“I don’t see a reason why the Czech Republic should take on a restriction in the form of the euro, says MARTIN FELDSTEIN, one of the ten most influential economists in the world and a Harvard University professor who advised President Reagan and is now an advisor to Barack Obama.
You warn that the US economy could very likely drop in the next year, and that the recession will take on the shape of the letter “W”. Why?
The US economy is now growing. It grew in the third quarter and it looks like it will grow in the last one as well, although not as much. But that growth is driven by fiscal stimuli. As soon as the government stops with that, as it no longer has special programmes like Cash for Clunkers and support for the real estate market, the stimulation of aggregate demand will also cease. And that is what I am afraid of.
Why. The economy is not yet able to stand on its feet?
Everything depends on the income of consumers. And that is down. Unemployment is growing – and will probably continue to grow – and consumer confidence is very weak. I therefore think that consumer demand will not grow very soon. And that is why there is a risk that in the aggregate there will be stagnation next year, or even another drop. It does not necessarily have to be that way, a slight growth may come, but I think that there really is a serious risk of a further drop. That means that unemployment, too, will remain very high.
Does the same apply to Europe or Asia, as well?
Europe, of course, is not just one country; but in general, I expect very slight growth there in 2010. Asia – I have just been to Chin, Japan and Korea – is doing better. The Chinese have stimulated their economy very effectively, which is having a positive impact on exports to other countries.
Some economists, however, claim that the Chinese economy is one large bubble and that the growth in the last few months is based on the enormous amount of money poured into the economy by the government.
In fact, they have not stopped the financial stimulus, it is still continuing. But I do think that they are successful in stimulating consumer expenditure and that the prediction that they would improve by nine percent in the upcoming year is justified.
Can the US and Chinese stimulus measures be compared? Can we say that the Chinese ones are more successful?
Yes, I think that they are more successful.
For what reason?
The Chinese stimulus package is larger than ours – and the problem with which they had to cope was, in turn, smaller. We have experienced a very dramatic drop in consumer capital, because the real estate and stock markets collapsed. There was a great drop in the construction business. The Chinese, on the other hand, “only” compensated for a drop in their exports with their stimulus measure. Furthermore, they had been talking for years about the need to stimulate consumer spending. And now they took advantage of the opportunity, that is, the crisis, to do so. They introduced subsidies for stimulating the consumption of rural and low-income households. They are spending lots of money in a well-conceived manner. Often, it was literally government expenditures rather than transfers to low-income groups.
Is China aided by its artificially undervalued currency? You are criticising it for that. Does China need to revalue its currency, for there to be a successful global recovery?
No. A recovery is possible even without it, although it would certainly be easier if the Chinese did that. Until they opt for such a measure, the dollar will keep dropping. It has to drop, because we have an enormous trade deficit, so the dollar has to go down to make up for the situation. It will, however, drop against most currencies – although not against the Chinese one – for example against the euro or the Japanese yen, which will cause troubles for those economies. That is why the revaluation of the renminbi (Chinese currency, note by L.K.) would help them.
By how many percent could the dollar drop? Nouriel Roubini, for example, predicts that it could strengthen by as much as twenty percent as soon as the Fed starts increasing interest rates.
Yes, but that will take a while. The dollar exchange rate is fluctuating and it is influenced by a number of factors. When it is rumoured in markets that the price of oil will go up, the dollar strengthens; when it is rumoured that the Fed will increase rates, it responds in the same way. But over the next three to five years, it will weaken in real terms. Take the fact that the trade deficit is already five percent of the output of the entire US economy.
Is it possible to calculate specifically by how much the dollar will drop?
Not exactly. It is very difficult. But if you were to ask me whether I would be surprised if the dollar would be twenty percent weaker in three years, I would say that I would not.
It is said that the dollar is also weakening because the threat of strong inflation hovers over it. That is interesting, because as of about six months ago, it was deflation that was the threat. Do you fear inflation at the moment?
No, or at least not for the time being. Core inflation is now low and the overall inflation level is, I believe, even negative according to the latest information. Imports are somewhere between fifteen and twenty percent of the output of the economy. The fall of the dollar will therefore not have the same effect on the growth in prices in the US, and the overall impact of the weak dollar on inflation will not be very large. The economy still has excess capacity. Until this starts changing significantly, we will not see any great inflation in the US. The markets may start fearing inflation in the future, but for the hot present, that fear is unfounded. Look at the interest rates on bonds with a long-term maturity – they are very low.
