Levy Economics Institute of Bard College Strategic Analysis December 2011 Is the recovery sustainable?

8/3/2019 Levy Economics Institute of Bard College Strategic Analysis December 2011 Is the recovery sustainable?

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Levy Economics Insti tute of Bard College

Strategic Analysis

December 2011

Is the recovery sustainable?

DIMITRI B. PAPADIMITRIOU, GREG HANNSGEN, AND GENNARO ZEZZA

Fiscal austerity is now a worldwide phenomenon. The United States andmany other countries are essentially importing fiscal austerity from troubledeconomies in Europe and elsewhere. This is one way of looking at thepredicament posed by the current world growth slowdown, which hasdeveloped during Americas weak recovery from the 200709 recession.Following the financial collapse of perhaps four countries in Western Europe,U.S. companies will not find much demand from their products abroad, mostlybecause it is extremely unlikely that a significant number of the affected

countries will be able to implement appropriate stimulus measures within evenone year. Rather, countries such as Greece, Portugal, and Ireland are beingforced to implement austerity measures as a condition for receivinginternational loans and bailouts, and some staggering giants such as theUnited Kingdom, Spain, and Italy are making deep budget cuts of their own.

Unfortunately, even before the collapse of the Greek and Italiangovernments and the debacle in the relatively large Italian bond market,forecasters were predicting weak economic growth in most of the world in thecoming months and years. Figure 1 contains bars corresponding toInternational Monetary Fund (IMF) growth-rate forecasts for this year and next

for some large nations, some groups of countries, and for the world. Theforecasts for the Eurozone are less than 2 percent and are the worst among allof the forecasts depicted in the figure. Also, the IMF forecasts that this regionwill experience even slower growth of 1.1 percent next year. The EuropeanUnions more recent forecast for its member countries was a grimmer 0.6percent. Overall, the advanced economies will grow at a 1.9 percent yearlyrate next year, according to the IMF numbers. The IMF expects a modestuptick next year in growth rates for many countries, but the important point isthat many very large countries are already in an abysmal slump, even as theeuro debt crisis intensifies and spreads. Moreover, as seen in the figure, eventhe economies of the developing world, which grew the most quickly last year,are expected to slow down at least modestly in 2012. Finally, some morerecent forecasts are even more downcast. In new figures released late lastmonth, the OECD has projected economic growth in the Eurozone at 1.6

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percent in 2011 and 0.2 percent in 2012 (OECD 2011). All official forecastersseem to recognize, if belatedly, the implications of the deepening of theEuropean fiscal crisis and related economic problems around the world.

Growth abroad is helpful to faltering economies, so the internationalslowdown documented by these forecasts is very unfavorable for the outlook ofpolicymakers at the national level. In these conditions, it will be hard for theUnited States even to turn a huge trade deficit into a moderate one, withouttransforming U.S. industry into an export leader, as Japan, Korea, and otherAsian nations did in the last half of the 20th century. This kind ofindustrialization has been a rare feat in world economic history, and it isunlikely that more than a handful of countries will follow in the footsteps ofJapan and other export-oriented, late-developing economies. To the extentthat more countries adopt an export-led growth strategy, they may accomplish

little more than drawing a small number of scarce customers away from otherexporting nations, who will also be counting on exports to lead domesticgrowth. IMF figures bear out this point of view. Figure 2 shows the currentaccount imbalances for various countries and economic blocs.

Bars corresponding to deficits appear below the horizontal line in thefigure; the bars above the line represent surplus countries and blocs. Since thedeficits and surpluses of all countries add up to zero (the balances of alltrading nations are included in the figures), the stack of bars above the line isas long as the stack below it. The scale on the y-axis measures fractions ofworld GDP. The black bars, which depict U.S. deficits for all the years shown in

the figure, shrank markedly during the recession of 200709. Last year, thedeficit once again began increasing. The IMF predicts further reduction of theU.S. current-account deficit through 2013, followed by a renewed expansion of

