Outlook for the Economy

MS. DYNAN: Thank you for that nice introduction. Let me introduce our panelists here. To my right I have Charlie Schultz. He is a senior fellow emeritus in the Economic Studies Program. He was chairman of President Carter’s Council of Economic Advisors. He is an expert on macroeconomic policy and budget issues whose work and words of wisdom continue to be frequently cited today.

To Charlie’s right, we have Gary Burtless, who is a senior fellow in the Economic Studies Program. Gary is coming up on his 30th anniversary with Brookings. He is an expert on labor markets, aging issues, entitlement programs, and income distribution issues, and he’s the author of many interesting articles for both academic and nonacademic audiences. My favorite recent work by Gary is his monthly analysis of the labor market data as it’s released, and if this is a scenario that interests you, I suggest you come to the Brookings website on the day the employment report is released every month because Gary’s analysis is better than anybody else’s that I see.

And then to my left I have Tracy Gordon. Tracy is the Okun-Model fellow in Economic Studies this year. That’s a program in which we bring rising academic stars in and fund them for a year as they do research. More permanently, Tracy is an assistant professor at the School of Public Policy at the University of Maryland. She is a wonderful addition to economic studies for a number of reasons, among them the fact that she is an expert on state and local public finances which is, of course, an incredibly important and policy-relevant issue right now.

So we’re here to talk about the economic outlook, and I’m going to ask each of these panelists a question to get things started, and then we’ll open up the floor to questions from you. To set the stage let me make a few points: First of all, as you all know, the recession officially ended in the middle of 2009. That was about a year or so ago. We’ve been in economic recovery since then. Yet, it doesn’t really feel that way, I think, to a lot of people. Why is that?

Well, of course, the end of the recession is just the bottoming out, and the recovery is how we get back to normal, to good times. By historical standards, this has been a fairly weak recovery in terms of economic growth: GDP growth has averaged 3 percent per quarter since the recovery began, compared with a more typical rate of 5 percent in the early quarters of past recoveries, and the labor market is recovering even more slowly. And that’s something that Gary’s going to be discussing.

The unemployment rate is at 9.4 percent. It is down from its peak, but job growth has been really paltry at, I think, just 100,000 per month since it hit bottom about a year ago. A particular concern is the number of long-term unemployed: the number of workers unemployed for 6 months or more stood at more than 6 million in December, and they account for 42 percent of the unemployed. And the long-term unemployment rate, which is the number of unemployed relative to the labor force, has risen from under a percentage point in November 2007 to 4.2 percent, which is well above the previous postwar peak of 2.6 percent in June in 1983.

This performance isn’t really a surprise in the sense that financial crises historically have tended to be followed by what Carmen Reinhart and Ken Rogoff have described as profound disruptions in economic activities. That comes from their excellent work where they analyzed eight centuries of historical data and came to that conclusion.

I think the issue is that we have been left with tremendous economic head winds, including a loss of household wealth and ongoing tightness in the availability of credit – for some types of borrowers at least — I think Charlie’s going to be touching on that more in his remarks.

Also among these head winds are the problems of state and local budgets, and that’s why we have Tracy here on the program because that’s such an important issue.

So with that background let me get started. Charlie, despite my gloomy talk so far, the recent sentiment about the recovery has actually been a little better, so I was wondering if I could get you to share your thoughts on the outlook for 2011, generally speaking, and why we’re seeing this widespread upward revision to forecasts.

Charles Schultze

MR. SCHULTZE: Okay. Two points to start with: First, looking around the room and having read about the snow that’s falling all over the southern and eastern part of the U.S., and all the flights that are currently being cancelled, I’m reminded of the opening line in Henry V before the Battle of Agincourt, “Oh, we brave, we valiant few.”

I want to talk about three things. First, the current pace of recovery has picked up over the last several months.

Second, the question of whether we can sustain the pickup and recovery over the next three to four years. Despite improvements in the economy now, we’re going to be fighting some head winds as we move ahead.

And third, a dilemma: How do you sustain healthy recovery while substantially raising taxes and cutting federal expenditures, assuming we will do at least some of that?

Three Phases of Recovery

There have been three phases in recovery to date from the trough in the fall of 2009. First, moderate gains from the fall of 2009 to sometime about March or April, then a lull for about three, four, five months during which the forecasts began to get more pessimistic. And then in late fall 2010 things began to brighten up again, growth speeded up, and forecasts began to get more optimistic.

Let’s start with consumer spending, which is 70 percent of GDP, and which has dominated what’s been going on.

