Harvard economist Martin Feldstein on US & Europe

Friday 14 September, 2012

The Chicago Council on Global Affairs kicked off it’s fall program schedule by hosting Harvard economist Martin Feldstein, who was the Chairman of Reagan’s Council of Economic Advisers & served on Obama’s Economic Recovery Advisory Board.  He opened by stating that Europe’s a mess, & that it’s difficult to even consider it as a whole because it’s countries differ so much.  The problems are concentrated in the periphery in Italy, Spain, & Greece, which is the most extreme basket case & probably will leave the Euro zone.  Europe suffers from 4 problems:

  1. fiscal deficits-originally high interest rates brought inflation down, but then governments borrowed to expand social programs.  When interest rates rose, the debt problem traveled down an unsustainable path.  Debt/GDP ratios of 100+% are too high & banks in Spain & Ireland have capitalization problems.
  2. recession/low growth-government’s responses directed from Brussels have been to raise taxes & curtail spending, which has depressed demand, bringing on recession & unemployment rates of 11-20+%.  The fiscal contraction has led to slow growth, which is reflected by strict labor markets & over-regulation, resulting in decreasing competitiveness.
  3. banking crises-extensive borrowing led to housing bubbles, & when repayments declined, bank capitalization fell along with bond values.  Government assistance created more deficits.  Bankers became nervous about their own capital & stopped lending, which makes depositors nervous, so other Europeans are sending their money to German banks.
  4. current account deficits-Europe as a whole has a surplus, only because Germany’s surplus is so large.  The rest of the continent is in deficit.  These imbalances reflect the constraint of the fixed exchange rate of the Euro within Europe.  Less competitive countries cannot devalue their currencies vs. other European competitors.  Theoretically the Euro was supposed to bring convergence to rectify these imbalances, but it hasn’t happened yet.

So what to do to solve these problems?

The IMF has imposed austerity programs in Greece, Portugal, & Ireland, but they still can’t devalue their currencies to export more within Europe.  Angela Merkel of Germany posed the crisis as a European problem, but Greece is in far worse condition than the other countries.  There is no European solution:  it hurts Spain & Italy to even be compared with Greece.  The fiscal compact has had no effect. Germany will not agree to Europe-wide deposit insurance or a banking union.  Progress is being made.  Italy has implemented pension reform, which is bringing those costs down.  The IMF reported that if Italy were @ full employment, they would have a surplus this year.  Italy’s deficit will shrink from 3% of GDP to 1.5% next year.  The European Central Bank will buy country bonds in unlimited amounts as long as these countries abide by the rules, which will bring down interest rates.  The problem is this takes the pressure off of governments to reform & leaves open the question “How much should the ECB buy?”  So the likelihood in addressing the above-mentioned 4 problems:

  1. depends on the ECB’s strategy & if countries will accept their conditions
  2. these are of no help
  3. there is a little hope of improvement
  4. nothing addresses trade & current account deficits

A devaluation of the Euro of 25-30% would enable Europeans to increase exports to the rest of the world, & decrease imports, which would spur domestic demand.  Bank losses would dissipate, which would push up wages & prices.  If the Euro rises, that becomes a  more difficult problem to solve.

On the U.S., the outlook for America is better than that for Europe because there is no monetary problem with the Euro.  America needs to solve 2 problems:

  1. accelerate the recovery-GDP growth is less than 2% & we need 2.5% growth just to absorb new workers entering the labor force.  We need 4-5 years of 4% growth to get unemployment down to 5%.   The fed can do very little & neither Obama (focusing on education & the environment are too long-term to help right now) nor Romney (tax reform would bring rates down but it’s open to question whether this would provide a stimulus) seem to have a plan.
  2. avoid increases in debt-it’s worrying that debt/gdp ratio is rising from 40% to 70% & is projected to surpass 100% soon.  Social security & medicare are problems which must be slowed.  Neither presidential candidate has made a promise not to make cuts or modify benefits.  The bigger problem is to slow the rise in the cost of care.  Obama’s advisory board can revise rates down.  Ryan’s plan supposedly leverages competition to produce efficiencies.  This will be a work in progress regardless.

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