The Economy and Higher Education
Forum for the Future of Higher Education
The Brookings Institution
Washington, D.C.
January 24, 2012
Prospects for the Financial Markets
Donald Kohn, Brookings Institution
MR. KOHN: When I talked to this same group in January
2011, we discussed how markets were improving, things were
getting better, and perhaps this was a precursor to stronger
growth in the U.S.
Well, one of the stories of financial
markets over the last year is that there was an interruption to
that trend of improvement over 2011.
As you can see in the top
half of Figure 1, the VIX -- volatility in the stock market -spiked in the middle of 2011.
It’s not quite as bad as post-
Lehman, when the financial sector was collapsing, but if you
didn’t have that 2008 jump in there, it would look like quite an
increase in volatility.
1
Figure 1.
Bonds/Treasuries Spread
CBOE Market Volatility Index, VIX (Avg)
70.00
60.00
50.00
40.00
30.00
20.00
10.00
0.00
Jan-2006
Jul-2006
Jan-2007
Jul-2007
Jan-2008
Jul-2008
Jan-2009
Jul-2009
Jan-2010
Jul-2010
Jan-2011
Jul-2011
Corporate Bond over Treasuries Spread %
12
10
A Spread
BB+ Spread
8
6
4
2
0
Jan/06
SOURCE
Jan/07
Jan/08
Jan/09
Jan/10
Jan/11
: Haver Analytics
At the same time, looking at the bottom half of the
figure, the spread of corporate bond rates over Treasury rates
went up -- especially for below investment grade corporations,
BB+.
As we know, a number of things were happening at that
time that were disturbing financial markets.
One was the fiscal
situation in the United States, the debt ceiling debate.
The
folks in Washington did not cover themselves with glory in
dealing with a very difficult situation. They were dealt a bad
hand and played it very poorly. They undermined confidence by
flirting with default, and by failing to reach agreement on very
serious longer-term issues.
You could see a collapse in
2
consumer confidence around that time.
That was not a
coincidence.
What was also going on at the same time, however, was
Europe. The European situation was getting worse, and the
European countries once again were seen as maybe just barely, or
maybe not doing enough to get ahead of their problems.
So there was tremendous volatility, a decline in stock
prices, which we’ll see on the next figure, and general risk
aversion that occurred over the summer of 2011. The improvement
in financial markets that we’d seen over the last couple of
years came to a halt.
The other thing that was happening was that in the
first half of 2011 growth in the U.S. was very weak so people
began to worry about the U.S. economy, too, and that would tend
to put a higher risk premium onto bonds.
At the same time, Figure 2 shows that in the stock
market (on the left hand side), there was a sharp drop in the
middle of 2011.
That’s when that VIX index spiked up. It wasn’t
just about uncertainty, which is not good for financial
instruments and financial markets.
It was also about pessimism.
So the stock market went down, and the recovery in the stock
market that we saw over 2010 in effect came to a halt in 2011 –
the stock market ended up, more or less, about where it started.
3
Figure 2.
Stock Prices and Treasuries
SOURCE: St. Louis Fed
Treasury bond rates, however, were going down.
Look
at the right side of Figure 2, particularly the 10-year rate,
the blue line.
Both rates went down over 2011, but the 10-year
rate is particularly notable in its decline to around 2 percent.
That reflects a number of things.
One is the flight
to quality that was occurring because of the issues I just
mentioned -- the higher volatility, the so-called risk off
trade.
People were risk-averse, so they bought the safest
asset.
U.S. Treasury securities still are seen as the safest
asset. Our legislators and people on both ends of Pennsylvania
Avenue seem to be intent on undermining that, but they haven’t
4
quite done it yet.
And maybe it’s only by comparison to
whatever other options you have to invest in.
quality drove down the rates.
So the flight to
The weaker economy -- as I noted,
the U.S. economic forecasts were being revised down -- tends to
drop interest rates too.
And finally, as we’ll come to later in this
discussion, there were Federal Reserve actions to reduce
interest rates.
So the Treasury yields were going down -- I
think that was a sign that things weren’t good.
I think a
better sign would be to see those yields going up -- going up
because the economy was strengthening, because people were
moving back into riskier asset--but instead they were going
down.
But all the news on the financial front wasn’t bad
over 2011.
We see some healing continuing in the financial
markets, particularly in the banking sector.