Exhibit 1.
Three Phases of Recovery in Consumption and Income
(percent changes @ annual rate)
  Sep. ’09 to    Mar.’10 to    July 10
  Mar. ’10   July ’10   Nov. ’10    whole period *
Consumption     2.60   1.43   4.22   3.18
Wages & Salaries   -0.88   6.17   1.83   2.18
Disposable Income     1.38   2.52   1.07   2.49
* Change over 14 months

 

If you’ll look at Exhibit No. 1 you’ll see the moderate gains in consumption during September of 2009 to March of 2010, then a drop-off from 2-1/2 to 1-1/2 percent, and then a substantial pickup from July to November, which is the latest I can get monthly data. You can see that three-phase movement.

Over the whole period, wages and salaries and disposable income rose somewhat less than that in a little bit of an erratic pattern. And over the whole period, consumption increased moderately faster than the growth in income, and the saving rate, which has gone up a bit, then dropped a little.

Then, if you look at other parts of the economy, there are two big sectors that had an important influence in this recent pickup. One was a continued healthy expansion in business purchases of equipment and software. And then, secondly, a recent sharp slowdown in the flow of imports, which until recently, had been actually dragging the economy down, the imports were coming in so fast. That didn’t completely go away, but it substantially fell. You put all that together and you have the main elements of why the economy’s picking up.

Over all, the U.S. is headed into 2011 with some higher momentum in GDP and output. Gary will talk later about the labor market, which isn’t always behaving the same way that output is. In addition to the improvement we’re now seeing, in this year we’re going to get the advantage of a significant fiscal stimulus from the December compromise tax and related legislation. In that agreement, the administration won a number of concessions that will pump about $200 billion in the economy towards lower and middle-income workers. These are going to provide not huge, but some significant stimulus next year.

Several of the most prominent economic forecasting firms have estimated that this will add about 1 percentage point to growth, which together with the recent pickup in economic activity will, according to their forecasts, result in a 4 percent GDP growth over the coming year, well above the 2-1/2 percent growth that had been commonly forecast before this pickup got going. I suspect 4 percent might be a little bit too much given some of the problems still facing the economy, and that a 3-1/2 percent growth might be a better bet. It seems like a small number but, if that half-percent difference should continue for a long time, it begins to make a difference.

Potential and Actual GDP

Second question: Can we sustain the improved output growth beyond this year? Let’s start with Exhibit No. 2, which I’ll call the Gap Exhibit.

Exhibit 2. Potential and Actual GDP

This shows the difference between actual GDP and potential GDP. Potential GDP is simply the output that would be produced from an economy operating in a normal non-recession level of output with unemployment at about 5 percent.

At the bottom of the recession, as you can see, actual GDP fell almost 8 percent below potential. And with a growing working-age population and a continued rise in output per worker, the gap between actual GDP and potential GDP has so far fallen only about 1 percent during this recovery from, as I say, 8 to down just a nudge below 7.

It would take about 5 years of sustained GDP growth, averaging 4 percent a year, to take us back to the economy’s potential. If it was a 3-1/2 percent growth rate, it would take 2 years longer.

There are a number of head winds to be overcome in sustaining a 3-1/2 to 4 percent growth rate in the years immediately ahead at least. Let’s look at some of those head winds. One was the huge loss of consumer wealth during this recession.

Exhibit 3. Household Net Worth

Exhibit No. 3 shows that since 2007, American households have lost $11 trillion of their net worth, about 70 percent from collapsing home prices and the remainder from financial asset losses elsewhere.

After large declines in wealth, consumers tend normally to work down their debt and build up their saving rate and try to get back a little bit of their depleted wealth. And household saving rates have in fact risen from the abnormally low 2 to 3 percent during the boom period before 2007 to 5 to 6 percent over the last 2 years.

It’s hard to pin down the quantitative impact of such huge losses on consumer behavior. I wouldn’t pretend to try, but at best over the next several years I doubt that consumer spending will grow any faster than household income. It won’t be an independent kick to economic growth.

Another head wind we face is housing construction, which continues to be weak, and the outlook in the near term isn’t bright. Something like 25 percent of homeowners with mortgages are now under water, implying a continuing large flow of foreclosures. And as the paperwork mess is sorted out over the months ahead, the execution of pending foreclosures will speed up. And home prices have now fallen back to — but not below — their normal relationships with household incomes. They got up to a tremendous peak above what was normal during the housing bubble over the last few years.

Let me turn to another point that has to do with corporate retained earnings, or undistributed profits, not distributed in dividends. There have been numerous reports in the media that retained earnings — undistributed profits — have risen very sharply during this recovery. Some commentators have argued that if the current speed-up and demand for goods and services continues for awhile, the availability of such a kitty of unspent funds would be highly favorable for an upsurge in business investment.

Exhibit 4. Corporate Retained Investment as a Percentage of Business Development

Unfortunately, this is a mirage. Exhibit No. 4 shows that while it is true that total corporate retained earnings/undistributed profits have risen very sharply recently, little of that has occurred among nonfinancial corporations, which account for the bulk of investment in equipment and structures — the kind of real output that produces employment.