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this drain on demand for U.S. products beginning the following year. Through2014, the U.S. deficit is expected to fall from $468 billion to $273 billion. Thiswould amount to a reduction in the current account deficit of $194 billion, orabout 1.3 percent of the approximate U.S. GDP of $15 trillion. The currentshortfall in aggregate demand from the private, public, and foreign sectorscombined is far larger than this. The U.S. Bureau of Economic Analysisestimates that GDP was 6.7 percent below its potential level in the third

quarter of this year.While IMF is expecting a lesser role for export-led growth in China andGermany, it also expects other countries in emerging Asia to rely on exportsfor growth, so that the overall level of global imbalances stabilizes. Recentfigures suggest that the IMF may have, if anything, underestimated the pace ofexport growth in Germany, as that country is expected by some observers toset all-time records for export volumes in 2011 (Parkin 2011). As implied inthe chart, this requires other nations in the rest of the world to be willing toabsorb Asian imports by running a current account deficit. Since it is hard tobelieve that other developing countries will be able to sustain domestic growthwith an external deficit on this scale, IMF projections may prove to beinconsistent. To wit, overall import demand may be insufficient to enable theworlds economies to achieve the growth rates projected by the IMF.

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To estimate the impact of an export-led growth policy, intended to

reduce the current account deficit, we report the results of a simulation. Thescenario that we simulate assumes a 10 percent devaluation of the dollar,relative to a basket of world currencies. Figure 3 shows each of the three U.S.financial balances, which add up to zero, by accounting identities. They showhow each balance would change in our scenario relative to a baseline in whichthe value of the dollar is held constant through the end of the simulationperiod, in the fourth quarter of 2016. We focus on the uppermost line in thefigure, which corresponds to a simulated path for the current account balance.Following a one-time depreciation beginning next quarter, the line risesthroughout the simulation period. The response to our hypothetical

depreciation reaches +1 percent of GDP in 2012, but never surpasses +1.5percent of GDP at any point in the simulation period. quarter, the line risesthroughout the simulation period. The response to our hypotheticaldepreciation reaches +1 percent of GDP in 2012, but never surpasses +1.5percent of GDP at any point in the simulation period. As we see in a latersection, our baseline analysis shows that a far larger impetus to growth will berequired to restore the economy to health.

Turning to the domestic private sector, signs of hope do not abound evenin markets for such products as paper towels, wheat, or automobiles.Consumption is now growing again in real terms, as shown in Figure 4, where

we depict the percent change in consumption, wages, and personal disposableincome, all measured at constant prices and at an annual rate. It is interestingto note that the effects of fiscal stimulus, in both the 200102 recession and

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the recent Great Recession, are visible in the chart when disposable income sustained by net transfers from the public sector grows faster than wages.

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The chart also marks the end of the worst part of the recession, withaccelerating wage and disposable-income growth beginning in 2003 and 2010.

From the chart, it is also evident that the effects of the stimulus are now over,and with both real wages and real disposable income not growing in realterms, the recent increase in consumption will either be temporarily sustainedby an increase in borrowing, or possibly revised downwards with the next,

final release of GDP data from the B.E.A.Some domestic demand growth may come from nonresidential

investment. As shown in Figure 5, an increase in profits in the nonfinancialindustry is usually followed by an increase in investment, with a highcorrelation after a lag of about six quarters. We therefore expect that therecent strong surge in profits in this sector will sooner or later show up in

investment, which has started to pick up already. On the other hand, profits inthe financial industry have recovered from the Great Recession and thefinancial crisis, but the correlation between profits in this sector and grossinvestment is very small. We therefore expect no net contribution to aggregatedemand growth from the financial sector, even if the major U.S. banks manageto emerge from the Eurozone sovereign-debt crisis in relatively good shape.

The lack of strong growth in demand has kept unemployment at highlevels since early 2009. The ratio of employed people to total populationremains well below the levels that were first reached as women entered thelabor force in the 1970s and 1980s (see figure 6.) Results from the

governments most recent (September) Job Openings and Labor TurnoverSurvey show that there are about 3.4 million jobs looking for employees, while12.6 million Americans (5.6 million women and 6.9 million men) reported to

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the Census Bureau that they were completely unemployed and looking forwork in November (BLS 2011). In that month, more than 5.6 million peoplehad been looking for work for 27 weeks or more. Another 8.3 million wereworking part-time rather than full-time for economic reasons.