5
Figure 3.
Money and Credit
SOURCE:
St. Louis Fed
The blue line in Figure 3 is business loans. This
shows the percent change year-over-year, from 12 months before.
The zero line, then, is particularly important.
When a line
crosses above the zero line, which it did early in 2011, that
means business loans at banks are finally growing again.
This
is an important point, and the growth has been pretty
substantial.
It’s up there at 10 percent, and it’s been holding
on the year-over-year basis at 10 percent for some time.
So after two years of very substantial declines in
business loans, banks were lending and businesses were borrowing
again in 2011.
That’s good news.
The same thing is true to a lesser extent for consumer
loans.
The green line in the figure is consumer lending.
It’s
6
not just lending by banks -- it’s total consumer credit
outstanding.
It doesn’t include mortgages, but does include
credit cards, automobile loans, all of that.
And that also has
begun to edge higher over recent months.
The red line is money growth -- M2 growth.
Growth in
the money supply, which had been bouncing around at about 3, 4
percent through 2010 picked up too.
Some of that growth –-
including that small upward tilt in the middle of 2011, which
happened right about the same time that there were problems in
the financial markets -- is a result of the flight to quality.
That is, people, and particularly corporations, getting out of
money market funds and putting their money in banks.
Right now, through the end of 2012, zero interest
demand deposits at banks have unlimited insurance on them.
So
when problems began in Europe, businesses that had a lot of
their spare cash in money market funds went into banks, and that
pushed the M2 growth up.
The money market funds, we noted, had
exposures to Europe.
So the fact that M2 is growing at 10 percent is not
entirely great news.
Part of it is this flight to quality.
But
I do think expansion of the bank lending is good news. It
implies that both businesses and households want to borrow
again.
They’re feeling a little more comfortable with their
debt levels.
Some of the deleveraging that’s occurred over the
last couple years has left them in better shape, and it implies
that banks are more willing to make some loans.
We see more
direct evidence of that in Figure 4.
7
Figure 4.
Loan Terms
SOURCE:
Fed
The upper left of the figure shows the tightening
standards for business loans.
2009.
Look at that spike in 2008 and
Those markets just shut down.
very substantially.
Banks tightened up very,
And since 2010, they’ve been easing some of
those terms. I think terms and standards for business loans are
still very tight, but they have been easing off.
The upper right of the figure shows consumer loans,
and you’ve got the same kind of situation -- a sharp tightening
in 2008, 2009, some easing recently -- for credit card loans,
auto loans, other consumer loans.
Banks are easing off to some
extent from very tight levels. We don’t want the banks to go
back to where they were in 2005, 2006, 2007 because that got
them in trouble.
Loans were too easy to get.
But as long as
8
credit was really, really tight it was going to be hard for the
economy to get traction.
So having the banks ease off somewhat
on these terms is an important piece of the economy beginning to
pick up a little momentum.
The bottom of Figure 4, however, shows you an
exception to this general pattern of banks easing up on credit
terms and standards, and that’s residential mortgage loans. Look
at the small box on the right hand side.
One hundred percent of
the banks were tightening up in ’08 and ’09, and there’s been no
easing since then.
The housing market is one of the markets that’s maybe
beginning to show a few signs of life, but not much.
It’s very
depressed and credit remains extremely tight in the housing
market, and that’s one of the things that’s impeding the
recovery of the economy.
The Federal Reserve is very aware of that and, in
fact, send an unsolicited whitepaper up to Congress a couple
weeks ago saying, here are some things we think you ought to be
doing about the housing market to loosen things up, to make
credit a little easier, to make refinancing a little easier. The
Fed sees the housing market as a definite impediment to having
the full effect of its easy monetary policy feed through to the
economy.
The Federal Open Market Committee (FOMC)
That brings me to the Federal Open Market Committee
(FOMC) and the Federal Reserve, and what it’s been doing.
The
Federal Reserve Act gives the Fed three objectives: maximum
employment, stable prices and moderate long-term interest rates.
No one pays any attention to the moderate long-term interest
rate objective -- as long as prices are stable and inflation is
9
low, you’ll just automatically get that.
Figure 5.
FOMC Objectives
• Federal Reserve Act:
– Maximum Employment
– Stable Prices
– Moderate Long-Term Interest Rates
Source: Fed
This is often referred to as a dual mandate -- maximum
employment and stable prices.
