The Economy: An Optimistic Thought Experiment

Jul. 12

Over the past few years the economist in me has been profoundly pessimistic about the short and medium term economic destiny of the developed world, a view that is profoundly at odds with my fundamentally optimistic nature (see Cognitive Dissonance be damned, I am a pessimistic optimist).

I can very well imagine catastrophic or merely unpleasant scenarios for the coming decade. In fact, they are the most likely outcome of the situation we find ourselves in. However, all this talk about doom and gloom got me wondering whether we might be overlooking positive outcomes. After all it was not so long ago in 1979 that we were announcing the end of Western civilization. The West had suffered from two oil shocks. Stagflation was rampant with both inflation and unemployment above 10%. The US had lost Vietnam and most of South East Asia was under Soviet influence. Latin America was mostly governed by dictatorships. China was still extraordinarily poor after the follies of the Great Leap Forward and the Cultural Revolution. Theocracy had been instituted in Iran. The future looked bleak for the West.

No one predicted the golden age we were about to enter, that the course of the next 30 years would profoundly alter the face of humanity for the better. We witnessed a technology-led productivity revolution. Inflation and unemployment both sustainably fell. Dictatorships were replaced by democracies across Eastern Europe and Latin America. The integration of India and China in the world economy led to the fastest period of wealth creation in the history of humanity with over 400 million people coming out of poverty in China alone. In terms of life expectancy, infant mortality and most metrics of quality of life, there has never been a better time to be alive. However, if you live in Western Europe, the US or Japan today, it sure does not feel that way. The mood is morose and the outlook seemingly dire on almost every front.

I.Where are we, and how did we get here?

A.United States

Since 1980 recessions were mostly caused by central banks increasing interest rates to stave off inflation. The increase in the cost of capital would lead companies and consumers to cut back on their spending, pushing the economy in recession. A combination of expansionary fiscal policy and looser monetary policy would then set the economy back on a growth path led by consumer consumption.

This recession, however, really is different. The continual slashing of interest rates since the abandonment of the Bretton Woods agreements and moving to a Fiat money system has tripled personal debt levels relative to income in the United States. This debt-fueled growth came to an end in the 2008 financial crisis as asset prices, especially real estate prices, fell while liabilities remained at their original values triggering a balance sheet recession.

Faced with the specter of insolvency, over-levered households and corporations focus on repairing their balance sheets by paying down debt. In this environment, monetary policy loses much of its effectiveness: the principal problem is not access to credit, but instead a dearth of demand for borrowing. Thus the playbook that the Fed has run in response to economic downturns ever since the Greenspan era – cut interest rates, encourage consumers to borrow more, and celebrate the comeback in consumption-led GDP growth – breaks down as economic actors reach the limits of their ability to take on more debt. With everyone focused on paying down debt, there is no one to take out more loans.

In light of the lack of unlevered growth opportunities, normal growth won’t resume until the economy has deleveraged. The reality is that we are far from clearing all the imbalances in the economy. Throughout the past 2000 years, financial crises have been followed by sovereign debt crises as countries have nationalized the debts of their banks to avoid the banking systems from collapsing. While preserving their banks as engines of credit creation and economic growth, countries call into question their own ability to finance the debts – thus leading to a sovereign debt crisis. This time has proven no different. We have not deleveraged; we moved leverage from the individual and corporate balance sheets to the government balance sheet and, if anything, we’ve become more levered as the government has borrowed to an unprecedented degree.

Moreover the imbalances that got us into the crisis are far from being resolved. The federal government deficit is clearly not sustainable. Job losses have been far more severe than during any recession since World War II, hampering consumer demand. There is $1 trillion in commercial real estate debt that is underwater and needs to be rolled over in the next few years. Twenty-five percent of households have negative equity in their houses hampering labor market mobility, entrenching unemployment and limiting the demand for loans.