Meanwhile, the sudden intensification of the Euro debt crisis in November

led to an abrupt deterioration in consumer sentiment and to ripple effects inthe domestic financial sector. All of these developments have helped to bringmore pessimistic U.S. economic forecasts from all quarters.

Given this bleak situation in industries that must sell their products topaying customers at home or abroad, further fiscal stimulus is in order. But asin Europe, a particularly ill-timed round of fiscal austerity seems to be inprospect. In fact, as a result, Washington may be in a situation as perilous asthe one that Roosevelt faced in 1937 and 1938 (Bartlett 2011; Krugman2011). To wit, the lead-up to the recession in those years began with a politicaldefeat not unlike the one suffered by the Congressional Democrats in 2010s

off-year election.In 1936, having waged a bruising and largely unsuccessful campaign on

behalf of the Democratic Congress, he returned to the capital to find a moreconservative mood there. His Treasury secretary was advising sharp cuts in thedeficit. It appeared that strong growth had gained momentum, and thefinancial and business establishment was anxious to put an end to what itregarded as dangerous overspending. What followed was a cut in governmentstimulus that could not have been more decisive. The deficit, which hadsharply increased during Roosevelts first four-year term, plunged because ofdeliberate and untimely policy actions. Specifically, federal spending was cut

by about 7 percent in 1937 and 11 percent in 1938, while the introduction ofpayroll taxes for the new Social Security program resulted in a tax-revenueincrease of 38 percent in 1937 and another 24 percent the following year. Theresulting rise in the government balance predictably led to a new recessionwithin the Great Depression, with growth turning negative in 1938.

Against a similarly hostile political setting, President Obama was forcedin July to agree to a set of automatic spending cuts to discretionary spendingamounting to a total of $1.2 trillion over a 10-year period. These cuts were togo into effect if the Congressional supercommittee failed to come up withdeficit reductions of a similar size and get them approved by the Congress as a

whole and by the president. With the supercommittees deliberationsdeadlocked over the appropriate choice of spending cuts and tax increases, theautomatic cuts will begin to go into effect in January 2013, probably resultingin massive layoffs of federal government workers.

Obamas most recent stimulus proposalwhich amounted to $447 billionin deficit-neutral changes to taxes and spending programsfoundered on theCongressional rocks. The plan contained provisions for cutting corporatesubsidies and reforming the tax code that lent credibility to theadministrations description of the bill as deficit-neutral. In other words, ifpassed without amendment, the bill would have paid for itself. Keynesiantheory suggests that the multiplier for new spending that is exactly matchedwith new taxes is equal to one. This means that $1 in new spending coupled

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with $1 in new taxes raises overall GDP by $1.1 This plan has unfortunatelyfailed in Congress, where Republicans continue to insist on cuts for largerbusinesses and wealthy taxpayers, as well as a virtual ban on new spending.Only a few, relatively minor provisions in the bill have made it through

Congress so far.The main economic proposals offered by the Republican presidential

candidates similarly purport to be revenue neutral, leaving the deficitunaffected, once both tax cuts and increases are taken into account. Thecandidates plans for flat taxes, sales taxes, and other tax reforms would tiltthe burden of taxation further toward the middle and lower classes. Theirpositions tend toward cutting spending above all else, regardless of the state ofthe economy and the labor market. Their speeches hold out little hope that thisanti-Keynesian approach will bring prosperous times or help the country growstronger in any other way; rather, they only rail against government

interference and the governments purportedly illegitimate use of money forwhat the candidates regard as inevitably frivolous expenditures. This emphasiscontrasts with the substance of the AJA, which includes practical and simpleitems such as money to help localities avoid cutting police, firefighters, andteachers.

1 However, this simple rule of thumb assumes that everyone will spend the same percentage of any new disposableincome that they receive. Obamas bill and its Democratic counterparts in Congress are geared toward helping the

poor and middle-income classes, who are more likely than the rich to spend new income right away (White House2011). For example, the largest item in this stimulus package was an extension of last years Social Security tax cut

for employees through 2012, a cut that would cost some $240 billion. This payroll tax is applied at a flat rate, startingwith the first dollar of earnings each tax year; the amount of earnings subject to these taxes is currently capped at$110,100. Clearly, the tax is regressive, though the formula used to calculate benefit amounts is designed to favor

people with lower earnings.

