The "new economic reality": how new and how real?Is there a "new economic reality" as the United States gradually emerges from the Great Recession? It appears that some major new forces are indeed likely to persist and must he taken into account in public policy and business planning. Others may or may not be transitory. Still other major factors, both good and bad, are not new but are likely to persist for the foreseeable future. This NABE presidential address describes the factors that are likely to have the most influence on the U.S. economic future and the implications that they have for economists in contributing to productive analysis and debate.
Business Economics (2011) 46, 17-21.
Keywords: uncertainty, emerging markets, government debt, regulation, economic illiteracy, household savings
There has been a great deal of discussion on whether the United States is entering a "new economic reality." For example, Jeff Immelt, CEO of GE, has talked about the United States and global economies as being in a "reset" mode. Mohamed El-Erian, co-Chief Investment Officer of PIMCO, has spoken of the "new normal." At the same time, we have learned to be suspicious of references to "this time is different."
How new and how real will the "new economic reality" truly be? My assessment is that major forces impacting the economy will fall into three major categories. Some will represent major change. Others will represent change that could prove to be largely transient or only partial in nature. Other factors will remain largely unchanged.
1. Real Change
At the Jackson Hole Conference hosted by the Kansas City Federal Reserve this summer, European Central Bank President Jean-Claude Trichet  emphasized that the normal distributions we have generally assumed for economic and financial variables may no longer prevail. Rather, as illustrated by Figure 1, many of the variables we analyze may have distributions with "fat tails," with much higher probabilities of extreme outcomes than we have previously assumed. More disturbing still, in many cases, we may have no knowledge at all of the underlying probability distribution.
Emerging markets rapidly grow their world share
One dominant theme seems certain to be continued: outperformance of emerging market economies relative to those of industrialized countries. In 1990, emerging markets accounted for 20 percent of world GDP. Based on International Monetary Fund figures, that share is expected to double to nearly 40 percent in just five years, with Nobel Laureate Michael Spence believing the share could rise to 50 percent in the next decade.
Demographic trends in a number of industrialized countries have reached or will shortly attain inflection points. Populations in Japan and Germany have already started to decline. Although population growth will moderate in a number of emerging markets as well, including China, notable population increases will continue in such countries as India, Mexico, and Brazil over the next decade.
Looking at the next 10 years, as depicted in Figure 2, growth in the emerging markets is likely to be 2 to 2-1/2 times that of the industrialized nations.
It would appear that in many cases, our models have been much too "U.S. centric," without nearly enough attention to the actions and interactions with the 20 percent that is moving rapidly to 40 percent or 50 percent of the world.
Government debt escalates
A dominant feature faced by a number of countries, but most prominently by the United States, will be a mounting load of government debt at both the federal and state/local levels. When we poll our membership, NABE economists have consistently pointed to public debt as the most serious challenge facing us over the next several years.
Figure 3 is from a recent paper by Alan Auerbach and William Gale . They show two trends of the ratio of federal government debt to GDP. One is the Congressional Budget Office (CBO) baseline, which assumes current law, including the ending of all tax cuts at the end of 2010. The other assumes that Congress will act as it typically does, such as extending various temporary tax cuts. Figure 3 indicates that even after we reach full employment in a few years, the debt/GDP ratio continues to rise, reaching its 1946 war-time high of about 109 percent in 2033 under the CBO scenario but much sooner, just 12 years from today, under the "extended policy" model.
What is particularly disturbing is that--contrary to the rapid decline in the debt/GDP ratio after World War II--in either of the two scenarios shown here, the debt-GDP ratio continues to rise rapidly--reaching explosive levels by the latter part of the century.
Policies will surely change before we get to these levels, but the combination of federal, state, and local borrowing can be expected to continue to exceed any private saving in the United States, furthering our reliance on external funds. This suggests ultimately higher interest rates and a slower potential economic growth rate than we have previously assumed.
2. Change, But How Permanent?
Less trust in markets
The financial crisis has precipitated a major decline in the trust in private markets to guide economic activity. Some have blamed free-market capitalism for the financial meltdown and subsequent recession. Others have opined that we have gone through a period of "market fundamentalism," suggesting that almost-religious zealots were in control for a time.
The attack by various politicians on banker bonuses and Wall Street greed has been extended to a general critique of corporate America. Meanwhile, the ability of China to avoid the impact of the financial crisis and to rebound quickly from the downturn has increased endorsement of "state capitalism," embracing large amounts of control, intervention, and centrally directed investment in the economy.
