iTulip's Eric Janszen interviews noted economist James Galbraith
November 28, 2006
Dr. James K. Galbraith is Lloyd M. Bentsen Jr. Chair in Government/Business Relations and Professor of Government at the University of Texas. He teaches economics and a variety of other subjects at the university’s Lyndon B. Johnson School of Public Affairs. He holds degrees from Harvard (B.A. magna cum laude, 1974) and Yale (Ph.D. in economics, 1981), studied economics as a Marshall Scholar at King's College, Cambridge in 1974-1975, and then served in several positions on the staff of the U.S. Congress, including Executive Director of the Joint Economic Committee. He was a guest scholar at the Brookings Institution in 1985. He directed the LBJ School's Ph.D. Program in Public Policy from 1995 to 1997. He directs the University of Texas Inequality Project, an informal research group based at the LBJ School.
Galbraith has co-authored two textbooks, “The Economic Problem” with the late Robert L. Heilbronner, and “Macroeconomics” with William Darity Jr. He is the author of “Balancing Acts: Technology, Finance and the American Future” (1989) and “Created Unequal: The Crisis in American Pay” (1998). “Inequality and Industrial Change: A Global View” (Cambridge University Press, 2001), is co-edited with Maureen Berner and features contributions from six LBJ School Ph.D. students. His most recent book is unbearablecostbook just published by Palgrave-MacMillan.
Galbraith maintains several outside connections, including serving as a Senior Scholar of the Levy Economics Institute and as Chair of the Board of Economists for Peace and Security. He writes a column called "Econoclast" for Mother Jones magazine, and occasional commentary in many other publications, including The Texas Observer, The American Prospect and The Nation..
On November 22, 2006, I spoke by Skype with Galbraith in Fuzhou, the capital of Fujian province in China, where he is on leave this fall.
EJ: Dr. Galbraith, thank you for your time this evening. The iTulip community will be grateful for your take on the economy, inflation, the dollar, asset bubbles, the possibility of recession and other current topics.
JG: My pleasure.
EJ: Before we get to questions, a bit of background for you and new readers.
Since 1998, iTulip has been writing about speculative bubbles and their impact on the U.S. economy, both positive and negative. Our operating theory is that speculative bubbles are belief systems that, while irrational, are predictably irrational, resulting in a cycle of bubbles. We help our readers “play the bubble cycle," to whatever risk tolerance suits them. We let them know in 1998 that the NASDAQ was a speculative bubble, later suggesting in March 2000 that a collapse of the tech bubble was imminent. We announced in April 2000 that a secular bear market had started. That gave our readers insights they needed to make key asset allocation timing decisions. Among those taking action on this information, the adventuresome reported significant gains while the more conservative reported a mitigation of losses.
Similarly, we pointed out in August 2002 that housing had entered a speculative phase and in June 2005 that this phase had ended. This insight gave our real estate speculation-minded readers a chance to play the real estate bubble, and the risk averse a chance to sell properties they did not plan to hold on to during the correction and could not afford to sell at a loss.
We attribute our record of accuracy to two factors. One, we have been at it for so long that we’ve had a chance to learn from our many mistakes. Two, fools look for reasons why they are right, the wise why they are wrong. We invite experts to disabuse us of our cherished, pet beliefs. That’s where you come in. We look forward to your savaging our most carefully cultivated hypotheses.
JG: Looking forward to it. I'll do the best I can.
EJ: The last time we predicted a recession was the 2001 post-stock bubble recession that officially started in March 2001 according to the federal Bureau of Labor Statistics. We called it in January, A few months earlier. Currently we are predicting a post-housing bubble recession that will start in mid-2007. In that context, I'd like to focus today on questions that may help us to characterize a 2007 recession, with emphasis on the impact of the collapsing housing bubble, so that our readers can use their judgment to make preparations as they have in the past. Since you have special expertise in the impact of bubbles on wealth inequality, I'd also like to discuss the potential political consequences of wealth inequality caused by both the housing bubble and the aftermath of its collapse as that bears upon likely policy responses.
JG: No one can be certain that there will be a recession in 2007, but I agree that a recession is possible. In any case, I'm glad to help characterize a potential recession.