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But many groundbreaking and major projects also remain to be doneasand need to be completed as soon as possible. One need only think of thenations potholed roads and meager disaster preparations to see that stimulusspending need not be spending for spendings sake, or for the enrichment ofan elite. The American Society of Civil Engineers (ASCE) keeps track the

nations efforts to keep ahead of the decay of bridges, roads, pipelines,drinking water systems, etc. In its latest report, it gave U.S. infrastructure lowratings once again (ASCE 2009). Only one category of infrastructure energy has increased its mark above its 2005 level (p. 1). Even this rating was aD+. As one example of the ASCEs concerns, their report estimated thenations five-year shortfall in public infrastructure spending at nearly $550billion in the roads and bridges category alone (p. 7). Figure 7 shows theUnited States has lagged behind most industrialized countries in this regard. Inother words, we are among the countries that have directed the mostresources to higher individual consumption and private investment, as opposed

to the construction and maintenance of long-lasting public goods. The need forimproved and better-maintained infrastructure is seemingly evident to almosteveryone but various political candidates vying to establish their conservativebona fides in the struggle for the Republican presidential nomination.

As a final example, how about investments in care work (Antonopouloset al. 2010; Kim and Antonopoulos 2011)? This term refers to labor-intensiveservices such as home health-care work, preschool, and day care for children.New jobs in this area could be created simply by scaling up a number ofexisting federal, state, and local government programs. These include HeadStart, which has never been fully funded, and home-based care provided by

Medicaid, which has unfortunately lost its funding in some states.Thus, Keynesian stimulus need not involve make-work, though simply

putting people to work is relevant any time there is a large supply of availableand even desperate workers. Rather, infrastructure work answers an importantlong-term need. Also, researchers and ordinary Americans dont have to lookhard in their localities to find families who badly need help with child care,health care, and other services that involve labor-intensive care work.

Right-wing economists claim to be able to show that the governmentspending multiplier is less than oneeven when the spending involved is paidfor by selling bonds. Figures cited in some of their opinion pieces in the press

purport to show that a $100 increase in government spending would decreaseGDP or increase it by at most a few dollars (Barro 2011). Figures of this typetend to be repeated in the media, but they lack a solid basis in facts and logic.

It can be put no more plainly than by Alan Blinder in a recent newspaperarticle: In sum, you may view any particular public-spending program aswasteful, inefficient, leading to big government or objectionable on othergrounds. But if its not financed with higher taxes, and if it doesnt drive upinterest rates, its hard to see how it can destroy jobs (2011). By definition,when the government hires people to work for the government or buys goodsfrom the private sector, it is undertaking economic activity that counts as partof officially measured GDP. As long as these activities do not cause thebusiness sector to reduce its total output of goods and services, they will

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immediately increase GDP at least dollar-for-dollar as government spendingincreases.

Moreover, it is hard to escape the conclusion that government spendinghas an additional multiplier effect. Namely, people who are hired by thegovernment or by government contractors tend to contribute most of their

paychecks toward household purchases, broadly defined. Hence, one wouldtend to assume that the effects on GDP of a $100 increase in governmentspending would be a multiple of the original spending increase. For example,suppose for a moment that such a spending increase leads to a $60 increase inthe after-tax income of workers households. The household savings rate in theUnited States is currently about 6 percent, and has not been above 10 percentin the last 20 years. Hence, it seems reasonable to guess that governmentworkers households would save roughly 6 percent of a $60 increase in theirpaychecks, or $3.60. This would leave $56.40 for new household purchases.Hence, including first- and second-round effects, our hypothetical $100

stimulus would increase GDP by a total of $156.40.As suggested above, orthodox economic theory sometimes suggests that

multiplier effects may be much smaller than in this example (Barro 2011).Many economists believe that households tend to save a much higherpercentage of increases in their incomes than 6 or even 10 percent. Theyargue that unless people know their incomes will remain at increased levels fora fairly long time, they will increase their household expenditures by much lessthan one dollar for each dollar of new disposable income. They often usemodels that rely upon the existence of a measurable human preference tospread purchases out over ones entire lifetime. In behavioral studies, such

economic theories often prove inadequate as explanations of observedconsumer spending habits. For example, many consumers will wait months fora much-anticipated check to come in the mail before committing the fundsrepresented by the check toward new purchases.