Seventy percent of current, as it’s accumulated, undistributed profits come from financial firms, and this brings us around to the problem of financial deleveraging. For a number of reasons, financial firms are building up their capital rather than lending it out or paying dividends, including the fact that under recent financial reform legislation, government regulators will soon be requiring them — especially the larger ones — to increase the amount of capital behind their assets, and they are now building up that capital. And having been recently burned so badly, financial institutions have become somewhat more reluctant to take on risks.

Over the next few years, progress in closing the GDP gap and reducing unemployment will be difficult to achieve, especially if the next few years are a period of substantial budget stringency with large spending cuts and tax increases.

All of this brings me to my final point, which involves a serious dilemma for policymakers. Many of the head winds I’ve described will gradually die away or in some cases even reverse themselves, but there’s a real question as to whether the economy can sustain healthy growth over the next three years while also absorbing substantial tax increases and large cuts in budget spending.

There’s a school of thought, however, that says failure to begin now to tackle a long-run budget problem will disturb global bond markets and lead to increases in U.S. interest rates large enough over the near-term to substantially slow our growth.

I’m skeptical. But I don’t think the worry can be cavalierly dismissed. Prudence would suggest that the country begin now an extended program of serious budget-tightening despite the still somewhat iffy economic conditions. To deal with this dilemma, what’s needed is a legislative process that has two components:

First, a package of spending cuts and tax increases enacted this year large enough to convince financial markets and serious economic commentators around the world that the President and the Congress are going to bite the bullet.

Second, it should be a multiple-year package under which the spending cuts and tax increases very gradually take effect over the next, say, four years. The expenditure cuts would involve multiyear appropriations, and changes in entitlement benefits and tax laws that start out slowly and increase in size over the next four years. Some combination of legislative language and associated rule changes in the House and Senate would be part of the process to create maximum assurance, such as an ironclad requirement for supermajority votes or other measures, to prevent future legislation that would reduce those spending cuts and tax increases.

It’s going to be hellishly difficult to enact large spending cuts and tax increases. But if agreement can be reached on a basic package phasing it in, it might not be quite so hard.

MS. DYNAN: Yes, Charlie, if I can ask you just a quick follow-up, would you care to put odds on the likelihood of a double-dip recession? And if we were to see double-dip, what would be the most likely source? You talked about possibility of a debt crisis; other people talk about problems in the housing market driving house prices down.

MR. SCHULTZ: Well, I start with the proposition that I learned 40 or 50 years ago when I was a staff member at the Council on Economic Advisors. The natural course of the U.S. economy isn’t a flat line, it’s growth. There are a lot of things that tend to build in growth. Particularly as innovations occur that improve the quality or lower the costs of goods and services, and business firms invest to take advantage of those opportunities. That gives the economy forward momentum, so I would say you have to have fairly significant obstacles in the way once a recovery is started to give you a double dip. It’s not impossible, but I think it’s not very likely, and if you look at the kind of head winds I’ve talked about, A, they are not the things that are going to come down and hit you over the head, they’re gradual; and B, they will eventually get worked out and, in some cases, reverse themselves.

For example, auto sales have been one of the big things increasing consumption spending lately, and, in part that’s probably because we’re not producing enough automobiles to keep up with the stock as it gets old and gets washed out.

So all kind of things, I think, make it not impossible, but do get in the way of having a double dip.

Gary Burtless

MS. DYNAN: Thanks Charlie. Let’s move on to Gary. Gary, one critical element about the sustainability of the recovery, of course, is whether we end up seeing an improvement in the jobs market. Can you offer your thoughts on what the recovery of the job market looks like so far, and what you think that means for employment and wages over the coming year?

Job Market Recovery

MR. BURTLESS: Well, you mentioned a couple of things that are relevant. Over the past year employment in the United States has grown about 100,000 a month. The payroll employment number suggests that private companies have added about 112,000 people to their payrolls every month. It sounds like a big number, but bear in mind that this is a country that has 154 million people in the labor force, and so that actually is pretty anemic growth.

And at the same time, the public sector of the United States, consisting in this case mainly of state and local governments, has shed about 18,000 workers every month. And that shedding of workers had continued up through the most recent reporting period. It seems to be mostly concentrated in local government, but there’s been a big drop, for example, in local government education employment over the past year.

And unlike a lot of other recoveries where sometimes it makes a difference where you get your statistics about what’s happening to the job market, whether you ask employers what’s happening or whether you ask household heads to describe what people in the household are doing, in this case there isn’t very much difference. Both the household survey and the payroll statistics every month are telling pretty much the same story. We’re adding roughly 100,000 jobs each month. It’s a little bit bigger in the household survey and a little bit smaller in the employer survey, but they’re both basically telling us the same thing.