The immediate response to weakness or failure of the market economy has been to introduce a larger government role and more regulation. The distrust of markets, for instance, has helped scuttle some of the earlier support for a "cap and trade" system in energy. The demand for more government regulation has now taken hold in financial services, health care, food products, energy, and many other sectors.
How long-lasting will this trend be? The emergence of the "Tea Party" movement represents some backlash, but it is hard to know when or whether a Reagan/Thatcher type of philosophy might actually return.
Another area of change, but perhaps only semipermanent change involves the green economy.
"Green is in." Precipitated by a drive to reduce U.S. dependence on imported oil and concerns about global warming, efforts to reduce energy consumption and increase the use of alternative energy have ramped up substantially.
Many companies have embraced energy conservation and economic sustainability into their corporate plans.
Market forces--most notably the higher price of oil--have prompted some of these efforts. When gasoline prices reached $4 a gallon, consumers abandoned fuel-guzzling vehicles before gradually returning as prices receded. Voluntary conservation has occurred in some instances, and schools are emphasizing conservation among younger children. Mandatory rules to limit energy consumption have developed at the federal and state levels. New buildings are rated on their energy savings and environmental factors. The Environmental Protection Agency has for many years mandated fuel economy standards for cars. California is requiring the state's utilities to generate one-third of their electricity from alternative energy sources by 2020. Governments also are relying heavily on subsidies to steer the economy toward a "greener" platform. Subsidies for solar energy and wind systems are now prevalent.
How deep or long-lasting many of these efforts will prove to be remains in question. A large drop in oil prices would render most alternative energy sources uneconomic. Budget problems at all levels of government will limit the extent of subsidies. Proposed measures to implement a system of carbon taxes or restrictions on energy usage that could dampen economic activity would face intense opposition, especially in a period of still high unemployment.
Finally, will even the "greenest" of consumers be willing to change their lifestyles to reduce energy consumption? For example, one of the greenest of all communities, Boulder. Colorado, found significant inertia or resistance to efforts to implement major reductions in energy usage. Many consumers appear unwilling to pay a price premium for "green products."
Still, oil and other commodity prices could be at levels that would make conservation and the drive for more efficiency even higher priorities for many organizations.
Household thrift replaces consumer spending
The Great Recession has certainly altered the recent behavior of American households, pushing the saving rate up to an average of about 6.0 percent last year and this. Falling home prices and stock market valuations have battered balance sheets, driving households to try to rebuild their net worth. High unemployment has also increased saving.
The question is now whether there has been a permanent cultural shift. Figure 4 shows the historical record. The children of the Great Depression certainly behaved much differently than the baby boomers. Have consumers this time been so traumatized that they will be much more frugal in the future? Or as net worth and the unemployment rate improve, will households resume their quest for spending?
When I ask various audiences, the answers are usually split. Our latest poll of NABE economists of the causes of savings behavior, shown in Figure 5. indicates that about one-fifth of them believe a major change in attitudes has taken place.
Only time will tell.
3. Old Elements in the New Reality
Some economic factors will show little change, with some on the positive side and others on the negative side.
The recession appears to have scuttled efforts to achieve a further reduction in global trade barriers. The good news is that, despite the sharp rise in unemployment throughout the world, the rise in various barriers to trade has been limited. In contrast, the protectionist trade war of the 1930s exacerbated the depth and length of the depression. Still, the recent race to devalue currencies reflects the underlying frictions at work.
Most economists applaud efforts to achieve free trade, understanding the importance of comparative advantage and the gains from the unfettered exchange of goods and services. They are fully aware of some of the dislocations to industries and workers that may result. However, instead of trying to support industries that are no longer competitive, they advocate retraining programs to shift workers into sectors where the United States has a comparative advantage.
Yet, the U.S. public has a very different view, as shown in Figure 6.
Why did the Doha Round of trade liberalization negotiations collapse? The parties to the conference broke into two camps: emerging market economies and industrialized nations. Developing countries have gained greater clout and demanded freer access of their agricultural products into the markets of industrialized countries. Developed economies resisted under pressure from their farm sectors, while also asking for greater access of their industrial goods and services into developing nations.
Bilateral trade agreements between various nations are likely to continue over the next several years, but the divide between developing and developed countries may block a new major global trade agreement. Meanwhile, individual firms, industries, and sectors will continue to lobby political leaders for protection.
Complex tax system persists
Laurence Kotlikoff of Boston University has argued that the pressing need to address the U.S. federal budget deficit presents an opportune time to repair a convoluted tax system. Do not count on it.