Many stimulus skeptics have gotten used to the idea that the Fed is farbetter suited than the Congress and the President to deal with a lack ofaggregate demand. In other words, we should just lower short- and long-terminterest rates further and wait for the business sector to respond withincreased investment. Indeed, proposals for new types of monetary-policystimulus continue to emanate from the academy, including nominal-GDP

targeting (Romer 2011). This would be quite a departure from the Feds defacto practice of informally targeting an acceptable range of inflation rates andtreating growth as a secondary objective. In general, the academic literature isskeptical of claims that interest rate changes substantially affect corporateinvestment. Hence, it seems likely that the Feds actions are aimed at stocksand at the housing market, where prices are still falling. Real price indices forthese markets are shown in figure 8. It is clear from the figure that theeconomic progress since the official end of the last recession relied at least to asignificant extent on a rising stock market.

Even the business-oriented Fed itself has been pointing out that in thisera of contraction and stagnation, restoring growth will require more thanreadily accessible loansprobably much more. Daniel Tarullo, a Fed governorand member of the Feds policy-setting committee has pointed out that

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neither monetary nor fiscal policy will be able to fill the whole aggregatedemand shortfall quickly. But appropriate policies could surely boost output

and employment (2011, p. 6). He goes on to attack the red herring thatunemployment is high mostly because of structural problems in the labormarket, such as a workforce that is largely ill-qualified for work in the keyindustries that are still hiring. Such comments are a measure of theextraordinary seriousness of the current crisis. In fact, the Feds recent pleasfor additional stimulus legislation represent a real departure from thatinstitutions usual fiscally cautious approach. During the past 30 years has theFed done nothing more frequently in Congressional hearings than urgelegislators to cut fiscal deficits.

There are several reasons that in our view tend to justify Tarullos views

on the power of monetary stimulus to awaken the stagnant economy. First,nonfinancial corporations are already sitting on at least $2 trillion in cash.Specifically, the most recent flow-of-funds data report from the Fed Board ofGovernors noted the following assets on the books of nonfinancial, nonfarm,corporate business: $84.2 billion in deposits in foreign countries; $501.8 inchecking accounts in the United States; $574.5 billion in time deposits andsavings accounts; $479.7 billion in money market funds; $77.0 billion incommercial paper; $46.1 in Treasury securities; $15.4 billion in certain othertypes of federal securities; and $235.5 billion in mutual fund shares (FederalReserve, 2011c). Second, banks had about $1.5 trillion of excess reserves on

their balance sheets as of early November (Federal Reserve 2011a) and areoffering extremely low rates for many kinds of loans, such as mortgages.Third, loan officers are apparently still pessimistic about the chances that

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business borrowers will repay their loans on time and with interest, givenfinancial and economic conditions. Fewer loan officers report easing theirlending standards in October than in previous months (Federal Reserve Boardof Governors 2011d). Even major Fed policy actions will not easily changelenders minds about the riskiness of lending during this financial and economic

crisis of sorts. The data depicted in Figure 9 suggest that low interest rates andreduced mortgage lending have lowered the burden of servicing existinghousehold debt, but an aura of financial caution seems likely to prevailfollowing the traumas of the subprime crisis. The deleveraging process hasreversed a long rise in household borrowing, but as seen in the figure the costof servicing household loans is no lower than it was in the aftermath of themuch milder recessions of the early 1980s and early 1990s. Once again, weare reminded of the high likelihood that demand will be weak in the comingmonths and years in the absence ofincreased fiscal stimulus.

Our baseline forecast remains glum

As usual in work for our strategic analysis series, we have conducted abaseline simulation based on various given conditions, which include officialforecasts for the future paths of the deficit and growth in the rest of the world.The baseline forecast assumes no change in the value of the dollar and deficitlevels consistent with the bipartisan Congressional Budget Offices most recent

no-change scenario (CBO 2011). The prices of oil and other commodities areassumed to grow at an annual rate of 2 percent throughout the simulationperiod. Next, we assume that interest rates will remain at current levels. We

posit gradually rising rates of business and household borrowing.As shown in Figure 10, the results of our simulation show that given the

