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How to Save the World

Winter 2008/2009 |
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Dear Mr. President:

By now, you are painfully aware of the gravity of the economic crisis you will soon inherit. It is clear that this is no ordinary business-cycle downturn. The crisis is the product of the bursting of one of the largest credit and asset bubbles in modern financial history that has set off a painful deleveraging process in America's household and financial sectors. This deleveraging process has now spread across other sectors of the world economy. In fact,few countries have been immune from falling asset prices and collapsing financial institutions, or from falling demand for their goods and services. This is the stuff great depressions are made of, and that is why Time magazine devoted its November 24 cover to you, Mr. President, in the guise of FDR.

Unfortunately, the outgoing administration was often one step behind the curve in dealing with this fast-moving crisis. You will therefore need to anticipate the condition the economy will be in when you take office and the risks that require your urgent attention. Over the past several months, the Federal Reserve and Treasury have undertaken extraordinary measures--from extending federal guarantees to most parts of the financial system to direct capital injections into the nation's leading banks--to unfreeze the credit markets and prevent the collapse of the nation's economy. The European Central Bank and the central banks of Britain, Switzerland, Japan, and other countries have also stepped forward to inject money into the world's banking systems. Nearly all of the G-20 economies have approved some form of stimulus to try to offset the downward pressure on their economies.

Yet, as you know, these measures have not been enough to stop the rapid deterioration of the economy. By the time you take office, unemployment will have ticked up another point or two; more businesses, including U.S. automakers, will be on the brink of failure; and budget-strapped state and local governments will have been forced to lay off more people and cut social services.

Thus, there is a risk that cascading job losses and bankruptcies could further destabilize the American financial system, adding to the danger of deflation taking hold. What is worse, the crisis will have taken its toll on a number of emerging and newly developed economies, requiring more international rescues of the kind that have already been undertaken in the cases of Iceland and Hungary.

It is therefore not too much of an exaggeration to say that the fate of the world economy rests on the recovery program you pursue upon taking office. It also depends upon the international cooperation you are able to organize around a coordinated global economic recovery.

As you surely recognize, this crisis is increasingly global in scope and is clearly too big for the United States to handle alone. We will need to see more coordinated rate cuts, financial injections, sovereign debt rescues, and fiscal policy expansion on the part of G-20 governments if we hope to avoid a deep and protracted world recession-if not a global depression. At the same time, you must design your economic recovery program not just with the goal of preventing the worst from happening. You must also structure the program with the objective of putting the American and world economies onto a new, more sustainable growth path--one that does not depend upon debt-financed consumption in the United States to drive global economic growth, as it has over the past decade. In this sense, you will be judged not only on whether you have avoided the worst but also on whether your program has made the U.S. and world economies stronger and more productive in the longer term.

Redesigning Recovery

The two-year economic recovery package you have broadly outlined--extension of unemployment benefits, assistance to state and local governments, middle class tax cuts, incentives for green technology, and some infrastructure spending--is a clear improvement over the first stimulus package Congress passed in February 2008. Yet it still falls far short of what is needed given the nature of the economic crisis.

To begin with, your program is too short in duration to generate a sustainable recovery. I know you have been told by your economic advisers that stimulus is best if it is made temporary, especially if you are concerned about inflation down the road. But as the experience of Japan in the 1990s suggests, economies suffering from burst credit and housing bubbles tend to relapse once the short-term stimulus is taken away. This recession could be particularly long because many American households are seriously over-leveraged and are experiencing a decline in the value of their homes. With home prices falling, many households are no longer able to maintain consumption levels by tapping home equity as they have in the past. Moreover, with unemployment rising, they cannot easily or quickly replace the credit they previously relied on with new sources of income. Thus they will have no choice but to cut consumption and increase savings. In light of the fact that housing markets by their nature are slow to correct, this household deleveraging process could take years to play out. Household consumption, which at its peak accounted for more than 70 percent of the economy, may thus be a drag for some time to come--at least until wages rise or home values begin to increase again.