Martin Feldstein (69)
Professor of Economics at Harvard University, who studied at Harvard and Oxford, is one of the ten most influential economists in the world. For a whole thirty years, from 1978 through 2008, he was the President and Chief Executive Officer of the National Bureau of Economic Research. Between 1982 and 1984, he worked as the Chairman of the Council of Economic Advisors of President Reagan, and he is now an advisor of Barack Obama (he is a member of his Economic Recovery Advisory Board). When President George W. Bush was deciding in 2005 whom to appoint as the head of the US central bank after the outgoing Alan Greenspan, Feldstein and the present head Ben Bernanke advanced to the last round. According to certain speculations, Feldstein did not get the post because of his engagement on the board of directors of the gigantic insurance company AIG, which announced in the same year that it was revising its accounting statements for the last five years. On the occasion of the conference Prague Twenty, Feldstein visited Prague. This was his third time in our metropolis – he first came in 1961 and then immediately after November 1989. He is married and likes to travel. He drives a Mercedes.
Are you then still afraid of deflation?
I think that the weakening dollar, and for example the increase in energy prices that we noted last year, will help us to prevent against a deep drop into negative figures in terms of the price level. Labour costs have recently dropped significantly because productivity is up. Hence, certain pressures for a decline are evident, primarily in industry. But it is only a relatively small part of the US economy; services are much more important.
What do you think about the so-called paradox of thrift? Can economies in a recession be harmed by the fact that individuals are saving more? Is that leading to a decline in the overall level of savings in the economy, as the paradox says?
The problem of the US economy now consists of households gradually increasing their savings. Companies are relatively profitable – because of the relatively high productivity, which I have mentioned. Government expenditures are, however, considerable. The government deficit this year amounts to nearly ten percent of the economy’s output. And neither companies nor households will compensate that with their savings, hence, the overall savings – on the level of the entire economy – will be negative. The only reason why this does not lead to higher interest rates is that investments by companies and expenditures in the building industry are still on a very low level. So the problem lies in an inadequate level of savings.
Do you think that savings in the USA must grow in order for there to be a recovery?
I think that it is necessary to save more in the US, although I would not say that it is necessary directly in order to make the present recovery successful. Rather, we need it from the point of view of long-term growth, from the point of view of investment financing. We simply must be less dependent on foreign capital. I am definitely in favour of a higher level of savings, but not due to the fact that we would thereby better stimulate the economy.
The proponents of the paradox of thrift claim that increased saving is harmful at times of economic slow-downs and recessions such as this one.
Government expenditures – the dissolution of savings – are now so enormous that unless savings in the private sector grow significantly, the overall level of savings in the economy will be very, very low. That will lead to a problem on an international level. It is, therefore, more complicated than from the point of view of a closed economy. There, the rule applies that when more saving is done, the overall product is reduced, as the paradox of thrift says. But unless we reduce our dependence on foreign capital, a serious problem may occur.
In purely theoretical terms, do you agree with the theory of the paradox of thrift?
In a closed economy, I agree with it without discussion. And overall? Yes, I think that if I am to reply briefly, I do.
More than ten years ago, you said – perhaps it was misinterpreted a little – that the euro and the eurozone project will ultimately lead to disputes among member states that may end up in a war.
Well, I will tell you how it was. Helmut Kohl, the then German Chancellor, was saying that a monetary union must be created in Europe in order to affirm cohesion among the individual states and to prevent the repetition of wars such as were the First and Second World Wars. I then wrote an extensive article for the journal Foreign Affairs; I claimed in it that that is not a very convincing argument, because the US had a single currency as early as around 1780, and in spite of that, it went through a civil war in the 1860s. A great war can occur even with a single currency. The editors of Foreign Affairs then put the title “The Euro and War” on the article.
I understand that as a journalist.
Yes, it would certainly sell well.
And your present opinion of the euro?
I think that the currency has been relatively successful in the last ten years. Now, the conditions are very difficult, however, because for example Spain has unemployment between fifteen and nineteen percent, whereas Germany is at less than half that. I therefore think that it might be more fitting for the Spaniards to revalue their currency. Because the Spaniards have a significant trade deficit as well, whereas the Germans have a significant foreign trade surplus. But with a single currency, they of course cannot revalue. As soon as recovery occurs in Europe, the European Central Bank will consider an interest rate increase. That increase will be suitable for Germany, but not for Spain. This discrepancy will prepare the soil for possible disputes and conflicts between the governments of those countries.
The famous economist Milton Friedman predicted several years ago that the euro would collapse within fifteen years. Do you agree?
No. I would not pronounce such a radical prediction. I do think, however, that for certain countries, it may be more advantageous to remain outside of the eurozone or to even get out of it for some time.
Do you have any recommendations specifically for the Czech Republic? Should it adopt the euro, or not – and if so, when?
