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The Good, the Bad and the UglySome of the
Economic ChallengesOur Next President will Face
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Outline

• To be discussed in reverse order
• The Ugly - the current financial crisis
• The Bad inequality, health care, social
  security
• The Good productivity growth

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The UglyorWhat Just Happened?
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Events Leading up to the Financial Crisis
1977 Carter signs the Community Reinvestment Act. Designed to provide credit to under-served populations, i.e. those with poor credit
1995 Clinton Administration amends CRA to increase access Amendments provide for the securitization of subprime mortgages
1996 Clinton Administration directs Fannie Mae and Freddie Mac to allocate 42 of mortgage financing to borrowers with income below the median for their area. This is later raised above 50 by Bush Administration
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Events Leading up to the Financial Crisis
Late 1990s- early 2000s Low interest rates and large foreign inflows help fuel the housing bubble.
2004-2006 Few realize the real risk. The risk premium on sub-prime mortgages is just an extra 1.3 percentage points Credit agencies give the mortgaged backed securities good ratings.
2005-2006 40 of all home purchases are for speculation or as vacation homes
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Timeline of the Last 14 Months
8/9/07 Liquidity crisis Fed and European Central bank begin injecting capital
3/08 Fed rescues Bear Stearns
9/8/08 Treasury nationalizes Fannie and Freddie
9/15/08 Lehman Brothers files for bankruptcy largest in U.S. history (600 billion in assets)
9/16/08 Fed makes bridge loan to A.I.G., the largest insurance company in the world.
10/3/08 Government passes bailout authorizes Treasury to spend up to 700 billion
10/31/08 Dow is down 34 since its peak last October
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Didnt Any Officials Foresee the Crisis?
From the NY Times September 11, 2003 The Bush
administration today recommended the most
significant regulatory overhaul in the housing
finance industry since the savings and loan
crisis a decade ago. Under the plan, a new
agency would be created within the Treasury
Department to assume supervision of Fannie Mae
and Freddie Mac Fannie Mae and Freddie Mac have
been criticized by rivals for exerting too much
influence over their regulators. Among the
groups denouncing the proposal today were the
National Association of Home Builders and
Congressional Democrats who fear that tighter
regulation of the companies could sharply reduce
their commitment to financing low-income and
affordable housing. ''These two entities --
Fannie Mae and Freddie Mac -- are not facing any
kind of financial crisis,'' said Representative
Barney Frank of Massachusetts, the ranking
Democrat on the Financial Services Committee.
''The more people exaggerate these problems, the
more pressure there is on these companies, the
less we will see in terms of affordable
housing.''
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The Lesson for the Next PresidentGood
intentions are not enough
The best of intentions (extending home ownership
to low income individuals) has led to the worst
of crises. Everyone, especially low income
individuals, will be much worse off as a result.
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The Fallout
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The Bubble Bursts
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The Effects Spread

• 1 in 6 homeowners owes more on mortgage than the
  house is worth
• Foreclosures have climbed dramatically, jumping
  71 in the 3rd quarter of 2008 relative to year
  earlier
• Worldwide credit markets have seized up no one
  trusts anyone elses balance sheet
• The stock market has plunged

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Credit Markets Seize Up
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The Stock Market Crashes
Source Shiller, updated to Oct. 24, 2008
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- 27, 4 yrs to recover peak
- 81, 29 yrs to recover peak
- 53, 16 yrs to recover peak
- 67, 20 yrs to recover peak
- 46, has not recovered peak
- 34, 2 yrs to recover peak
Source My calculations based on Shillers data.
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Employment has been declining since Jan.
2008 Employment is expected to plummet in the
October report.
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What can the government do?

• The attempts by the Treasury and the Fed to
  provide liquidity to financial markets and
  recapitalize banks are the best hope.
• The potential effects of more fiscal stimulus are
  uncertain. Consider the effects of the recent
  tax rebate

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The Effects of the Recent Tax Rebates
Tax rebate
After-tax income
Consumer expenditures
Saving rate
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Bottom Line on Current Crisis

• We will probably have a moderate to severe
  recession because of the fallout from the
  subprime mortgage debacle.
• If government feels compelled to try a stimulus
  package, infrastructure investment would be best.
  At least spending on infrastructure would have
  some side benefits, even if it didnt stimulate
  the economy.