assumptions above, growth will be remain very weak indeed. The results show

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a path that begins with growth of a bit more than 2 percent in 2012. The paththen falls somewhat and stays between 1.5 and 2 percent through 2016.Growth of this magnitude does not generate sufficient demand for labor,according to the results shown in Figure 12. The line in the figurecorresponding to our baseline estimates indicates that unemployment will fallslightly in 2012, and then rise again, remaining somewhat above 9 percent upto our forecast horizon. Figure 10 shows that in our baseline scenario, thegeneral government budget deficit (that of all levels of government combined)falls significantly, while the debt increases, reaching 94 percent of GDP by the

end of 2016. The private sector deficit, also shown in the figure, is nownegative, meaning that saving exceeds investment in that sector. During thesimulation period, the absolute size o this deficit also falls, an outcome thatindicates more borrowing and/or less lending by the private sector. Finally,reflecting the fall in the private sector and current account deficits, the currentaccount balance gradually rises to zero by the end point of the simulationarebalancing act that could end with the economy falling over anyway.

In other words, if our assumptions hold true, recent fears of a prolongedstagnation of output and employment levels are well justified.

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Scenario 1 indicates that the austerity ahead will only make thingsworse

As pointed out above, the federal government will soon be forced toimplement large budget cuts, which will add up to a total of $1.2 trillion overten years, starting in 2013. In Scenario 1, we modify the assumptions used inour baseline simulation, attempting to simulate the effect of new austeritymeasures of a similar magnitude. However, we assume that the spending cutsall occur between the next fiscal year and the end of our simulation period.Specifically, spending and net transfers are reduced relative to the baseline,

beginning in the fourth quarter of 2012, in amounts that add up to $1.5 trillionthrough the end of the simulation period in the fourth quarter of 2016.

In the case of government spending cuts, the multiplier effect works inthe direction of reducing economic growth rather than increasing it, relative tothe outcome of the baseline scenario. Hence, growth remains stable atbetween 2.3 and 2.8 percent per year during calendar year 2012, as depictedin Figure 11. It then falls as low as approximately 0.06 percent in the secondquarter of 2014, before leveling off at around 1 percent for most of the rest ofthe simulation period.

The figure also shows the nations three financial balances. As seen

there, the government deficit falls gradually to about 0.2 percent, reflectingboth spending cuts and reductions in revenue that occur because of lower GDPgrowth rates. The private sector deficit also moves fairly steadily toward

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balance, reaching as high 2.6 percent at the end of the simulation period.This private-sector rebalancing is faster than the one in the baseline scenario,

mostly because the government deficit falls more quickly in this case.The total deficit of the two domestic sectors, which equals the negative

of the current account balance, moves above 2.4 percent by the end of thesimulation period. This reversal occurs largely because slow domestic growthtends to reduce imports relative to exports. It is likely that such a reduction ofimport demand would cause severe consequences for foreign economies thatexport to the United States. These consequences would reverberate among alltrading nations, including the United States.

Not surprisingly, given the sharp expenditure cuts and the lack of adevaluation in this scenario, unemployment gets worse, rising to 10.7 percent

by the fourth quarter of 2016. (Again, see Figure 12.)

Scenario 2 shows that even a frugal stimulus package would be of greathelp

In Scenario 2, we conduct a fiscal stimulus experiment. The modeststimulus package considered in this exercise is made up of two components:1) an extension of the 2 percent reduction in federal payroll taxes that wentinto effect earlier this year; and 2) an increase in outlays large enough to yielda reduction of unemployment to approximately 7 percent by 2016. We foundthe appropriate increase in outlays by starting with the baseline CBO fiscal-policy assumptions and adjusting total government expenditures and transfers

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until we found a path that reached the 7 percent unemployment rate objectivein 2016.

Again, we begin our discussion with projected growth rates. As shown inFigure 13, the additional stimulus assumed in Scenario 2 increases real GDPgrowth very quickly. Growth rises to 2.4 percent in the first quarter of 2012,

and continues to increase, peaking at 4.0 percent in the first quarter of 2013.The effect of the stimulus gradually subsides, causing the growth rate to fallgradually, starting in the first quarter of 2013. Yet the growth rate remains ata reasonably strong 3.0 percent even at the end of the simulation period.