The Federal Reserve, including
Chairman Bernanke and Chairman Greenspan and Chairman Volcker
before him, were careful to say that they thought the Fed’s main
job was to keep prices stable, to reduce uncertainty about price
levels, and that would be the best way the Fed could contribute
to maximum employment over time.
But still, the Federal Reserve
has an employment aspect to its Congressional mandate.
Many other central banks have this mandate, but they
have stable prices as their main objective.
And then once they
hit that, they can pay attention to these other objectives.
The
10
Federal Reserve has a more equal parsing of its objectives but,
I think, recognizes that without stable prices, we’re never
going to get maximum employment.
As the Federal Reserve looked at the situation through
the year, it could see that it was probably falling short on
both the employment and the inflation side. The Fed’s latest
table of projections, from November, is at the bottom of Figure
5. This illustrates the point I’d like to make.
maximum employment objective.
Think about the
Let’s look at the ”Central
tendency” section of the table, rather than the full range.
It’s easier to tell that story.
Look at the “Longer run” column
-- the fifth column over from the left. The open market
committee members see unemployment as falling somewhere in a 5-¼
to 6 percent range over the long run, but look at that
projection across that top line.
They saw it as around 8-½ at
the end of 2012, 7-¾ or 8 at the end of 2013, and high 6’s, mid7’sat the end of 2014.
Over the next three years, they didn’t see themselves
coming anywhere close to what they thought would be maximum
employment over the long run.
first objective.
So, definitely missing on that
Then look at the stable prices objective and
the longer-run inflation projection. They see 1.7 to 2.0 as the
long-term objective for the Federal Reserve.
And they saw
themselves as at or perhaps a bit below that objective along
with this high unemployment rate.
There’s no problem on the inflation front, maybe even
a little to the low side of the objective, and way to the high
side of the objective on the unemployment rate.
So, the Fed saw
itself as missing on both of its legislative objectives.
Well, if you’re in a situation like this, what do you
do?
Ordinarily, when I was on the Federal Reserve board, before
the end of 2008, we would have said, well, unemployment is high,
11
inflation is low.
We’ve got to ease monetary policy.
would lower short-term interest rates.
And so we
The FOMC, every time it
came together, eight times a year, would have a long discussion
about what to do with the overnight interest rate.
And in a
situation like this, it would have been lowering the overnight
interest rate.
Why would it lower the overnight interest rate?
Because that should lead to other interest rates going lower -the rates at which businesses and households borrow to buy
houses, cars, capital equipment, and make investments of various
sorts -- and that would increase spending on houses, cars, and
capital equipment.
The lower interest rates themselves would tend to
increase stock prices and other asset prices.
Think about the
discounted value of a future stream of earnings.
rate goes down as those interest rates go down.
The discount
As bond rates
go down, people move from bonds into stocks to get the returns.
So when interest rates go down, stock prices tend to go up.
When monetary policy eases, interest rates go down.
And think about the exchange rates. Interest rates go
down in the United States relative to, say, Europe or Japan, and
people say, well, I can earn more over there in Europe or Japan.
I’ll move some of my money from the U.S. to Europe or Japan.
That puts downward pressure on the dollar.
As the dollar exchange rate declines, U.S. exporters
are more competitive in global markets.
U.S. producers are
competing with imports that have become more expensive, and so
have an easier time of it.
That also expands production and
spending.
12
Achieving the Fed’s Objectives
Monetary policy affects capital asset prices and the
exchange rate by lowering short-term interest rates.
But once we got to December 2008, short-term rates
were already at zero.
In response to the crisis, we had lowered
rates very aggressively, especially at the beginning of 2008.
We got to zero shortly after the markets froze up in
September/October 2008 and so faced a real moment of, what do we
do now?
Notice I said that the transmission was short-term
rates to intermediate and long-term rates and then to all these
other things. We couldn’t do anything more to short-term rates,
so we worked on the intermediate and long-term rates more
directly.
How do you do that?
By buying securities.
We bought
long-term securities, which drove up the price of the securities
and drove down interest rates.
You can also do that by about talking about what
short-term rates are going to be in the future.
those intermediate and long-term rates?
What determines
One of the really
important determinants is what people expect to happen to shortterm rates in the future.
You’re making a choice.
Should I
make a short-term overnight loan, or should I make a three-year
loan?