Now, over the last year, the unemployment rate fell a half a percentage point from almost 10 percent to about 9.4 percent, but most of this was due to a continued fall in the percentage of adults who say they’re in the labor force. Employment edged up about fast enough maybe to hold the unemployment rate constant, but the number of people who say they’re in the job market has declined. It’s not surprising. A lot of people might be discouraged about their prospects of getting reemployed if they have been looking for work a long time.

About 45 percent of the unemployed in an average week last year had been jobless for 6 months or longer. The average duration of an unemployment spell in progress jumped five weeks last year. It’s now 341/2 weeks. That’s how long the typical unemployed person has been jobless. It’s much worse than we’ve ever seen in the postwar period in the United States. The previous low for this kind of a statistics or high, depending on how you want to think about the number, was in the aftermath of the 1982-1983 recession. But even at the worst point, only about one in four unemployed workers in the early 1980s had been jobless for six months or longer. So this is a real change in the dynamics of the American labor market.

In the late 1980s, Charlie and I worked on a book together, and a lot of economists on both sides of the Atlantic Ocean worked on the question of why was there so much more dynamism in the job market here in the United States than in Europe, especially Continental Europe. And one of the hallmarks was the low rate of job creation, and that is precisely the situation that we have in the United States now. It’s not that our layoff rate is extraordinarily high. In fact, over the last year and a half the layoff rate has returned to pretty much its normal rate. If you had a job at the beginning of a month, the chances that you’ll lose that job are now back to where they were when the economy was growing steadily.

What is really extraordinarily difficult is for jobless people to become reemployed. The fact that workers’ spells of unemployment are getting longer and longer actually is harmful to their chances of being reemployed, because employers tend not to hire from the longest-term unemployed when they have an alternative, like someone just freshly graduated from college or somebody who already had another job and the employer wants to poach them.

The bright side for the unemployed is, yes, it’s the worst job market in the postwar period, and their chances of finding a job are grim, and the duration of their unemployment is as bad as its been in the postwar period. But, on the other hand, one other thing is also as long as it’s ever been in the postwar period, and that’s how long they can collect unemployment benefits.

Before this recession, the longest anyone could collect unemployment benefits was in the mid-1970s, when people could collect 65 weeks, and this time you can collect up to 99 weeks of benefits. And I didn’t know whether it would happen, but the Congress and President agreed at the end of December to continue those extensions through the end of next year.

How has the situation improved or deteriorated over the last year? Well, one way to gauge that is to look at the percentage of adults in different educational groups who are employed. And there was some improvement for people who are high school dropouts and for people who have some college but haven’t graduated from college, and there was some deterioration for people who have a high school diploma but no more and for the people who have a college diploma. But in no case were the improvements large or the deterioration very noticeable.

One of the silliest themes of newspaper and magazine articles I’ve seen over the last 18 months has been reporters questioning whether it pays to earn a college diploma. And the idea is, well, a lot of people have spent all this money going to college and they’re finding it tough to get a job. Let me report some numbers:

Since the end of the last economic recovery, which was December 2007, the proportion of adult dropouts in jobs has fallen 9 percent. The proportion of folks with a high school diploma in jobs has fallen has fallen 8 percent. The proportion who have some college but haven’t graduated from college has fallen 7 percent, and the proportion of college graduates in the adult population who are employed has only dropped 4 percent. So, yes, it’s true getting a college diploma doesn’t guarantee that you’ll have a job, but it certainly has provided better protection against job loss than have other levels of education.

In the last year there’s been good news for the employed. Charlie alluded to this, but let me give you a couple of details. One is it’s true that wage increases are very anemic, but people sometimes forget that price increases are even more anemic. So a slow rate of nominal wage growth has nonetheless translated into inflation-adjusted hourly wages that have improved about a percent over the last year. That’s not great but it’s not terrible.

In addition, one way that employers have been meeting their demand for extra workers, given the fact that consumption and the demand for some exports is rising, is that they have added to their workers’ weekly hours: weekly hours are up 1-1/2 percent over the year, and average weekly earnings are up about 21/2 percent, which is not a bad performance.

And maybe, for psychological reasons, another important thing for employed workers is that compared with a year and a half ago, your chances of being laid off from your job have fallen a third. So there’s been a real improvement in the situation of the employed, which contrasts with the continued deterioration in the situation facing people who are jobless, who were laid off and have not been able to get reemployed for six months or so. Those people are facing very grim prospects.

Now, the bad news is that over the course of the recession and the ensuing recovery, we’re still a long way from where we were when the recession began. Charlie used some numbers on the GDP gap to show that, but here are some other numbers: Employment in the United States is down about 6-1/4 percent in spite of the fact that we’ve had 3 years of population growth. So, we have fewer people employed and a larger population that needs employment. Total hours worked are down 7-1/2 percent since the end of the last economic recovery. So that is not a healthy situation.