The same figure shows that the government deficit declines fairlysharply, despite the implementation of the tax-cut extension and the spendingincrease. The projected fourth quarter, 2016 deficit of 6.5 percent of GDPexceeds our baseline, but may sound remarkably low, given the hysteria aboutdeficits currently found in much of the news media. As mentioned earlier, theprivate-sector deficit is now negative, reflecting households and businesses

tendencies to keep spending low as they deleverage from the excess borrowingof the boom years that preceded the Great Recession. Returning to Figure 13,we see that our scenario 2 stimulus plan causes the private sector to beginspending more, leading the private-sector deficit to rise upward, though itremains below 4.6 percent throughout the simulation period.

Finally, the current account balance continues its rising trend accordingto our simulation results, beginning with a deficit of 2.9 percent in the fourthquarter of 2011 and reaching approximately 1.9 percent by the end of 2016.These figures show welcome progress from the much-larger current accountdeficit of around 6.5 percent of GDP run by the United States about 6 years

ago, in the fourth quarter of 2005, despite the administration of a serious doseof fiscal stimulus.

According to our simulation, the stimulus package does raise the ratio ofgovernment debt to GDP, as seen in Figure 14. The increased deficits in thislast scenario cause total government debt to rise somewhat relative to ourbaseline numbers, but not by much: 97.4 percent of GDP in Scenario 2 versus94.4 percent of GDP in the baseline and 91.1 percent in Scenario 1. Thisdifference in the path of the government debt/GDP ratio is relatively small,because the assumed fiscal stimulus package has the effect of increasing thedenominator of the ratio as well as its numerator.

Possible impact of a Eurozone crisis

Our simulations have been based on the latest IMF projections for worldgrowth, discussed earlier on, which do not take into account recent events inthe Eurozone. It is thus interesting to evaluate how a further slow-down in theEurozone, or possibly a financial crisis, might affect our simulation results.

The importance of the Euro area has declined steadily as a market forU.S. exports: while its weight was over 24 percent in the 1970s, it nowaccounts for only about 16 percent of total U.S. exports, while other countries,

mostly in Asia, have increased their relative importance for U.S. trade. Slowergrowth in Europe will thus have an impact on U.S. exports, and therefore onU.S. growth and employment, but one of limited size.

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On the other hand, a financial crisis that affects the value of U.S. assetsheld abroad in the Eurozone may have a much more significant impact on netU.S. financial wealth, which in turn is an important determinant of privateexpenditure, according to our model.

Figure 15 breaks down the total value of U.S. debt securities (bonds,notes, bills, etc.) by country of origin. As seen in the figure, Greece, Ireland,and Portugal contributed a fairly modest slice of U.S. debt-security portfolios

as of 2009, according to the latest available IMF figures. On the other hand, allEuropean economies are at risk. For example, Italy has been running a budgetsurplus, not including interest payments of course, but bond markets havebeen spurning new securities offerings, leading to escalating yields on thesovereign debt of that country. Also, the United Kingdom, which still enjoys thebenefits of low interest rates, has nonetheless been rapidly implementingharsh fiscal austerity measures, and may already be caught in a spiral of lowgrowth, falling tax revenues, rising debt, and government spending cuts. Asseen in the figure, that country accounts for more than 20 percent of total debtsecurities holdings in the United States. So, even though the United States is

not directly holding a large percentage of its financial assets in troubledEurozone countries, its assets in the U.K. and other international financialcenters may be significantly affected by a financial crisis in the Euro area.Many of the worlds central banks have been intervening to lend to these debtmarkets, attempting to prevent a financial collapse. Such a collapse wouldthreaten the world economy with a crisis perhaps much more severe than theone that followed the bankruptcy of Lehman Brothers in 2008. The U.S.government must take this threat far more seriously. It could do no betterthan to prevent itself from sliding into a recession that contributes to a chainreaction of defaults and misery.

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Parkin, Brian. 2011. Exports to Breach $1.3 Trillion in Sales for 2011, Shrugging Off Debt Woes.Bloomberg. November 29. www.bloomberg.com/news/2011-11-29/german-exports-breach-eu1-trillion_sales.html

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Documents

Levy Economics Institute of Bard College Strategic Analysis December 2011 Is the recovery sustainable?