Making that decision, I want to think about what’s
going to happen to the overnight rate over the next three years.
If I can convince you that it’s going to be lower than you
thought it would be, then instead of overnight loans, you’ll
move into three-year loans, which have the higher rate, and
that’ll lower the rate on three-year loans.
Therefore, lowering expectations of short-term rates
is also a way of lowering intermediate and long-term rates.
13
That should loop back up to reduce the cost of capital, which
should raise stock prices, lower exchange rates, and stimulate
spending in the U.S.
As we came to the second half of 2011 in particular,
the Federal Reserve, as I showed you in Figure 5, could see that
it was probably going to fall short on both pieces of its
mandate, and so they acted on both of those things:
In August of last year, the Fed said, we’re going to
hold short-term rates at zero, and if things work out as we
expect, we will hold interest rates at zero at least until mid2013.
That did lower intermediate and long-term rates.
I think
that mid-2013 date wasn’t all that different than the markets
already anticipated, but by the Federal Reserve saying that,
they took out some of the risk that they might move before then,
which gave more assurance to people and helped to lower
intermediate and long-term rates.
The other thing the Fed did, in September 2011, was
indicate that it was going to operate on its portfolio as well.
In the previous examples, when the Fed had purchased long-term
securities, it had financed that by issuing reserves to banks.
They purchased the long-term securities with cash.
That cash
flows into the banks, and the banks bring it to the Federal
Reserve.
That increases their deposit at the Federal Reserve.
So you’re basically buying securities on the asset side of the
Fed’s balance sheet.
On the liability side of the balance
sheet, there are the deposits to the banks at the Federal
Reserve.
That was what the Fed did in the end of ’08 and
beginning of ’09, and at the end of September 2010.
When they
got to September 2011, they said, we can drive down these longterm interest rates by buying long-term debt.
have to issue reserves to do that.
We don’t really
We can just sell some of the
14
short-term debt in our portfolio.
So the Fed did what was called an Operation Twist.
They’re still in the process of doing this -- to the extent that
the Fed has Treasury bills and short-term Treasury debt in their
portfolios, they’re selling that and using the proceeds to buy
longer-term Treasury debt.
term interest rates.
The effect of that is lowering long-
So they’re moving along both these things.
The Fed is also focusing more on communications. The
Fed has shown us what forecasts and charts it’s going to publish
about this, and has said that it’s going to release what the
FOMC thinks is going to happen to the federal funds rates over
the next couple of years.
This is not going to be based on a
vote of the Open Market Committee and what they’re committing to
do with rates.
Instead, this will be the projections of all 17
people –- there are two vacancies on the board now -- around the
Open Market Committee table, and each person will have a dot on
the chart, and we won’t know who’s who.
It would be nice if
they labeled one BB for Ben Bernanke, but they’re not going to
do that, and I don’t blame them.
So the public will know, at least, where the FOMC
members expect Fed fund rates to go. That will be helpful in
reducing uncertainty, and in giving us on the outside some
guidance about what they think is going to happen if the economy
evolves as they think it’s going to evolve.
These forecasts
will be put out at the same time as they update the economics
projection table I showed you in Figure 5.
So they’ll update that table –- which actually has
more lines on it than in the figure, including GDP projections,
and give us the interest rates that each person sitting around
the table thinks goes with the forecast in order to achieve the
Fed’s objectives.
When I served on the FOMC, we were told to submit our
15
forecast assuming whatever monetary policy we thought was needed
to achieve the Fed’s objectives.
And now we’ll find out what
those forecasts are.
There are a lot of questions about whether the
unconventional policies -- asset purchases and rate guidance -work or not.
hope or wish.
I think they do work, but not as well as you might
I think that when the Fed has made announcements
about communications, and about additional purchases of
securities, including the Operation Twist, it has tended to
lower intermediate and long-term interest rates.
to help buoy the stock market.
It has tended
And if people are wealthier,
they’ll tend to spend more.
It’d be nice if they could also put a little floor on
housing prices.
My guess is that having lower interest rates
means that housing prices fell less than they otherwise would
have.
It’s a little hard to prove, but it’s logical in my mind,
and it probably also lowered the exchange rate somewhat.
The
U.S. exchange rate has strengthened somewhat over recent weeks
and months.
I think that’s mostly because, although we have
problems, the rest of the world has even worse problems,
especially in Europe.