There is one area — it’s been a golden time for one thing, and that is business profits. Even though wages, total labor earnings are down from where they were at the end of the last recovery, company profits are at their highest level in history. That is an amazing fact. I think there’s been a very fast rebound in the profitability of American business, if we can believe the national income and product accounts. And this is reflected in stock market prices.

The rise in stock market prices is such that since the low point in March 2009, under the broadest measure of the value of stocks in the United States, they’ve almost doubled in value. So, if a lot of your wealth — and that would be true of many of the universities represented here — is invested in common garden-variety stocks, and you don’t have a lot of exotic investments, then there’s been a substantial recovery in your portfolios. That’s also true of everyone in the United States who has large amounts of stocks in their portfolio and didn’t lose heart and say let’s go buy something else, let’s go buy some land or something. Those folks are doing well.

Now, Karen started with asking, well, what’s the outlook given all of this? Employment gains have been modest over the past year because, essentially, economic growth in the United States has been modest. When we had really anemic productivity growth in the United States even that modest growth would have resulted in greater, faster growth in employment. But the fact of the matter is that productivity growth in the United States since the mid-1990s has been near its high point.

Our productivity is growing fast, and so the economy has to grow faster to generate employment gains, and we just don’t see them. Charlie discussed where the sources of new demand might be. I think employment in state and local government is going to continue to be weak because of the fiscal situation. But Tracy can talk more about that.

Total earnings and compensation in the government sector may actually fall, either from salary freezes or furloughs. Governor Brown in California has asked state employees to take a 10 percent pay cut over the next year. That doesn’t sound very good. I think state and local government contractors are going to be in trouble. Housing is going to continue to be weak for some time, I believe, for reasons that Charlie outlined. Consumer demand has certainly picked up speed. I think that is one reason for the greater optimism we see in business economists’ forecasts.

The big question marks are business investment and net exports. I think that the Rust Belt of the United States and other parts of the country would be greatly helped if the dollar declined much further than it has so far in this world economic recovery. But as a lot of you know, the reasons the dollar doesn’t decline as much maybe as it ought to, are uncertainty about the situation of the euro in Europe, the financial problems facing Europe, and the Chinese insistence on maintaining a constant exchange rate with the U.S. dollar.

Business investment I have no knowledge about, but unless the demand for goods and services produced here in the United States picks up speed compared with where it’s been so far in this recovery, I don’t foresee very much improvement in the labor market, and especially in the situation of the unemployed over the next year.

MS. DYNAN: Thanks, Gary. Just a quick follow-up question about your remark about stock portfolios. I think this is a group that probably thinks a lot about propensities to retire given concerns about generational balance at universities, and you said stock portfolios have improved a lot but kind of on net relative to pre-crisis. Where do we stand in terms of the damage to people’s balance sheets and how is that going to affect propensities to retire?

MR. BURTLESS: I haven’t looked at what people actually do, but I dabble a little bit in readings of what behavioral economists say. Probably, if you had had a steady nerve and maintained your investment position and constantly rebalanced your portfolio over the last couple of years, you would not be very far down right now, in truth, because there has been such an amazing recovery in the stock market and because bond prices are actually higher than they were when the recession began. So if you had a plain vanilla kind of investment portfolio, you would be doing reasonably well now. The speed of the recovery has been great.

But a lot of research suggests that if you look at what people, theoretically, could earn if they had a stable investment philosophy, their actual returns trail those by about 4 percentage points. And that’s because people tend to do the opposite of what a good investor would do: they sell when prices are low and they buy when prices are high and rising. And so I suspect that actual portfolios are worse than you would guess, just based on what a good investor would have done.

Tracy Gordon

MS. DYNAN: Thanks Gary. Tracy, I think now we’ve all kind of pointed the finger at your sector — state and local finances – as representing a major headwind to the recovery. Is that your sense and do you have a sense of where things are heading?

State and Local Finances

MS. GORDON: I’ve been trying to think of how to follow-up on Charlie’s Shakespearean analogy and I would say that it’s not an existential crisis for state and local governments along the lines of Hamlet, but perhaps, rather, the winter of our discontent. Where are state and local governments right now? As you all probably know, a lot of states are starting to come out with their budgets. Gary mentioned Governor Brown’s proposal for California, which is a tough budget.

Just as an aside, first-term governors have an incentive to propose really strong solutions in their first budget. This is what Gray Davis did in the first year of his second term in California and that ultimately led to a recall effort against him, so that strategy can backfire sometimes.

