"Kee" Points with Jim Kee, Ph.D.

Where is the U.S. headed? That was the question posed in many of the sessions I attended at the American Economic Association’s Annual Meeting in Philadelphia over the weekend. This is where professional economists (i.e. PhD’s) share their research and outlook, and following are a few points that I thought would most interest Kee Points readers:


Bernanke’s talk: Fed Chairman Ben Bernanke acknowledged that the Fed’s forecasts has been overly rosy during the past few years but nevertheless asserted that the U.S. economic outlook was strong going forward. That’s because “most of the major headwinds are gone.” These include: (1) the housing market, which is much healthier now; (2) the banking system, which is much stronger now and several years ahead of the rest of the world with respect to balance sheet (capital) strength; (3) private sector (individual) balance sheets are stronger and deleveraging (lowering debt relative to income) is largely complete; (4) less fiscal restraint going forward; (5) on-going accommodative monetary policy, even with tapering.


Interestingly, a panel of top economists following Bernanke’s speech were far less optimistic, arguing that aggregate demand would remain subdued and growth subpar, largely because a larger fiscal stimulus (government spending) was required. This panel included conservatives (e.g. Martin Feldstein) as well as not-so-conservatives (e.g. Larry Summers). Summers argued, correctly, that the global savings or liquidity glut was building before the crisis, and that companies were drowning in cash flow they couldn’t spend. What that means is that savings is greater than investment. As an aside, under normal circumstances, if people or companies save more, it doesn’t mean that spending declines because that savings gets channeled into investment spending through the financial system. So spending doesn’t change or decline, but its composition changes from consumption spending to investment spending. But in times of recession, the story goes, savings doesn’t get invested, it just sits there, so spending in the aggregate does decline. According to Summers that’s why government needs to step in and spend more.


But a session led by the University of Chicago’s Steven Davis, creator of the Fed-adopted Economic Policy Uncertainty Index (along with Nick Bloom and Scott Baker from Stanford) made a convincing case that it has been higher policy uncertainty that led to less business investment spending, hiring, and output. They did exhaustive testing of the impact of policy uncertainty as measured by their index on macro-level economic (aggregate) data and with company-level data. The results strongly supported their view.


That dovetailed with the view of Edward Prescott, who won the Nobel Prize in 2004 for his work in macroeconomics. Prescott asserted that we had two shocks, one from the financial crisis and one from a regime change that induced a lot of policy uncertainty. Both of these have diminished. U.S. consumers have lowered their debt-to-income ratios, and policy uncertainty is much lower since the fiscal cliff resolution at the end of 2012. So Prescott’s forecast was for GDP growth of 2.8% for 2014, just below the long-term average of 3%. That’s where I’d place my bet.


Other interesting points:


Bernanke also suggested that the reason they underestimated the impact of the housing bust on the economy was that they were drawing from the tech bust, which led to only a minor recession. Interestingly, the aggregate decline in stock market values during the tech bust (1999-2002) was about $6.5 trillion, roughly comparable to the $7 trillion decline in housing values. But about one fifth or $1.5 trillion of housing losses were through the highly leveraged financial sector from mortgages and mortgage backed securities, and that leverage (too little or “inadequate” bank capital,) made the difference. Bank “capital adequacy ratios” have improved significantly since.


Larry Summers, you may recall, was in the running with Janet Yellen to be the next Fed Chairman. Yellen is known to have some enthusiasm for “macroprudential” or pre-emptive policies (i.e. bubble popping). Both are Democrats, but Summers took a stab at the notion of macroprudential policies by quipping that “maybe you can rely on the same people that told you Lehman Brothers was well capitalized an hour before it collapsed.”


Key takeaway: Prescott’s number, 2.8%.