So I think the Fed’s actions have helped to ease
financial conditions. How much has it boosted spending? I think
I know the sign of these derivatives, but the size is a little
hard to say.
The logic is, all those things I said probably did
boost spending, at least a little.
But remember, the housing market has always been an
important channel for lower interest rates to boost spending in
the U.S., and we haven’t really seen that.
few faint glimmers, but not much yet.
Maybe we’re seeing a
I think the fact that
housing hasn’t really responded and, if anything, has remained
extremely weak, has detracted from the effectiveness of the
16
extraordinarily low interest rates that we have now.
The 10-year real interest rate -- the inflationprotected interest rate -- is slightly negative.
So people are
willing to lend the government money at a negative interest rate
for 10 years for the inflation protection.
They’ll get money
back because the CPI will go up.
A negative 10-year real interest rate is an
extraordinary thing, and if you had said to me five years ago,
the Federal Reserve will drive interest rates down that low, I
would have said that we’d have a boom in the economy.
haven’t had a boom.
We
Part of the problem is the housing market,
which is part of the larger deleveraging process.
Uncertainty
Another issue that’s detracting from the
effectiveness of low interest rates is a huge amount of
uncertainty -- uncertainty about what’s going to happen to the
economy, uncertainty about fiscal policy and tax rates, and
uncertainty about regulation.
There’s some pretty good economic theory which says
that the more uncertain people are for a given set of prices and
interest rates, the less they’re likely to spend.
There’s an
option value to waiting, to see what happens before you make a
commitment.
So if they’re uncertain, people tend to postpone
spending.
There’s also a high degree of uncertainty because we
don’t even know what our tax rates are going to be. We don’t
even know if what our payroll taxes will be come March, much
less what taxes are going to be in 2013 after the Bush tax cuts
expire.
It’s very hard to plan and to make commitments when
there’s so much uncertainty about the environment in which
17
you’re making commitments.
So I do think these policies have worked, but they
certainly haven’t been as effective as we might have hoped for,
for various reasons.
Will the Fed’s actions lead to inflation?
That’s a
common concern, especially among Republican candidates for
President, and the intense bashing of the Fed is often centered
around its supposed
“debasing the currency.” Obviously the Fed
actions haven’t led us to inflation so far. I can recall going
to academic seminars in the spring of ’09, and people saying,
you’re buying all these securities, the monetary base is
increasing, of course there will be inflation. Zimbabwe, the
Weimar Republic always came up.
But I think we’re in a situation in which those
reserves and the increase in monetary base are just beginning to
be put to work.
We saw what’s happening to bank loans on Figure
3. Banks are just beginning to try to expand their portfolios,
are just now feeling comfortable enough with their capital
positions, comfortable enough with the financial conditions of
the people they’re lending to.
So those reserves really haven’t been having much of
an effect, and I think most people expect inflation to be lower
in the next couple years. The Fed’s forecast in Figure 5 is
reasonable, and most of the participants in the FOMC have
inflation going down.
Remember, in 2011, inflation was pushed
up by petroleum commodity prices.
This forecast is for PCE
inflation, total inflation, which includes petroleum commodity
prices.
Most people expect that to go down.
So we haven’t
had inflation, and most economists don’t expect inflation to
come.
All the reserves will need to be absorbed and taken
out when the time comes to tighten, though, so they do
18
complicate the exit.
They complicate the tightening process,
but while businesses are sitting right now with a huge amount of
excess labor and excess capacity, the reserves are not having an
inflationary impact.
Will asset price distortions come back to haunt us?
One of the things that buying all these securities does, is
deliberately distort asset prices. It drives up bond prices.
drives up stock prices.
It lowers the exchange rate.
It
That’s
how it works.
There are two kinds of concerns here.
One is that by
keeping interest rates so low, you’re in effect trying to bring
consumption and investment from the future, by inducing people
to spend now rather than waiting to spend.
They’re not getting
rewarded for saving, they’re getting rewarded for spending.
And
we keep bringing consumption from the future to the present
through easy monetary policy and through some types of fiscal
policy, like Cash for Clunkers and programs like that.
So people worry that we’re distorting resource
allocation over time. My personal view would be that with so
much underutilized productive capacity, both in business and in
labor markets, it’s better to put that to work than to let it
sit idle.
That’s a distortion of resource allocation, too.