But Governor Brown has come out with a really strong proposal to cut spending, including public-sector compensation and social services, and a pretty interesting proposal to realign a lot of services to the local level. It’s not a surprise that he has proposed a lot of strong solutions because the budget gap has been estimated at $25 billion. Illinois has a budget gap of about $13 billion, and they haven’t paid about $6 billion worth of bills. New York has a budget gap of about $10 billion. So there are a lot of big problems out there.

At the same time, we’ve hearing that state revenues are picking up, so that in the third quarter of 2010 they were up by about 5 percent, which is much better than where they were in the previous year: down by about 5 percent compared to a year earlier. And in particular, personal income and sales tax revenues are growing, consistent with what we’re hearing about the state of the economy, so that that is good for state governments.

On the other hand, we also know that there tend to be lags between economic recovery — regardless of what you think of the pace of the recovery — and state and local government spending. As I said, this could be the winter of states’ discontent. In a lot of ways they’ve done the easy things, like borrowing, and temporary solutions such as temporary tax increases, which are now set to expire.

Another of those temporary solutions was relying on federal stimulus dollars, which as you all probably already know, are going away. Just recently, Paul Ryan came out and said, in case you think that we’re going to extend any more helping hands to state and local government just be prepared that, no, that’s not going to happen. In fact, Chairman Bernanke was asked recently if the Fed was interested in doing anything and he said, no, that’s a fiscal and political issue and not really a monetary issue and we’re not going to, for example, buy up municipal debt.

Short-term fixes are fizzling, revenues are improving but still below their pre-recession levels, and there are pension problems, which have been much in the news lately. State and local governments have something like a trillion dollars in unfunded liabilities that they report. Current accounting rules allow them to use historic returns to value future liabilities; in fact, that’s not really correct because the benefits they have to pay are riskless, so they should use a riskless discount rate, which is closer to 3 percent as opposed to the historical return of 8 percent. In fact, those liabilities really balloon to about $4 trillion overall. So there are some big concerns in the long-term, which are becoming more current concerns for places like Illinois, which has just stopped making their annual required contribution for pensions.

Some states are looking at reforms of their pensions and of course the best thing you can do when you’re in a hole is stop digging. They’re adopting some reforms that will largely affect new retirees. However, a lot of states have strong language in their constitutions that say that you can’t change existing promises to current employees, and that creates a constraint on how much states can do to get out from that hole.

As I said, there’s less appetite for federal support for state and local governments right now and there are also restrictions on bankruptcy. As you’ve all probably heard, states can’t declare bankruptcy because they’re sovereign entities — the Eleventh Amendment prevents that, and most states restrict local governments’ ability to declare bankruptcy. Sometimes they have to sign off on it, or they just might not even allow local governments to declare bankruptcy. Even bankruptcy for local governments is not always a solution because unlike Chapter 11, Chapter 9, the bankruptcy code that affects local governments, doesn’t give judges the ability to liquidate the assets of the entity — again stemming from the sovereignty of these governments — so that there is no threat that forces everybody to get on board to a workout plan. We see the city of Vallejo, California, which declared bankruptcy in May 2008, and proceedings are still continuing because of holdouts to negotiations and the judge has no leverage over those holdouts.

Where are we headed? You hear a lot in the news these days about widespread defaults that are expected. Sometimes when you look a little bit more closely at those quotes, it’s actually defaults on social contracts, which means painful choices ahead, much like Charlie was talking about at the federal budget level. So there are some difficult decisions that states and local governments will have to make in terms of what people want from government and what they’re willing to pay for. Twenty-three states have already formed commissions to try to look for efficiencies in ways to modernize their tax codes or reap more productivity from spending. You could almost think of the formation of these commissions as a lagging indicator of the economy. They’re one way of trying to address the fiscal problems that stem from the recession. But in general I think these efforts focused on innovation are a good thing.

The federal stimulus package also included some incentives for innovation, like the Race to the Top funds for education, so perhaps there are some ways that states can try to do things better. But as Gary mentioned, they’ve already cut about 250,000 jobs. We probably can expect some stabilizing in those numbers. We can also expect some cuts to spending, which could create a drag on the economy: generally, state and local government spending increases by about 2-1/2 percent per year; it’s actually decreased over the last couple of years and will probably grow but at a slower rate than in previous years, probably more like 1 to 1-1/2 percent over the next couple of years. That creates a modest drag on the overall economy and slower job growth in the private sector for a couple of years after that as states continue to deal with the lagged effect of the recession on their revenues and continuing pressures on the expenditure side of the budget.

MS. DYNAN: Tracy, I have to ask about the handwringers out there who are quick to identify one state or another as the next Greece. Is that fair? What are the parallels between the situations in states and those in the most troubled European countries, and where are things different?