EJ: Let's start with the paper you and Travis Hale wrote in 2003 (pdf) about the impact on wealth inequality caused by the 1990s tech stock bubble. You conclude that the information technology bubble had a major impact on the geographic dispersion of income in the country, and this effect was driven very largely by the impact of dramatically higher incomes in a very small number of places, such as northern California. There was a dramatic effect on living costs in those places, forcing low-income people to live elsewhere. You were struck by how a huge continental economy like that of the United States could experience so much income change concentrated in such a tiny fraction of the available land space. You go on to point out that the concentration of bubble wealth effects in California was a major factor in the subsequent fiscal and political crisis of that state.
You state in the paper that the policy implications of the collapse of the tech bubble are not very different from those associated with an analysis of the speculative mania of the late 1990s itself: "It was not a good idea for the authorities to look the other way, encouraging the notion that a 'new paradigm' had arrived that would, on account of information technology alone, transform everyone’s lives. It would have been better had they encouraged a wider distribution of economic gains, and a broader geographic distribution of income gains. It is possible that, had they done so, both the local and the national consequences of the ensuing slowdown might have been less severe."
JG: Three weeks ago, in “Economists’ Voice,” Travis and I published an update to the 2003 paper. We did the same analysis on the 2001-2004 period and conclude that, post bust, two changes occurred in the wealth inequality created by the technology bubble. First, the big losers after the bust were the big winners during the boom. In that respect, the bubble distributed pain and gain fairly symmetrically. Wealth inequality decreased after the bubble ended. The winners in the following expansion were geographically concentrated around Washington, D.C. Among the top ten gainers in 2001-2004, four contain or are near to the nation's capital—D.C., Fairfax (Va.), Montgomery (Md.) and Baltimore (Md.). Two contain state capitals—Davidson (Tenn.) and Suffolk (Mass.).
EJ: Imagine my surprise. And the others?
JG: A couple are in California; one of them is San Diego County, with its Navy installations. So after 2001, we have some local economies that are led by government spending without much else going on. We also have regional economies that are led by housing, but this effect is not as geographically concentrated as government spending, so it doesn't show up in a county by county analysis.
EJ: So what you are saying is that post-bubble reflation policies, including tax cuts and an increase in deficit spending, allowed a few of the areas that benefited from the tech stock bubble to benefit from government policies designed to support the economy after the tech bubble popped—in effect bubble double dipping?
JG: No, the geographic pattern changed. Under the Democrats, income growth was led by companies, large and small, in the tech sector. After the tech bubble collapsed, the recovery was led by the government sector, especially military spending, and by the continued expansion of housing.
EJ: Interesting that you mention the increase in military spending. That’s not discussed much. I'll relate it to events here in the Boston area for local readers. The Boston Globe recently ran a piece—“The defense dollars flow: In antiwar state, contracts have soared since 9/11"—that goes a long way toward explaining why the economy is doing as well as it is in our area, the suburbs outside Boston. The growth ain't coming from biotech: I'll quote from the article, "Since 2001, contracts awarded annually to Massachusetts companies by the Pentagon have surged from $5.3 billion to $8.3 billion. Almost $1,300 is being spent by the military for every man, woman, and child in Massachusetts." Military spending contributes three times as much to the local economy as biotech. This explains why the nearby Burlington Mall, for example, is packed this holiday shopping season. Since we didn't make your county list, this local phenomenon is apparently not outstanding and so perhaps is occurring across the United States near the levels we are seeing here, with defense contracts increasing 30 to 40 percent.
OK, so here we are with a post-tech stock bubble economy dependent on housing and military spending. What's next? Do you think the collapsing housing bubble is enough to throw the United States into recession?
JG: I agree that housing is in free-fall. Can it throw economy into recession? Maybe, maybe not. Demand for new homes will fall off a cliff. This will have a substantial impact, but employment directly related to housing, such as in construction, probably isn’t large enough to throw the economy into recession on its own. The decline in the housing bubble may shave 1% to 2% off Gross Domestic Product (GDP) growth next year. Even the White House is building that into its forecasts going forward at this point.
EJ: The tech industry represented only about 2 percent of the economy when the NASDAQ bubble collapsed and sent that industry into a depression from 2001 until 2004. What surprised many, but not us, is that the contraction of that relatively small industry threw the entire U.S. economy into recession from Q2 until the end of Q3 2001.