Second, your program, although bigger than the initial proposal, is still too modest to make a substantial difference to an economy damaged by the unwinding of the bursting of the housing and credit bubbles. You should note that economists as politically diverse as Paul Krugman, Stephen Roach, and Ben Stein agree that you should err on the side of overkill and that a massive recovery package is called for. Even the bursting of the tech bubble in April 2000, which had relatively little impact on most Americans and resulted in only a modest increase in unemployment, required a fiscal stimulus the equivalent of more than 6 percent of gross domestic product (GDP) (measured by the increase in the budget deficit) over a three-year period, in addition to 16 cuts in the federal funds rates to 1 percent. In light of the much larger effect housing and credit has on consumption and employment, the unwinding of the housing and credit bubbles will require an even larger stimulus.

Third, even with the addition of incentives for green technology and increased infrastructure spending, your package is still too heavily weighted toward short-term consumption and not enough on job creating investment. Thus, to the extent your package is successful, it will merely reinforce a suboptimal and ultimately unsustainable pattern of economic growth that over the past decade has been too dependent on debt-financed consumption and inflated asset prices. The root cause of this suboptimal pattern of growth has been the excess savings generated by the Asian export economies and the petro-dollar states of the Persian Gulf, which were recycled into the U.S. financial system, fueling the credit and housing bubbles. The housing bubble in turn helped inflate consumption, as U.S. households took advantage of poorly regulated new financial instruments to purchase more expensive homes and tap rising home equity. Domestic consumption in turn helped drive Asian export growth, resulting in even larger trade surpluses. The weakness in this pattern of economic growth lay in the fact that U.S. consumption was made possible not by real wage and income gains but by unsustainable increases in home prices and household debt.

Seen from this perspective, the bursting of the housing and credit bubbles was a necessary, albeit painful, adjustment in the pattern of U.S. and world economic growth. The goal of your recovery program, therefore, must not be to recreate this pattern with more short-term, consumer-oriented stimulus but to steer the economy onto a more sustainable growth path. Future economic growth should be driven less by debt-financed consumption and more by investment that leads to the creation of good jobs and rising wages, and by rising exports to those economies that have underconsumed for much of the past decade.

A new economic recovery program would obviously include measures such as the extension of unemployment insurance or assistance to state and local governments to ease the adjustment many households are now experiencing. But these worthwhile measures are no substitute for what must be the overriding goal of your economic recovery program, namely finding a big, new source of economic growth that can replace personal consumption as the main driver of economic growth and job creation in the short term and that, over the medium term, can lead to higher wages and incomes to support increased household consumption.

There are two areas of enormous pent-up demand on which such a recovery program can be based. The first and most important is the critical U.S. need for public infrastructure improvements in everything from roads and bridges to broadband and air traffic control systems to new energy infrastructure. We not only need to repair large parts of our existing basic infrastructure but also put in place the twenty-first century infrastructure for a more energy-efficient and technologically advanced society. This project, entailing several trillion dollars in new government spending over the next decade, would provide millions of new jobs for American workers.

The other significant source of potential growth is the enormous pent-up demand in China and other emerging economies for both consumer goods and the productivity enhancing and energy-efficient technology needed to sustain both corporate profitability and rising living standards. For years now, these economies have suppressed domestic demand at the expense of the living standards of their workers and have been able to use low wages to offset the rising cost of energy and other materials. But with the American consumer laid low by the housing and credit crisis, relying on exports is no longer a viable growth strategy. These economies will have to do more to generate their own consumer demand to offset the slower rate of consumption in the United States. And with higher energy prices looming again in the future, they must also do more to increase productivity and energy efficiency by increasing their investments in technology.

This shift in growth on the part of high-savings but energy-inefficient economies like China will increase demand for U.S. goods and services, allowing the United States to improve its trade balance and remove a drag on economic growth. In particular, it will help fuel demand for American technology across a broad range of new growth clusters where U.S. companies enjoy a leadership position or, with new investment, might assume such a role in the future. These areas include not just such traditional American strengths as aerospace, information technology, and networking, but emerging growth areas associated with what might be called the "triple green revolution" in agriculture, efficiency enhancing clean technology, and renewable energy sources. Your recovery program, Mr. President, should be designed with this ultimate goal of spurring demand for American technology.

Public Infrastructure Investment

The main pillar of your economic recovery program must be a massive increase in public infrastructure investment, in part because it would provide a sustained boost to job creation and also the foundation for private investment in the productive economy.