The other issue people have with these distorted asset
prices is, what happens in the exit? When the Fed starts to
tighten, there could be some violent reactions in securities
markets.
My personal experience goes back to 1994 and earlier,
when the funds rate had been 3 percent for a couple years, and
just a 25 basis point increase in February ’94 precipitated
quite a break in the bond market over the spring of ’94.
A lot
of people lost a lot of money on that, particularly in mortgage
securities.
it.
Some hedge funds went out of business because of
So I do think everybody’s going to be a little bit worried
19
about what happens when the Fed starts to tighten monetary
policy.
But it’s better to tighten policy as necessary to avoid
inflation when the right time comes than to avoid tightening
because you are fearful of what’s going to happen to financial
stability as rates rise; in any event, it could be an
interesting time when that tightening happens.
The other point that’s sometimes made about the
policies of the Federal Reserve is that they’re disadvantaging
other economies.
As I mentioned, one of the effects of the
Fed’s policies is a lower exchange rate for the U.S. and, in
effect, that’s exporting our problems to the rest of the world
to some limited extent.
flows.
There is also concern about capital
When the U.S. interest rates were lowered, the exchange
rate went down.
That incented capital flows to other countries,
and the recipient countries aren’t always happy about getting
that.
They’re worried about asset bubbles in their countries.
My personal view is that this exchange rate mechanism
is part of every adjustment.
part of it.
It’s not the major part, but it is
No one has an interest in a weak U.S. economy, and
we’re seeing that now.
The U.S. economy looks stronger than
Europe, and if the U.S. economy were weaker, the global economy
would be even weaker than it is now.
The Federal Reserve needs to do what it can to
strengthen the U.S. economy.
Other economies can adjust, and
one of the ways they adjust is through changes in exchange
rates.
Some of the countries objecting to the U.S. easing
monetary policy are countries that refuse to let their exchange
rates float up.
China is the best example, along with several
other Asian countries that feel constrained because China won’t
let its currency appreciate.
They’re afraid, as they have very
strong trading ties with China, to let their currencies
appreciate as well.
20
When you’re in a situation like that, if you tie your
currency to another country’s currency, then you end up
importing that country’s monetary policy.
And for people who
are thinking about capital flows and about investing in the
other country, if you think that currency is tied together but
it’s an unsustainable situation -- it’s going to have to rise at
some point -- that’s just another incentive to bet.
It’s a one-
way bet because that currency won’t go down and could very well
go up.
I think a lot of these problems are a result of a lack
of flexibility of other countries’ currencies.
I don’t think we
can ask the U.S. to run a weaker economy and absorb higher
unemployment to stop inflation in China.
We shouldn’t, and we
can’t, and it’s up to them to figure this out.
There are spillover effects.
a globally interconnected world.
those spillovers are.
We are making policy in
We need to be aware of what
We need to be in close communication with
other central banks and governments about what we’re doing, but
we can’t sacrifice our own welfare, particularly when they’re
not using some of the tools they have to enhance their own
welfare.
That’s my little sermon, and I’d be happy to take
questions.
Discussion
SPEAKER: How does the Fed take into account things
like the social changes that are happening in the United States
-- fewer people marrying, less interest in owning a house and
putting up with the payments and all the work involved with home
ownership, more urbanization?
A lot of the houses that were
built are in places that just may not be attractive in the
21
future. How does all that get factored into the work of the Fed?
MR. KOHN: I think from the Fed’s perspective, they
need to be aware of those changes and how they’re affecting the
economy, and take that into account when they’re projecting
unemployment and inflation.
They take those sorts of things
into account not only when they’re projecting what the
unemployment rate is going to be, but what they think it can be
over the longer run.
One of the things people worry about is that the
decline in house prices and the many distressed and underwater
loans make it harder for people to move and harder to match
people in jobs and, therefore, might be raising long-term
unemployment rate to some extent.
But actually, the studies
that have been done on this suggest that that effect is small or
nonexistent. People are looking at renters and owners, and not
seeing much difference in their mobility.
I think this shift from owning to renting is a good
thing.
I heard Barney Frank finally say a year or two ago,
“Everybody should live in a house, but not everybody should own
one.”
There were too many owners.
People were too extended,
buying more house than they could afford.
So I think shifting
from owning to renting is not a bad thing for some people.