JG: Two points. One, you can trace the roots of the housing boom back to the Tax Reform Act of 1986. That legislation eliminated the tax deductibility of interest except for mortgages, and had the effect of increasing homeownership. I doubt this was specifically intended. The later housing boom was the result of low interest rates that the Fed undertook as a policy after the extreme stresses put on the economy by the crash of the tech stock bubble and then 9/11. Two, the negative wealth effect of a collapsing stock market is more immediate and concentrated than the impact of a housing slowdown. Everyone marks their portfolio to market within a quarter after the collapse. A housing bubble deflates slowly. Housing price value changes are not experienced by property owners until they try to turn the property into a liquid asset, either by selling or by refinancing. Home owners do this at different times and in various places, so there is no rapid, geographically concentrated negative wealth effect as there was after the tech stock crash. When a housing market pops, the result is more like a soufflé than a bubble. The extent of the economic impact of the housing market decline depends more on secondary effects than on employment directly related to housing. If the negative wealth effects of falling home prices are transmitted to consumer spending, they will then affect business spending, and then we may have a recession.
EJ: That said, I'm going to persist on this aggregate negative wealth effect issue because it's critical to getting a handle on next year's recession. A report by Eric Belsky & Joel Prakken, "Housing Wealth Effects: Housing’s Impact on Wealth Accumulation, Wealth Distribution and Consumer Spending," Joint Center for Housing Studies, Harvard University, December 2004, page 2, says: "Consumers spend about 5 cents (5.5 percent) out of every dollar increase in housing or stock wealth in the long run. It takes about one year for spending from housing to reach four fifths of this long-run effect compared with several years for stock wealth.”
For example, a $25,000 (11 percent) increase in median home values from $200,000 to $225,000 resulted in a $1,250 (5 percent) increase in per household consumption, or roughly $50 of increased spending for every $1,000 in housing price rise, within about a year after the housing price increase.
JG: However, that does not necessarily mean that prices will decline in a similar fashion on the way down, that is, maybe not a $50 decline in consumer spending per $1,000. It could be less.
EJ: Still, will the ongoing decline in housing wealth, while slower to transpire and affect consumption spending, have a greater impact on real GDP than stocks because housing wealth is three times as great as stock wealth in relation to total household net worth?
JG: That's a fair point.
EJ: In January 2005 I projected a 10-year correction in the housing market. Normally, these corrections take five to seven years, but given the extremes of this boom, a more severe correction is likely. Do you agree?
JG: Five to seven years is the historical norm.
EJ: You say in your paper that during the tech stock bubble "it was not a good idea for the authorities to look the other way, encouraging the notion that a 'new paradigm' had arrived." In "The Fed: Dishonest or Incompetent?" I lay the blame for inaction directly at the feet of the Greenspan Fed. In addition to two unattractive explanations of incompetence or dishonesty, the piece logically directs readers to a third explanation, which I believe is the fact: That the Fed's decision to look the other way in both cases–the technology and the housing bubbles–was politically motivated. What do you think was the Fed's excuse for allowing a speculative boom to develop in real estate—a "new paradigm" in housing?
JG: Quite simply, the U.S. economy needed the stimulus from the housing market to avoid a major recession so they looked the other way.
EJ: It appears that the new modus operandi for the Fed, then, is to not interfere in asset bubbles on the way up and play cleanup crew after they collapse.
JG: I think that is apparent. For one thing, Greenspan had his free-market ideological commitments to keep. As a result, in matters where he had discretion, he reverted to those beliefs—to temporize when possible, to not interfere and to let these asset pricing issues get sorted out by the capital markets. One common criticism of Greenspan during his tenure is that he was slow to react to financial system problems. Greenspan correctly discounted Friedman's theory of a Non-Accelerating Inflation Rate of Unemployment (NAIRU) and realized that there is no direct relationship between employment and inflation. But he went on to overextend the "new paradigm" idea to justify inaction. Clearly the Fed is confident that the government can deal effectively with the aftermath of asset bubbles. Only time will tell whether that confidence is justified.
EJ: Let's explore that for a moment. Do you think the U.S. banking system is at risk from the collapse of the housing bubble?
JG: You'd have to ask a banking expert, but my understanding is that the banks are confident that securitization and risk management have allowed them to make high risk loans safely, that banks will remain solvent even under the kinds of credit market conditions that may occur if the housing market declines significantly and rapidly. That said, as Keynes once pointed out, a banker's job is not to avoid risk, but to make sure that if he's making a mistake he's making the same mistake as everyone else, so that he's positioned to go down with everyone else and not stand out.
EJ: Reminds me of the Chinese saying, "No snowflake in an avalanche feels responsible.” The corollary is “No snowflake in an avalanche can be held responsible.”
