitive again. We have lost our ability to export competitively.
Kaufman: Before the President comes back in January and the legislative process begins, there is a continuing job for the Federal Reserve to continue the quantitative easing and be even more innovative. They have to do more. That will lower the cost of refinancing homes and encourage some private-sector lending which hasn't been taking place.
When the President comes in, in January, he has to indicate that there is a capital expenditure program being undertaken by the U.S. government that will improve our competitiveness, whether it is transportation, education, any of the other programs. And he has to put a dollar amount next to it so that we understand this is not permanent.
Calomiris: I don't have a to-do list for the President because the President is basically irrelevant in terms of leadership on this problem right now. The President is about to lose control of Congress, if he ever had it, and I think the real interesting to-do list is for the Republicans controlling Congress. Of greatest importance for them is to articulate a long-term vision of government, to articulate it in a way that is practical, that shows real leadership. And that will set up the transformation that has to come after 2012. My view is we are really not going to get out of this for many years.
Shiller: The most important thing right now, and I mentioned it already, is to do something about state and local governments. And I would propose that we do general revenue sharing. It has a Republican flavor to it because it is a proposal to decentralize, to get the expenditure decisions closer to the people, and to people who know what the local conditions are.
Orszag: I am a little hesitant to give my former boss a to-do list, but I think there are four things that need to happen. One is that both the congressional leadership and the Administration need to help provide a new sense of optimism, getting the [overheated] rhetoric down and having more confidence building.
Second, an additional program. I would focus on an infrastructure bank. Third, we need to figure out what we are doing on the [Bush] tax cuts that are scheduled to expire at the end of this year. I have a proposal to extend, preferably, only the middle-class ones, but if need be, all of them for two years and then have them all disappear, which would largely solve our medium-term fiscal problem. And then, finally, we have huge implementation issues. You have got, especially in health and in the finance bill, lots of things that need to be gotten right. And just from an administrative perspective, focusing on execution on those important pieces of legislation is a 2011 issue.