MS. GORDON: It’s nice to be in the spotlight. It’s nice to have people talking about state and local governments for a change. And, yes, these parallels to sovereign debt crises overseas are kind of scary but it’s not the same thing. If you think of debt burdens as a share of income, they are much lower at state and local governments than overseas. It’s something like 16 percent of GDP compared to over 100 percent in Greece — and I should say close to 70 percent at the federal level for the United States — so that it’s really not the same kind of burden on the economy, or on state and local budgets for that matter. It’s a small share of total spending, like 3 to 4 percent of total spending, so it’s not as though debt is busting state and local government budgets.

Another interesting fact about state and local debt is the maturity structure. The preponderance of debt is used to build assets like bridges and roads and airports. It’s not borrowing to finance current operations. States are not subject to the same kind of rollover risks that corporations faced in the debt crisis of the fall of 2008 where they just simply could not borrow to continue their operations. You don’t see state and local governments having debts coming due and unable to continue to borrow to keep providing services. State and local governments do have significant challenges facing them, so I don’t want to minimize that, but in terms of a meltdown along the lines of the subprime mortgage crisis — I just don’t see happening.

MS. DYNAN: Thanks, Tracy. We got started a couple of minutes late, but I presume we have a few minutes to take questions from the group here. Are there questions?

Discussion

SPEAKER: A topic that didn’t come up in your very informative presentation was health care, especially when you’re looking at employment. The statement that weekly hours have gone up is understandable if you don’t want to expand the number of employees that you have to incur a fixed cost of health care for. Are there any projections of what’s likely to happen going forward with health care costs?

MR. BURTLESS: Total spending on health care, according to the latest numbers, is slowing down a little bit. In terms of employment, all during the recession and early months of the recovery the health care sector has been one of the steadiest contributors to job growth. People get sick and injured even when the unemployment rate is 10 percent. I don’t know if they are sick or injured more frequently or less frequently, but they do continue to get sick and they do continue to get their health bills for the most part paid for some way or another, so that health care providers can keep adding to their payrolls, which they’ve done.

I think that the outlook for health care costs is at the moment especially cloudy because, first of all, we don’t know what success the Affordable Care Act will have in restraining the cost of future health care. We don’t know. But then there’s the further uncertainty that we don’t know whether that law is going to still be on the books in 2 or 5 years. I don’t think we even know at the moment what the structure for paying our health care bills is going to be. Certainly we have nothing to be proud of in this country in terms of how much we spend in exchange for the health care services that we receive. It just seems that we spend an awful lot more than the rest of the world does to get these benefits.

MR. SCHULTZE: Let me add one or two other points to the discussion of health care. The upward trend in health care costs is partly due to something that health care and the Pentagon share in common, which is the basic rule that invention is the mother of necessity, i.e., if it’s new and if it can be shown to have (and even sometimes otherwise) a health benefit regardless of cost, plug it into the standard procedures and operating conditions. There are two ways to get at that:

One, put a cap on spending. Create devices like vouchers where you give people a fixed amount of money for their Medicare and Medicaid and let them meet it. And my guess is that too much of that ultimately leads to a world in which you have a two-tier system. Or better, with luck, and courts being willing, the new health care legislation sets up a number of mechanisms that at least make a go at building into the standard operating procedures something that will get rid of this mother of necessity business, and slow that down without a cap. But that’s going to take a long time even if it works well, and I don’t think the first business is really going to be done; that is, putting a cap on spending, and secondly, it will take a long time to do it right, and so I don’t think the pace of cost increases will go down very rapidly.

MS. GORDON: I wanted to add something because obviously I think your question is motivated by the fact that health care costs are a huge pressure on both public and private budgets. At the state level, even before the crisis, the GAO was projecting that state and local governments would have large shortfalls way in the future, in 2060, because of exactly these kinds of pressures — health care and aging populations. Another short-term pressure on state governments is the Health Care Reform Act, which says that states can’t change their eligibility before 2014 in order to qualify for federal assistance in expanding through the Medicaid program as part of health care reform. So that restricts state choices in terms of balancing their budgets, in that they can’t touch a large part of their Medicaid budgets. A group of governors has written a letter to the federal government, to Kathleen Sebelius and the President, asking if they can be let out from under this burden because this is really tough.

Finally, it’s interesting that if you talk to governors, they ask, can’t we do some kind of bargain where the federal government just takes over Medicaid because this is such a huge cost pressure for us? They suggest, for example, that the federal government take over care for the elderly population and they’ll take the kids and young families because that seems fair to them. And of course young families don’t use very much health care compared to the elderly and disabled population, which accounts for something like one-third of enrollees and two-thirds of cost, so that kind of bargain that the states are wishing for is not going to happen.

MS. DYNAN: Is there a question back there?