JG: That's a nice way to describe the principle.
EJ: OK, back to the present. The government pumped the economy back up with military spending and a housing bubble, a two-legged stool. One of the legs–the housing bubble –is getting knocked out. With a democratic Congress coming in with a mandate to cut military spending, what does the government do for an encore to stimulate the economy?
JG: If you recall, the boost in military spending was a reaction to 9/11 attacks. After that, the federal government had a blank check to underwrite military spending. Housing got a huge boost in 2001 when the Fed cut interest rates to the floor. It created a housing boom instead of the intended effect of mitigating a decline in consumption. As it turns out, the consumption boom was a secondary effect of the housing boom. These short term stimuli were one-time, non-repeatable events. It will be many years before we'll see another boom in housing, and we are already running fiscal deficits that worry some people.
EJ: Aside from the bubble winners we talked about before, have government stimulus policies benefited most of society equally?
JG: Low interest rates help broadly, but all credible evidence is that the capital grant of the tax cuts went mostly to the wealthy.
EJ: What policy implications do you think this might have?
JG: Well, it's going to be tough to do it again, to cut taxes to the benefit of the wealthy...and unlikely under a Democratic Congress.
EJ: Seems like the menu of non-monetary stimulus options is short, with tax cut and deficit spending bullets spent. There is evidence that the Fed is considering the extreme case. Evan F. Koenig, Vice President, Senior Economist, Federal Reserve Bank of Dallas, made a May 2003 presentation in which Bernanke's now famous "dropping money from helicopters" speech is colorfully embellished, complete with a picture of a helicopter hauling shipping containers–the implication being that these could be filled with money. He suggested possible anti-deflation policies including re-classifying certain assets now defined as "restricted" under the Federal Reserve Act, such as mortgages, to "unrestricted," the same as government debt today.
JG: That might help, and I'm not necessarily against it. The challenge is, as the Japanese have found, once an economy becomes dependent on this kind of government support, it's difficult to transition back out of it.
EJ: Paul Volcker recently said, "I am ... worried about inflation. Not that it’s high, not that it’s going to go running away, but it’s kind of creeping up. And I am impressed by the degree of pressure—if that’s the right word—psychological pressure, political pressure there is not to do anything about it. A lot of people out there on Wall Street and on Main Street are operating on the assumption that nothing very startling will happen in terms of restraint. And that’s reflected in attitudes pretty broadly. But once people are convinced that that’s the case, it can creep up on you. And the more it creeps up on you, the more difficult it becomes to do something about it.” Are you worried about inflation?
JG: I think some of these guys are still living in the era of the gold standard when there was a mechanism that drove trade balances back to zero. Those do not exist anymore. Those kinds of views are tainted by a Bretton Woods view of the world. That discipline disappeared in the early 1980s. Perhaps the most delayed realization in the history of economics is that inflation disappeared in 1983. The Fed still operates like inflation is on some kind of hair-trigger mechanism, that if the Fed doesn't remain vigilant—always with a tightening bias—that the economy will fall into an inflationary cycle that will be very expensive to transition back out of. They behave as if the economy is dangerously unstable with respect to inflation, that the economy is ready to enter into a 1970s-style inflationary spiral at any time. But even during extended periods of loose monetary policy, inflation has remained tame. It hasn't happened and won't. The risk went away with the rise of the U.S. trade deficits.
EJ: So what options does that leave? Our pet theory is they will allow foreign lenders to inflate our way out of it by sending back our dollars.
JG: Foreign central banks generally, and China's and Japan's particularly, have changed the arithmetic of global interest rates and inflation. They do not follow a conscious policy of supporting the dollar and U.S. interest rates in order to maintain exports to the United States. Their economies have a limited import absorption capacity. The $1 trillion in dollar reserves held by China represents a $1 trillion capital inflow for investments into the economy from outside, especially in real estate. The reserve results from the government sterilizing the money by issuing local currency. It may not be sustainable, but neither is this situation necessarily highly unstable.
EJ: Let's look at the potential downside of that equation. In "Conquest of Inflation, the World's Second Oldest Profession", I make the point that the trade deficits have shifted inflation risk from the Fed to export countries that are buying U.S. debt to support U.S. consumption. The Fed doesn't control U.S. interest rates and inflation as much as U.S. creditors do. In a story entitled “Rubin, Volcker Say Investors May Avoid Buying Dollars, Bloomberg recently reported this: "Robert E. Rubin, Treasury secretary under President Bill Clinton, and former Federal Reserve Chairman Paul Volcker said foreign investors probably won't keep increasing dollar holdings, raising the risk of a slump in the currency." Do you not share their concern about the trade deficit and the dollar?