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Some Long-term Economic Challenges

• Income Inequality
• Health Care
• Social Security and Medicare
• Global Warming (I wont have time to discuss)

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Income Inequality

• There has been a dramatic increase in income
  inequality in the U.S. since the late 1970s.
• Economists attribute the increase to factors such
  as technological change and globalization.

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Real Wage Growth by Education Level - Males
From Autor, Katz, Kearney (2005).
Composition-adjusted full-time weekly earnings.
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Real Wage Growth by Education Level - Females
From Autor, Katz, Kearney (2005).
Composition-adjusted full-time weekly earnings.
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Caveats (1) Recent research suggests that the
real wage growth of low income households has
been faster than we think. The price of goods
bought by low-income people have increased much
less than the general rate of inflation.
Adjusting for this effect eliminates 2/3 of the
increase in inequality. (2) Time use studies
show that those with higher education levels now
work longer hours and have less leisure than
those with less education. On average a high
school dropout has 9 hours more leisure per week
than someone with a graduate or professional
degree.

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Historical Perspective Income Share of the Top
10 of the Income Distribution, 1917 - 2006
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Comparison of France and US
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How Did France Prevent the Rise in Income
Inequality?

• High minimum wages
• Highly regulated labor markets
• Generous unemployment benefits
• Powerful unions

But at what cost?
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Unemployment Rate Trends in France vs. the U.S.
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Bottom Line on Wage Inequality

• Wage inequality has risen significantly since the
  1970s
• However, the well-being of lower wage individuals
  may be understated.
• Trying to decrease wage inequality through labor
  market restrictions might lead to higher
  unemployment.
• Obamas tax reforms do more to reduce inequality
  than McCains reforms.

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Health Care

• The U.S spends more than 15 of GDP on health
  care
• For the privately insured in 1960, 62 of
  expenses were paid out-of-pocket in 2006, only
  22 were paid out-of-pocket
• 16 of the population is without health insurance
• 27 of the population is covered by government
  health insurance

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Source OECD
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Source OECD
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Would we be better off with a national health
insurance system? Some Comparisons of U.S. and
Canada Current spending per person on health
care U.S. 5,700 Canada 3,000.
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Bottom line on Health Care

• All evidence points to gross inefficiencies in
  the U.S. health care system.
• Other countries have flaws in their systems, but
  they seem to be able to produce similar health
  outcomes at much lower cost.
• Reforming health care is one of the most
  difficult challenges facing our next president.
• Neither candidate has suggested the overhaul we
  really need.

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Social Security and Medicare

• The basic problems
• Too many retirees per worker (due to longer life
  expectancies and reduced fertility)
• - In 1960, 9 workers paid the bill for each
  retirees Social Security Benefits
• - By 2030, there will be only 2 workers
  available to pay the benefits for each Social
  Security recipient
• Medicare costs are rising dramatically

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Social Security and Medicare have dramatically
cut the poverty rates of the elderly.
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• A SUMMARY OF THE 2008 ANNUAL REPORTS
• Social Security and Medicare Boards of Trustees
• A MESSAGE TO THE PUBLIC
• The financial condition of the Social Security
  and Medicare programs remains problematic.
  Projected long run program costs are not
  sustainable under current financing arrangements.

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Projected Tax Income Shortfall, Percentage of GDP
Source Social Security and Medicare Board of
Trustees
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Bottom Line on Social Security and Medicare

• Either taxes must be raised or benefits must be
  cut.
• The problem with raising taxes is that it could
  discourage work.
• One way to cut benefits is to raise the
  retirement age.
• McCain has indicated that entitlements must be
  cut, Obama hasnt indicated that he will try to
  address this problem.

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The Good

• The U.S. is still a leader in productivity, which
  is the ultimate source of increases in standards
  of living.

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Recent US Productivity Growth has
Outperformed Other G-7 Countries
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Relative Labor Productivity, G-7 in 2007
Country Productivity (US 100)
Canada 81.4
France 100.9
Germany 91.8
Italy 73.7
Japan 71.0
UK 81.2
US 100.0
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Conclusion the next president faces many
economic challenges

• The Good The US continues to lead in
  productivity.
• The Bad Income inequality, the health care
  system, and the future of Social Security and
  Medicare are major challenges
• The Ugly the current financial crisis