Prospects for the Financial Markets

Speaker:Donald Kohn

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.

Figure 1. Bonds/Treasuries Spread
Source: 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 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.

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 quite done it yet.  And maybe it’s only by comparison to whatever other options you have to invest in.  So the flight to quality drove down the rates.  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.

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 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.

Figure 4. Loan Terms
Source: Fed

The upper left of the figure shows the tightening standards for business loans.  Look at that spike in 2008 and 2009.  Those markets just shut down.  Banks tightened up very, very substantially.  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 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 low, you’ll just automatically get that.

Figure 5. FOMC Objectives
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 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.  Think about the maximum employment objective.  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, mid-7’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.  So, definitely missing on that first objective.  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, inflation is low.  We’ve got to ease monetary policy.  And so we would lower short-term interest rates.  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.  The discount rate goes down as those interest rates go down.  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.

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.  What determines those intermediate and long-term rates?  One of the really important determinants is what people expect to happen to short-term 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.  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 mid-2013.  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 long-term interest rates by buying long-term debt.  We don’t really have to issue reserves to do that.  We can just sell some of the 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.  The effect of that is lowering long-term interest rates.  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 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.  I think they do work, but not as well as you might hope or wish.  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.  It has tended to help buoy the stock market.  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.  Maybe we’re seeing a few faint glimmers, but not much yet.  I think the fact that housing hasn’t really responded and, if anything, has remained extremely weak, has detracted from the effectiveness of the extraordinarily low interest rates that we have now.

The 10-year real interest rate — the inflation-protected 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.  We haven’t had a boom.  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 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 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.  It drives up stock prices.  It lowers the exchange rate.  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.  Some hedge funds went out of business because of it.  So I do think everybody’s going to be a little bit worried 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.  There is also concern about capital flows.  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.  It’s not the major part, but it is part of it.  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.

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.  We are making policy in a globally interconnected world.  We need to be aware of what those spillovers are.  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 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 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 value-added 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 value-added 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, 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.  I think it’d really be a good idea.

SPEAKER:  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 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.

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