JG: The world will not go on forever using dollars exclusively as reserves. The cost of production of reserve assets is zero versus the cost of producing things; the advantage is not permanently sustainable. Global monetary systems tend to last 30 years or so, and the current dollar-based arrangement that arose in the early 1980s out of the inflation crisis is getting a bit long in the tooth.
EJ: Let's leave the realm of informed speculation to advance into idle speculation. What events do you think are likely to precipitate the end of the dollar's reign as the world's reserve currency? What might a post-dollar world look like?
JG: You might like to design the new system first and then figure out how to get to the new system from here with the least possible transition cost. We won't be so lucky. Throughout history, these kinds of transitions have been precipitated by crisis, precisely because the transition cost is too high for most of the players in the system.
EJ: In the current instance, the United States.
JG: Right. That said, it's hard to imagine how any of the players will do anything intentionally to create the crisis that will lead to a transition. Think of a crowded theater where someone yells “Fire!” In the case of the global monetary system, the theater isn't very crowded. There are three seats in the front row occupied by sleepy, porcine men, representing Europe, Japan and China. If someone in the back yelled “Fire!” the porcine men might wake from their slumber, sniff the air and—noting a lack of smoke—go back to sleep.
EJ: I've speculated that one of the nations on the periphery of the system, say, France or Russia, is a likely instigator.
JG: That's possible. Not France, because France is now part of the euro, though France was the traditional instigator, demanding gold from the U.S. in the late 1960s and forcing Nixon to close the gold window in 1971, ending the convertibility of dollar reserves into gold. But the question remains, why would any of the three big players follow along, and if they don't, then it doesn't much matter what these smaller countries say. That gets us back to the question of what event will cause a new U.S., European, and Japanese multilateral reserve system to form. Reforming the dollar reserve system into a collective reserve system with the smallest disruption of trade requires, for example, that the European Union (EU) create a euro bond market that is as liquid and transparent as the U.S. bond market. Today, there is no euro bond market at all, only national bonds issued in euros. Creating such a market is no mean feat. Further, the EU will need to run a current account deficit. Given the retrograde and reactionary crew in charge in Europe today, that seems highly unlikely. Transition to a new system usually requires a crisis, but a crisis is not in the interest of any of the players, and the source of the spark of a real fire is not obvious.
EJ: Run on the dollar?
JG: By whom? If some country started to buy a lot of euros, the euro would appreciate, but that's not in the EU's interest. They don't want to get priced out of the market. They'd print euros and buy dollars to bring down the euro and support the dollar.
EJ: Any guesses as to a cause of crisis?
JG: Perhaps a political crisis that arises from world repudiation of U.S. foreign policy, making U.S. trade partners feel unsafe in their current financial arrangements with the United States. If the United States were to attack Iran, for example, or the U.S. were to get into a conflict with China over Taiwan. Neither of these seem likely at this point, though.
EJ: Let's exit idle speculation to advance into wild speculation. The next bubble. Gotta have one!
JG: Oil was a bubble that boomed and busted, and hardly anyone seems to have noticed. This has had a very restorative effect on the U.S. economy that may, getting back to your recession prediction, mitigating some of the negative wealth effects of the collapsing housing bubble. A new bubble won't form in information technology or housing. Given current trends, what will entrepreneurs most likely focus on? If I were to guess, I'd expect—and not be disappointed to see—a speculative bubble in alternative energy, in energy conservation and substitution technologies.
EJ: We’ve covered a lot of ground. To summarize, the housing bubble is collapsing, but slowly. Falling energy prices are helping to blunt the impact. Tough to predict the duration and extent of economic impact, although in the past down cycles have lasted five to seven years, and if the banking system gets hammered in the process, stand back. Trade imbalances are extreme but not necessarily unstable. Inflation from a monetary policy standpoint is dead, although the dollar will not be the world’s sole reserve currency after we go through the next monetary system transition, and that’s likely to be initiated by a crisis, and a rough dollar transition has inflationary implications.
I very much appreciate your time and look forward to talking to you again soon.
JG: My pleasure. I enjoyed it.
For guidance on how to play the coming currency corrections, see "Crooks on Currencies"
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