SPEAKER: My question is about wages, productivity and income. If I read the numbers right, 98 percent of Americans have had a decline in real income since the year 2000. But productivity is up. We’ve seen the debates about that. What do you think the implications are of that growing gap for both public policy and for American workers and American businesses?

MR. BURTLESS: A lot of the measures we see that show such limited income gains and, in fact, widespread income losses, focus on gross income and ignore the fact that there has been a sizable tax reduction since 2000. But the second point is that they exclude the spending on the item that we’ve been discussing, which is health care. That is just not counted. I think that for people near the median of the American income distribution, a lot of the income gains that they have received over the last decade or decade and a half have been in fact in the form of more real spending on the health care that’s provided to them. They may not have a perception that they’re receiving that because it doesn’t show up in their pay stub, but the fact of the matter is if you go with just national income accounting, that is where the money is going.

To give you an idea of the scale of the trend, in 1960 about 7 percent (or 6 percent depending on your preferred measure) of the total final consumption in the United States was in the form of health care. Now it’s 22 percent. It’s the most-expensive item in consumption, it’s more expensive than housing, if you believe national income and product accounts. Yet most of that increase is not paid for out of the incomes that Americans receive, and I’m afraid that a lot of the statistics that show this incredible maldistribution of income gains are calculated by people who forget this very elementary fact. For Bill Gates, the cost of his health care has gone up about the same rate as it has for someone in the middle. And for Bill Gates this is a trivial share of his income, but the amount of resources that go to providing a middle-income person’s health care represent a very nontrivial share of all of the income that those middle-income people are receiving.

SPEAKER: Of course the public policy problem is that people don’t think they’re getting an income increase when they get health care.

MR. BURTLESS: Exactly.

SPEAKER: The other part I wanted to ask about was productivity. Income growth has not been great outside of health care. I think you’d have to concede that. Productivity growth has been pretty good in the last 10 years. What public policy problems does that raise or what problems do you foresee, if any, in relationship to business and labor?

SPEAKER: Charlie can speak to this.

MR. SCHULTZE: I was about to say something else. I’m not sure I can speak to that. I want to raise the question of, what are you buying with that income? Very crudely, in the marketplace there is usually some competitive force to make you feel that something is worthwhile. Let me pose the question another way: Do you think the average, let’s say, 35-year-old would be willing to buy a health insurance policy that covers the rest of his life at the price he would have to pay in the market? I doubt if he’d say yes. There is a lot of good evidence that things like heart bypasses, treatment of heart attacks, so on down the list, by almost any measure do add to human welfare in terms of increased mortality and lower morbidity. But I wonder whether or not the system as a whole isn’t generating more health care than people would really be willing to buy if they had to pay for it all. I doubt it very seriously. So while on the one hand I think Gary is exactly right in terms of looking at the statistics on income distribution, there is an even larger question of whether we have a system that generates what people would be willing to pay for, particularly when you look at European countries where they pay a hell of a lot less and — at least in the crude measures — get a lot more by way of mortality and morbidity? I’m not so sure, but probably so. I’ll just leave it at that.

MS. DYNAN: I think we have time for one more question.

SPEAKER: Given at least the anecdotal notion that increases in state health care expenses cause decreases in higher education spending, do you have any comments on midterm and long-term funding of higher education programs as a result of all these other factors that we’ve talked about?

MS. GORDON: I think that that perception has been borne out in some analysis. Peter Orszag, among others, has a paper looking at that sort of crowding out of higher education spending because of rising health care costs. Unfortunately, it’s one of the areas that is cut, or tuition is increased for students, which also reduces the state’s obligation. So yes, I do think there is going to be a lot of pressure on higher education budgets.

Governor Brown’s budget proposes $1.4 billion less in higher education spending. I’ve heard the president of Arizona State talk about this — that some colleges and universities are trying to come up with a strategic plan where they are less reliant on government funding, with the idea being that it might not come back. There might be room to increase tuition in some states more than others. Obviously, as you all know, there is a lot of heterogeneity out there, but it is going to be an issue in the years ahead.

MR. SCHULTZ: I wanted to add a tidbit on the business of education funding, which is that I think the Republicans have vowed — at least a large group within the Republican Party — have vowed that what they’re aiming at in the 2012 budget is something that would roll back nondefense discretionary spending to where it was in 2008. It turns out if you look at NSF research funding, doing that would reduce it by almost 20 percent. That’s in part because of a big jump since 2008 due to the America Competes program, but it would take it back 20 percent, whereas it would take back all the rest of nondefense discretionary spending only by about 7 percent. So God knows what’s going to go through in this political environment, but in that particular area there is a significant threat.

MS. DYNAN: I want to thank our panelists for their interesting insights. If you have questions about any of these areas, I do encourage you to reach out to our scholars or to me and we’d be happy to field further questions.

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