There is increasing public recognition that two decades of underinvestment in public infrastructure has created a backlog of public infrastructure needs that is undermining our economy's efficiency and costing us billions in lost income and economic growth. The American Society of Civil Engineers estimates that we need to spend $1.6 trillion over the next five years to bring our basic infrastructure--roads, rail, bridges, mass transit--up to world standards. In addition, we need to spend sizeable sums in newer areas of infrastructure, like broadband access and new energy infrastructure for wind, solar, and clean coal.

Public investment of this magnitude would give a significant boost to the economy, filling the gap left by the fall off in housing construction and consumer spending, while laying the foundation for expanded productivity. Indeed, public infrastructure investment is the most effective way to increase demand and investment at the same time, and thus the best way to counter an economic slowdown caused by the unwinding of the housing and credit bubbles. If, in spite of low interest rates, companies will not commit to more investment spending because of weak demand or uncertainty, the best way to jump-start investment will be to do so by increasing public outlays. Public investment in turn will help stimulate new private investment by increasing the efficiency and potential returns, and by adding demand to the overall economy.

Public infrastructure investment would have the advantage of creating more jobs, particularly more good jobs, and thus would help counter the negative employment effects of the collapsing housing bubble. For example, the U.S. Department of Transportation estimates that for every $1 billion in federal highway investment, 47,500 jobs would be created, directly and indirectly. Similarly, an analysis by the California Infrastructure Coalition concludes that each $1 billion in transit system improvements, including roadways, would produce 18,000 direct new jobs and nearly the same level of induced indirect investment. If all public infrastructure investment created jobs at the same rate as transit improvements in California, $300 billion in new infrastructure investment spread over two years would create more than 5.4 million jobs directly, more than offsetting the jobs lost since the bursting of the housing bubble.

Public infrastructure investment not only creates jobs but generates a healthy multiplier effect throughout the economy by creating demand for materials and services. The U.S. Department of Transportation estimates that for every $1 billion invested in federal highways more than $6.2 billion in economic activity would be generated. Mark Zandi, chief economist at Moody's Economy.com, offers a more conservative but still impressive estimate of the multiplier effect of infrastructure spending, calculating that every dollar of increased infrastructure spending would generate a $1.59 increase in GDP. By comparison, a combination of tax cuts and rebates is estimated to produce only 67 cents in demand for every dollar of lower taxes. Thus, by Zandi's conservative estimates, $300 billion in infrastructure spending would generate a nearly $480 billion increase (or close to a 4 percent increase) in GDP in the first two years alone.

Public infrastructure investment would not only help stimulate the economy in the short term but help make it more productive over the long term. America's current economic structure--relying heavily on financial services, entertainment, and certain tech industries--reflects our low investment in public infrastructure over the past two decades. However, many of the potential new growth sectors of the economy (agriculture, energy, and clean technology) will require major improvements or new public infrastructure altogether: new transmission grids to tap the potential of wind and solar power in the Southwest and the Great Plains, better broadband access, new airports to support the growth of agribusiness and new tech companies in the lower-cost areas of the American heartland, and a new generation of information technology to reduce traffic congestion and speed up all manner of transactions.

Finally, by making public infrastructure investment the centerpiece of your economic recovery program, you would send a signal to the rest of the world that you plan to move the U.S. economy away from its dependence on debt-financed consumption, to strengthen the productive economy, and create jobs in the United States. This would have two positive effects: it would help attract new foreign investment into the United States and underscore the need for China, Japan, and other Asian export dependent economies to do more to expand their own domestic demand.

A Coordinated Global Recovery

The U.S. economy is no longer in a position to be the demand locomotive that pulls the rest of the world out of recession. Other economies will need to pull alongside ours.

Indeed, they will need to do some heavy lifting if we are to rebalance the world and avoid a protracted global economic slowdown. But there is a danger that, rather than being an engine for recovery, slumping economies in Europe and Asia could prove to be a drag on our recovery. You must therefore have a well-thought-out international economic strategy to complement your domestic economic recovery program.