Owning a house is a good thing, there are externalities from
flow from that in the sense that people tend to take care of the
houses they own, and neighborhoods are better off with higher
ownership rates.
But putting people in houses they can’t afford
is obviously a negative over time.
Another example of something that the Fed would have
to be aware of outside the housing market is labor force
participation.
For example, what are the effects of the recent
crisis and the decline in people’s wealth on people’s
willingness and ability to join the labor force?
So that’s
22
something the Fed studies.
These social trends are important as background for
the macroeconomic forecasts.
SPEAKER:
One of the measures that is often advanced
in talking about comprehensive tax reform is a potential valueadded tax, and yet most people would agree that upon the
imposition of that kind of tax, there will probably be a
recession of some kind.
I don’t want to be theoretical, but
could you address what the Fed might be doing in a situation
like that, if we actually have a couple years down the road we
actually have something like a value-added tax?
MR. KOHN: A lot of countries have increased valueadded taxes, and haven’t necessarily had recessions as a result.
It depends on what else is happening.
First, does the value-
added tax replace the income tax so people on balance aren’t
paying any more taxes?
And if they’re not paying more, then I
don’t see why there should be a recession.
Now the VAT does tax consumption while exempting, in
effect, the income that is saved; most economists would say
moving from an income tax to a value-added tax -- taxing
consumption rather than consumption and saving combined-- is
probably good for the U.S. over the long run, as it would
encourage more
saving, which in turn would encourage
investment in plant and equipment and in education as well. So
if there’s not a general increase in taxes, I don’t see why
there should be a recession.
The second point is that the Fed would then have a
projection of higher inflation for when that tax is going to go
into effect because the VAT would be added to retail prices, but
it would be a level jump in prices, and you can look through
that.
The Bank of Canada did a year or two ago.
They had an
increase in their value-added tax, and the Bank of Canada said,
23
we’re projecting 3 to 4 percent inflation, but we think that’s
going back down to 2 percent over time.
That’s their goal, and
so we’re not going to react to that.
So, I certainly don’t think a value-added tax has to
result in a recession.
SPEAKER:
I think it’d really be a good idea.
It seems that fiscal policy is the solution
to a lot of our problems.
But on the other hand, more
investment in developing our human capital and in higher
education could have an enormous payoff.
But the political
logjam in Washington and the focus on the debt makes that hard
to imagine.
MR. KOHN: Yes. I think you’re right that it would be
very hard under the current circumstances to get greater
government spending on almost anything. The issue instead is,
where are the cutbacks going to come?
It’s a shame. In a more
perfect world, people would see that there’s both a long-term
budget trajectory issue and an investment in people issue. We
know that the return from investing in people, the return to
education is very, very high when it’s done right.
And so you’d
hope that people would try to figure out how we can put all
these pieces together.
Yes, we need a much better trajectory for our deficit
and our debt over the long-term, but if we tighten up now we’ll
end up looking like Greece or Spain, with fiscal contraction
contributing to a weaker economy.
But thinking about a new
program for higher education now is hard to imagine under the
current circumstances.
There has been pretty good growth in investment in
business equipment and software -- not necessarily related to
education -- and I think both the tax system, with accelerated
depreciation, and low interest rates are helping that.
But
ultimately, businesses need to see a profit for their
24
investment, and the uncertainty about what’s going to happen in
the economy has depressed confidence and held back investment.
Going back to your point about investment in
education, there’s a lot of discussion about mobility in our
society.
And we’ve had some pretty lively discussions around
the lunch table and seminar tables at Brookings about what the
situation is and where the problems are and what to do about it.
Everybody seems to agree that the worst problem in the U.S. is
that it is so hard for people to climb out of the bottom fifth.
It’s a huge problem, and raises a lot of issues. There is a
Brookings study that Rick Santorum likes to quote, saying, “If
you stay in school and graduate high school, get a job and don’t
form permanent alliances and have kids before you’re 21, you
have a much better chance of climbing out of that bottom fifth
than if you do any of those other things.”
But I think that finishing high school and getting a
job is not so easy as it sounds.
My daughter is involved in
early childhood education and so she has imbued me with the idea
that you have to get to these kids early.
The family problems
are intense, and particularly for that bottom fifth.
I think an
investment in high school, elementary and pre-K for those kids
probably has a very high rate of return if we can figure out how
to do it right.
25