Every line of our tax code has a reason and an advocate. The deductibility of mortgage interest expense has avid support from the housing and real estate industry, even though it has added to some of the imbalances in our economic system.
Economists have long decried the costs and distortions of our tax system. Resources are wasted to avoid and evade taxes as well as just to comply with a complex and confusing system. Taxes can interfere with or replace the market in allocating resources.
Many of our members in recent NABE polls have advocated a simpler or more efficient tax system, including a Value Added Tax. But the reality is that politics will likely trump economics.
The "Great Recession" pummeled small businesses as sales nosedived and credit tightened. Aspiring entrepreneurs saw venture and other sources of start-up capital largely vanish. Fledgling firms constantly cite the restrictions and costs imposed by various regulations from all levels of government--federal, state, and local.
Yet, the spirit of entrepreneurship remains very much alive. Immigrants to this country quickly embrace the opportunities for new ventures. Business students and MBAs aspire to own and run their own companies. The success of Apple Computer, Google, Facebook, and thousands of other ventures is compelling. The ongoing rapid growth of technology and its applications continue to open up new markets and opportunities.
One of the hallmarks of the American economy also remains. This is the acceptance of failure, chances for rebuilding, and opportunities to begin something entirely new. This willingness to accept risks still allows us to be leaders in innovation.
Economic illiteracy prevails
The last element is much more discouraging. This is the pervasive lack of basic understanding of either micro or macroeconomics on the part of many of our public leaders and the populace at large. This is an element that Caterpillar CEO Jim Owens stressed in NABE's policy conference last spring. This is surely an issue that should concern us all.
4. Implications for Economists
What are the takeaways from these features of the new or perhaps not-so-new economy?
First, we need to recast our models, eschewing in many cases the normal probabilities that we explicitly or implicitly assume. We need to emphasize for our clients the ranges of our forecasts instead of point estimates, plus the awareness of the possibility of extreme occurrences that even fall beyond plausible ranges--so-called black swans, the inhabitants of probability distributions' "fat tails." A good dose of humility is also appropriate regarding our projections.
Second, we need to focus much more on the developing nations, moving away from models that are centered on the U.S. economy, as we focus more on the dynamics of a global scheme.
Third, we need to understand the full meaning, including the costs and benefits of a "sustainable economic or business model." Many companies, government agencies, and nonprofit organizations are embracing systems that focus on waste reduction and energy conservation. Many economists have typically dismissed this thinking as that of "tree huggers." But it could represent a major shift in economic trends that we should understand and help guide.
Fourth, as Chris Varvares stressed in his NABE Presidential Address last year, we need to have a voice in the policy debate. Who is in a better position to speak out on such topics as the public debt, capitalism, and trade than we are?
Finally, we truly have an obligation to try to reduce economic illiteracy in this country through any access we have to the media, our institutions, political leaders, or the educational system.
If we want to have any legacy, it should clearly be this.
Auerbach, Alan J., and William G. Gale. 2010. The Federal Budget Outlook. Chapter 11, September 15. http://www.econ.berkeley.edu/~auerbach/federalbudgetoutlook.pdf.
Trichet, Jean-Claude. 2010. "Central Banking in Uncertain Times: Conviction and Responsibility," Speech at the Symposium on Macrocconomic Challenges: The Decade Ahead, sponsored by the Federal Reserve Bank of Kansas City, August 27.
LYNN REASER *
NABE Presidential Address, presented at the NABE Annual Meeting, October 11, 2010.
* Lynn Reaser was NABE's President for 2009 2010. She is the Chief Economist at the Fermanian Business & Economic-Institute at Point Loma Nazarene University. From 1999 to 2009, she served as the Chief Economist for the Bank of America Investment Strategies Group, where she provided the global and U.S. economic framework for investment strategy for high net-worth, institutional, and brokerage clients. She previously served as Barnett Bank's and First Interstate Bank's (Wells Fargo Corporation) Chief Economist. In these roles, she furnished economic advice for all of the Bank's various business lines. Dr. Reaser is active in many professional organizations in addition to NABE. She is a member of the California State Controller's Council of Economic Advisors. Previously she served as Chairman of the American Bankers' Association's Economic Advisory Council, was a member of the Governor's Council of Economic Advisors for the State of California, has been an advisor to other governmental organizations, and has served a number of professional organizations. She holds a B.A. in Economics (cum laude) and an M.A. and Ph.D. in Economics, all from the University of California, Los Angeles.