The global glut of savings produced by China, Japan, Germany, and the petrodollar states was a major cause of the credit and housing bubble. These economies thus bear responsibility with the United States for the current crisis, and must take the lead in making the adjustments necessary to create a more balanced world economy. Indeed, they are in the best position to do so because they have large current account surpluses and significant foreign currency holdings. China, Germany, and Japan are running current account surpluses, respectively, of 8.5 percent, 6.5 percent, and 4 percent. The Gulf states have even larger current account surpluses, as do other petrodollar economies. All have sizeable foreign currency reserves. China's reserves now top $2 trillion, and Japan has more than $1 trillion in reserves.

For better or worse, these economies must be your main partners, Mr. President, in carrying out a global economic recovery program. They must become the collective substitute for the American locomotive, either by stimulating demand in their own economies or by recycling their surpluses to stimulate demand in other economies. None of these countries, however, can be expected to exercise the global leadership necessary to take a world economic recovery program work.

You must therefore take the lead in establishing the agenda and twisting the arms as necessary, but you must do so in a way that does not remind these countries of the worst of America's international economic diplomacy of the 1990s when the Clinton administration forced an agenda of financial liberalization on emerging economies that led to the 1997-98 financial crisis. That means the measures you propose must be seen as essential to the rescue of the world economy and as mutually beneficial to all concerned in the long run--even if they seem to call for uncomfortable changes in the short term. It also means that you will need to be prepared to make some meaningful concessions, such as ceding more power to international institutions like the International Monetary Fund (IMF) and the World Bank, in return for their active participation in your recovery program for the world economy.

The first meeting of the G-20 economies on the world financial crisis in November provided the framework for some parts of the global recovery program you must advance. It will be important to build on that framework by enlisting the support of key G-20 countries, especially the large current account surplus economies, around a three part program. That program would entail: 1) a coordinated fiscal expansion led by the current account surplus economies; 2) the re-alignment and active management of the world's principal currencies to facilitate a rebalancing of the global economy; and 3) the creation of a world economic recovery fund of sufficient size to handle emerging debt and solvency crises and to undertake a global stimulus program of spending and investment to complement fiscal expansion at the national level.

The first element of your international strategy, Mr. President, must be to encourage China and other large current account surplus economies-Japan, Germany, and the large oil-exporting countries-to expand domestic demand to offset weaker U.S. consumer growth. Germany, Japan, and the Gulf states all are well positioned to expand their economies-preferably by cutting taxes and increasing social spending to spur more domestic consumption. China has announced what at first glance appeared to be an impressive stimulus program of $586 billion over two years. On closer examination, it was mostly a re-packaging of already existing spending commitments by local governments and state companies heavily weighted toward infrastructure investment, which in China's case will do little to create more domestic consumer demand. Worse, the central government at the same time took steps to shore up the export economy by increasing export subsidies and slowing the appreciation of the yuan.

A true shift in the direction of China's economic growth, however, is critical to the success of your economic recovery program. Over the past decade, investment and savings in China have grown much faster than consumption. Consequently, China has an unusually high savings rate of nearly 50 percent, while consumption constitutes only 35 percent of the economy (the overall average of the other "BRIC" economies, Brazil, Russia, and India, is closer to 50 percent). Thus, there is enormous pent-up consumption demand in China, as there is in other Asian export economies. China, for example, has one-half the televisions, one-quarter the computers, and one-third the cell phones per capita as Europe.

Your administration, Mr. President, needs to do a better job of sending a message to Beijing that China needs to do more to generate its own consumer demand. In particular, you need to make clear to Chinese officials that they ultimately have the most to lose from a collapse of the world economy, since they depend more than other economies on exports to drive growth and employment. Indeed, China has the greatest excess production capacity. The Chinese leadership needs to understand that you are not totally opposed to some of the retaliatory trade measures a Democratic Congress might consider if China continues to manipulate its currency and suppress domestic demand. But the first and main appeal to Beijing should not rely on the threats of future trade retaliation--in the context of the current crisis, this should be seen as a last resort.

Indeed, the message of your international economic statecraft should be overwhelmingly positive in that you will not be preaching austerity and painful budget cuts as the Clinton administration did after the 1997-98 crisis. Instead, you will be asking the Chinese leadership to raise the living standards of their workers, spend more on health care and education, and do more to provide a decent pension for older citizens. These are initiatives that should endear China's leaders to their people. Indeed, you are urging your counterparts in Beijing to join you in becoming modern-day FDRs by using this crisis to create a truly modern safety net for Chinese workers. Because China lacks real welfare and pension systems and does not have reliable systems of health care and education, the country's workers engage in a level of precautionary saving that is restraining consumption. The best way to reduce this high level of precautionary savings is to encourage the leadership in Beijing to put in place a modern social safety net and do a better job of providing education and health care for its citizens. Chinese companies are overflowing with retained profits (another source of China's high savings) and could easily help finance health and pension benefits.