I do not have any specific recommendation, but in general, I would say this. Why should you want yourselves to be bound by the single currency, which may not be advantageous for the Czech Republic? What specifically will you gain by that step? Of course, the entry into the eurozone has a positive impact in terms of international trade. What is your inflation at the moment?
Zero. We have a slight deflation.
So for you, the argument that you will profit from the disciplined monetary policy of the monetary union with your entry into the eurozone does not apply. If you let yourselves be bound by the single currency, many disadvantages flow from that. And what will you do, when you will need a more competitive currency in ten years, for example, because demand for Czech products will change in some way? This happened to Italy, this happened to Greece. And there is nothing they can do about it. I see no reason for taking on a restriction in the form of the single currency.
In economics textbooks, you are mentioned primarily because of the so-called Feldstein-Horioka Puzzle That theory has been subject to much criticism since its was formulated in 1980, but for example the economist Charles Horioka, its co-author, with whom I spoke recently, still considers it valid. How do you evaluate it?
At the time we published the study, the savings retention coefficient was very close to one, about 0.9. That means that ninety percent of the savings were reinvested in the same country. Not long ago, I revised the study and discovered that in the eurozone the coefficient is no longer that high. Simply because it is now much easier to invest “cross-border”. When you make a calculation for all of the OECD and evaluate the individual member states according to their gross domestic product – with large countries, such as the US, Japan, and France being determinative – the coefficient is still relatively high. But not as high as it used to be – about 0.6. That means that most pensions and savings still remain at home. The number is smaller in small countries, because they have smaller markets – that theory is weaker for them. But some small countries are very specific, for example lots of money went into Ireland due to its low tax rates. I would say that the theory still applies to large countries. We have emphasised from the beginning that the theory views things in the long-term, that it is not evaluating short-term fluctuations in investments and savings.
What is the main explanation for the “puzzle”. “Home bias” – a sort of a deviation which is hard to explain rationally, to invest on one’s native soil?
It is a sort of a “home bias” by definition. In fact, you could say that we still do not fully understand why that phenomenon is arising. The fact that people are investing the most where they are at home, i.e., in the place they know best, is probably the best explanation. Currency risks are gone, as well. And that is what the eurozone makes possible. Savers from Belgium or the Netherlands are apparently more willing to invest their money in the eurozone, but outside of their homelands, than in the past, when they were to invest franks or guilders on the other side of the border.
Isn’t the Feldstein-Horioka Puzzle to a certain extent an argument against the creation of structures such as the eurozone? Because it seems that within such structures, there will still exist irrational longings for investing “at home”.
I don’t think so. A country that joins the eurozone will probably have better access to sources of capital, to savings from other countries within the eurozone, as cross-border lending will improve. Those who are saving also have greater faith in providing money abroad. Individual economies are thus less dependent on their own level of savings.
The theory of optimal currency zones claims, however, that one of the main assumptions for building a successful currency union is sufficient synchronisation of the economies of the member states. If what the theory around the Feldstein-Horioka Puzzle is studying applies, then tendencies to invest at home skew the situation such that synchronisation is hindered.
In order for the single currency and the entire monetary union to be successful, it is above all necessary to have a flexible labour market and a mobile workforce. The synchronisation of economies is not a necessary condition – but it is true that with it, it is easier to conduct a monetary policy. But it is not required for the functioning of the Union.
So it is not necessary to synchronise economies and their cycles?
Look at the United States. There, only individual regions or states are affected economically from time to time, but the single US market adapts very well to it as a whole. If a certain state experiences for example a slow-down in demand, it will get a large fiscal transfer from the national level. When for example Massachusetts has problems with demand, less money simply goes to Washington, which is, in fact, a financial stimulus for the state. Wages, however, also adapt to weaker demand very quickly: those who lose their jobs say to themselves: Well, there will be no work here for now, we will move to Atlanta or Arizona. Moving for work is easier there than in Europe.
Germany reunited nearly twenty years ago. In spite of that, significant differences prevail between its western and eastern parts. Is that not another argument against the eurozone?
But that would be the same even without the euro. That would be the case even if the countries united and continued to use their national currency.
You are opposing Obama’s healthcare reform in its present form. You say that by 2019 it will have contributed to an increase of the federal budget deficit, to more than one hundred percent of GDP.
Yes, but that will not be solely due to Obama’s healthcare reform, but also for a number of other reasons. That estimate is not mine, but comes from the Congressional Budget Office. Unless a change is effected, then I really do consider the deficit to be a great problem. And Obama’s intended healthcare reform significantly contributes to that.
Are you against the reform on principle, or would you only design it differently.