China's leaders, of course, are concerned with creating enough jobs to maintain political stability. You therefore need to point out to the Chinese leadership that domestic generated demand in the end would be a more reliable way of ensuring job growth than the current strategy of financing exports to stagnating U.S. and European consumer markets. The reason you must press China and other Asian economies to raise wages and improve living standards is not so the United States can reclaim jobs lost to Asia over the past decade, but to increase global demand so that all economies can begin to create more jobs. Higher wages in China and other high-savings Asian economies would increase the purchasing power of Asian workers and augment consumer demand.

The American economy would indirectly benefit from higher wages and living standards as the demand for American goods and services increases, especially labor-saving and efficiency-enhancing technology. Beyond this, Mr. President, you need to tell the Chinese leadership that the quickest way to raise the living standards of their people is by engineering a significant one-time appreciation of the yuan against the dollar and other international currencies. You might also note that yuan appreciation is the best way to fight future inflation caused by the accumulation of foreign currency reserves and by higher energy and food costs. A significant one-time appreciation of the yuan, rather the gradualist approach now being pursued, would help stop some of the speculative inflow of hot capital into China while reducing the cost of food, energy, and other exports for Chinese consumers.

The strengthening of the yuan would be an essential first step in a broader realignment of world currencies that is needed to help correct the global imbalances that have developed over the past the decade. The best short-run option would be for the current account surplus economies in Asia and the Gulf state petro-dollar economies to re-peg their currencies--by letting them appreciate against the dollar but without abandoning the dollar peg entirely. This would create the best of both worlds for the U.S. economy: it would provide continued support for the dollar while also increasing domestic demand within the Asian and oil exporting economies, thus expanding the market for U.S. goods and services. For this reason, you should move quickly to a new set of understandings about world currencies that would facilitate these adjustments. The goal should be to manage the dollar over the next few years to assure that it does not appreciate so much as to prevent an expansion of American exports or fall so far as to provoke a currency crisis.

A Global Recovery Fund

Most of the current account surplus economies will not be able to stimulate consumer demand sufficiently in the short term to reduce their excess to acceptable levels. Your world economic plan therefore must provide for the alternative, which is to recycle some of those surpluses in a way that is more supportive of economic growth than the current practice of buying U.S. treasuries and adding to the build-up of foreign currency reserves. The United States, of course, will need to have access to some of these surpluses to help fund its recovery program. But some of the surpluses could also be redirected to support another part of your plan--namely, to create a world economic recovery fund to deal with national debt and solvency crises and to support public works projects in developing economies.

Already, a number of countries-- Iceland, Hungary, Pakistan, and Ukraine-- have suffered serious debt and liquidity problems related to the current crisis, and have sought money from the IMF and other sources. These countries may need additional money in the months ahead. Other countries in Eastern Europe, Africa, Asia, and Latin America may also experience currency-related crises before the worldeconomy is stabilized.

The problem, as you know, is that the IMF's resources have not kept up with the growth of the world economy. Today, the IMF has $250 billion at its disposal for managing national debt crises--a mere pittance compared with the rescue plans that the United States, Britain, and other G-20 governments have embarked upon (or those that are still needed to deal with the crises waiting to happen in Turkey, the Baltic states, and other affected economies). It would be better to have the IMF in a position to respond to these currency and balance of payment problems than to rely on countries like China and Saudi Arabia to use their sovereign wealth funds for this purpose.

It is therefore important to shore up quickly the resources available to the IMF and the World Bank. The IMF could be a helpful stabilizer in global financial markets if it had access to the sizeable reserve assets of the current account surplus economies. In order to do so, Mr. President, you will need to tap contributions from China, Japan, Germany, Saudi Arabia, and other G-20 economies in return for giving them more power and influence. Just as it was necessary in October 2008 to assemble a Troubled Assets Relief Program (TARP) fund of considerable size to inject capital into the

U.S. financial system, you will need to create a world economic fund of comparable size. Over the years, your predecessors repeatedly blocked efforts to increase the working capital of the IMF and the World Bank. They did so in part because the proposed measures threatened Washington's preeminent position in these institutions-- and, in the case of the IMF and the World Bank, its de facto veto, since increasing the allocations of Japan, Germany, and other surplus economies in the G-20 would have increased their weighted vote.

But that has turned out to be a shortsighted policy. We have been left with cashstrapped and ineffective international institutions. That has put more burden on the Federal Reserve to use U.S. monetary policy as a crisis stabilizer, which has contributed to the build-up of the large asset bubbles in the past decade. It has also left the door open for the big current account surplus economies of Asia and the petro-dollar states to use their sovereign wealth funds to influence the course of the world capital markets.

A world economic recovery fund (call it "WERF") would make it possible for the IMF and the World Bank, along with regional development banks, to carry out a globally applied macroeconomic stimulus program to supplement national fiscal expansion. The IMF could tap WERF's resources to carry out currency stabilization programs and help countries manage their way through balance of payments problems. The World Bank and regional development banks could tap WERF resources to accelerate lending for job-creating public works and social investment in developing countries. Money from this global fund could also be made available to specialized agencies of the United Nations to carry out social investment projects related to health care, education, and the environment. This increased social and public spending would help stabilize consumption and investment in vulnerable developing and emerging economies.

As you know, Mr. President, there is a broad array of urgent public investment needs in many economies, ranging from road building to clean water development, environmental repair to new telecommunications infrastructure. Many of these projects could be expanded without sacrificing loans or environmental quality. Programs to meet educational, health, and nutritional needs are also of critical necessity around the globe. In this way, WERF funding could help bring basic health care, education, housing, and clean energy within the reach of billions of people, relieving poverty across Africa and South Asia.

To ensure that this expansion of lending does not disrupt the World Bank's regular lending programs, the United States, as the bank's largest shareholder, could ask for an immediate increase in the institution's statutory lending limit (with the understanding that capital increases could be paid over a three-year period or borrowed from the WERF). Such an increase would, in effect, increase the bank's gearing ratio without compromising its credit rating. It would thus give World Bank lending an additional stimulative effect. You could push for similar arrangements for each of the regional development banks.

There is an underlying rationale for such a global stimulus program. It would bemore effective and less potentially inflationary over the longer term than relying solely on domestic fiscal expansion. Equally important, such a program would yield a significant security dividend. Directing public capital into the depressed areas of the world economy that are undergoing balance of payments or currency problems would help ease the potential for political turmoil in those regions--without undermining the discipline necessary for adjustment efforts to succeed. By restoring growth in those areas, it could help improve profits and investment levels. Finally, a global public sector program would point the way to the longer term institutional reform that is now needed to maintain a growing and healthy world economy. Mr. President, if you succeed in creating institutions at the global level to do what the New Deal once did for our national economy, you will be remembered as a truly global FDR.

A Strategy of Mutual Prosperity

In the short term, the new economic recovery and growth program outlined here will help sustain U.S. and world growth during a period of painful adjustment following the bursting of the housing and credit bubbles. Over the longer term, it will put the U.S. and emerging economies on the path to mutually reinforcing productivity revolutions and mutually rising living standards. Increased public investment in the United States will lead to greater private investment and productive capacity, enabling American-based companies to take advantage of rising export demand for their goods and services. It will also lead to rising wages, enabling households to reduce their debt burdens without cutting back on consumption.

Meanwhile, in large emerging economies, higher wages and additional consumer spending will increase domestic demand, allowing these export-oriented economies to weather a slowing of U.S. consumer demand. Rising living standards in turn will accelerate the transition in these economies to more sustainable models, based on rising productivity and resource efficiency. This new growth orientation in turn will open up even greater growth opportunities for American companies at the forefront of technology.

It will be up to you and your administration to turn this crisis into an opportunity, and this opportunity into reality. To do so, Mr. President, you must quickly adopt a bold and optimistic economic recovery plan that goes beyond conventional thinking and harnesses the American economy to the new growth drivers of public infrastructure investment and rising global demand.

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