I would design it differently. Take, for example, that currently 85 percent of Americans have insurance. The question therefore remains how the remaining fifteen percent will be treated. But the question also is how to change people’s motivation, so that the expenditures on the system would not be so enormous. Probably all economists will agree that some kind of stimuli must be built into the system for people to really think about whether they indeed have to go for a certain medical test or examination. To consider whether they indeed have to undergo such an expensive examination – whether they, for example, could not start with a less expensive one and wait and see how their health develops. We have to address this by means of a deductible, but in legislation, these things are set very low, which is not a good way. There are lots of bad things, about which you need not worry in the Czech Republic.
Recently, I wrote an article for the Washington Post, in which I stated that one of the characteristics of insurance systems is that people who want insurance are entitled to go to an insurance company at any time. The proposed legislation makes it impossible for insurance companies to reject someone outright on the basis of his state of health already being poor, and furthermore, the new type of insurance can commence at any time. However well this is meant, it means the following: healthy people will start thinking about terminating an insurance programme, in order to save on premiums – after all, they can, once they or their relatives get ill, get insurance immediately. Why would they get insurance when they are young and healthy? Young people will therefore terminate their programmes and insurance companies will then be left primarily with the ill ones. That will, however, increase insurance costs – and also the level of benefits. That creates the wrong motivation. High insurance will, in turn, discourage a lot of people, and a spiral of increasing premiums and a declining number of insured people will develop. Fines are being considered for those who refuse insurance, but they are too low to really dissuade anyone.
Health insurance is compulsory in the Czech Republic; it is, in fact, a form of a tax. But many argue that there is then insufficient motivation for smokers to get rid of their bad habit, when the costs of their treatment will be borne by “the entire nation”.
I agree. In terms of the society, it is not efficient.
You say that one of the reasons why science cannot replace a qualified judgement is the behaviour of financial markets. How did you mean that?
In monetary policy, decisions must be made here and now. We do not have models at hand that would enable satisfactory predictions. We therefore have to work with judgements, with qualified estimates. To try to look at the information available and predict how companies, enterprises, and markets will most likely behave. Not everything can be left to computers. I will illustrate this with a story: the first fully automatic aircraft is flying across the Atlantic, without a pilot. When the plane takes off, a computer speaks to the passengers, in the place of the pilot: “You are on board the first fully automatic aircraft, equipped on the basis of the latest scientific methods. There is absolutely nothing to fear, nothing to fear, nothing to fear, nothing to fear…” (laughs). What I wanted to say is that without a pilot, purely scientifically, it is simply not possible.
You were an advisor to President Reagan. What do you think about Keynesian economics? That is, in many regards, in direct conflict with what Reagan proclaimed ideologically.
Keynesian economics, that is, textbook economics, which deals with the management of the economy through fiscal policy, has been dead for many years. Most economists, including this one, now think that fiscal policy cannot be used to stimulate aggregate demand, to cope with economic cycles. The delay is very great. Before a slow-down can be observed, for example, and a new proposal pushed through Parliament or Congress, it takes a long time, many months. With the exception of situations when the slow-down is long-term, such as was the Great Depression in the Thirties, or the Japanese crisis in the Nineties.
It is effective in this crisis. Not only because the crisis is so long, but also because monetary policy is no longer effective. The fiscal stimulus in the US is a necessary measure, although I do think that it could have been structured better. Even very clever people in the US are telling me that the financial stimulus does not have the desired effects. I think that in reality certain measures are more effective than others. I do not reject stimuli.
Why is monetary policy not effective at this time?
Just look at the previous recessions in the US. They were caused by the tightening of monetary policy. When inflation threatened, the central bank increased rates, which caused an economic slow-down and recession. As soon as the central bank came to the conclusion that the threat of inflation was gone, it reduced rates and recovery came. The recession had, therefore, been caused by high rates and it ended as soon as the causes that led to it had passed. With the present crisis, the issue is not excessively high short-term rates, but a poor assessment and evaluation of risk, over-indebtedness, and investments with borrowed means, a bubble on the asset market. It was, therefore, not possible to get rid of the crisis by a mere rate reduction. Because of over-indebtedness and a poor evaluation of risks, the entire banking system was not functional. In spite of reduced rates, credit flows were frozen, and companies had tough access to loans. The possibility to revive the economy through rates was lost.
You are, therefore, not blaming the Fed and its policy of cheap money?
No, no, I do see guilt in its actions. But I was only answering the question why monetary policy would not work this time.
But you said that the key reason was poor risk assessment.
Well, yes, but low rates contributed to that. That encouraged investors to put their money into short-term assets for quick profits. They were buying real estate because interest rates on mortgages were low. They did not asses the movement of real estate prices correctly – they thought that they would grow till infinity.
An abbreviated version of this interview, obtained in Prague, was published in Týden No. 47 on 23 November 2009.