Bank credit creation is still broken. Instead of cleaning up bank balance sheets to allow them to start lending again, we essentially have walking zombies which need to earn themselves back to health. Given that banks make money by the spread between short term rates which they pay to account holders (essentially 0% these days) and the rate they charge for long term loans (e.g., mortgages), low interest rate environments are very profitable for them. However, it will take years for them to earn enough to repair their balance sheets under the current strategy.

In general our policy response has been wrong. We are undergoing short term fiscal retrenchment at every level – federal, state and city at a time of economic weakness without addressing our long term fiscal outlook.

Over the past decade, we have seen a huge misallocation of capital with a disproportionately large share going to real estate. This is not an investment which leads to productivity growth, the ultimate long term creator of wealth. Given that the decline in residential real estate prices has been the root cause of the crisis, the Obama administration seems determined to limit the downwards pressure on prices by reflating real estate through a combination of measures such as first time buyer tax credits and encouraging the Fed to keep interest rates at record lows.

The solution to the bursting of a bubble is not to reflate that bubble! As I wrote in a previous article (Whodunit?), there were many causes for the real estate bubble. One of those was keeping interest rates too low, too long which led to too much risk taking in the pursuit of yield and helped inflate the bubble. Trying to reflate real estate will only continue unproductive capital misallocation and delay reaching the market equilibrium.

While the US still has the privilege of being the reserve currency, it can print money to meet its obligations. However, you cannot print your way to prosperity! Printing will ultimately devalue the dollar. While inflation is not a near term threat given the deflationary pressures on the economy, dollar depreciation is highly likely in the medium to term unless the US addresses its fiscal outlook. (Ironically, the dollar is likely to appreciate in the near term in a flight to the seemingly safest of bad alternatives given the more profound economic problems in the euro zone.)

If Japanese policy makers had to redo the decisions they made over the last 20 years, they would probably focus on cleaning up bank balance sheets quicker. They would be more thoughtful about the spending they did to prop up the economy and would have started working on addressing their long term fiscal outlook earlier.


Europe faces many of the same problems on a larger and more urgent scale than the US. The core difference is that Europe does not have the same tools at its disposal to address the problem. As I had predicted in a prior article (Is the Euro zone crisis by design?), a currency union without a fiscal union, cross country labor mobility and a pro-cyclical fiscal straightjacket are bound to lead to a crisis.

In the early 1990s, with many European countries struggling to maintain their competitiveness in an increasingly global economy, Europe’s political elites waged a successful campaign to adopt a European Monetary Union (EMU), with a common currency at its heart. Underlying the treaties that formally created the EMU were a series of implicit agreements among its founders. Europe’s new currency would be modeled on Germany’s Deutschemark and managed by a European Central Bank modeled on Germany’s Bundesbank. To ensure the common currency’s survival among diverse member states, countries joining would strive to harmonize their fiscal policies and to adhere to strict budgetary discipline (as delineated in Maastricht Treaty rules and the Stability and Growth Pact). Collectively, these steps would enable member countries to enjoy significantly lower borrowing costs, approaching Germany’s. And in a virtuous cycle, such lower borrowing costs would promote growth – giving weaker EMU signatories room to undertake the structural reforms and fiscal belt tightening they would need to remain members in good standing over the long term.

How did this vision play out? Sovereign borrowing costs for the EMU’s constituents did in fact collapse and converge toward Germany’s Bunds. Sure enough, these lower borrowing costs spurred a decade-long, credit-fueled growth boom throughout Europe. But instead of using this boom period to conduct needed economic repairs, EMU countries spent their growth dividends on various excesses. In Spain and Ireland, the excesses took the form of massive private sector housing bubbles. In Greece, Portugal, Italy, Belgium, and France, they manifested themselves in continued fiscal profligacy that saw public debt to GDP ratios soar. Significantly, no EMU member except Germany seized on the good times to embrace difficult measures that would improve its competitiveness (e.g., nominal wage reductions, longer working hours, etc.). Indeed symbolically, the direction in which Europe moved was better captured by France’s decision in the year 2000 to vote itself a thirty-five hour workweek.

Jim Rogers famously remarked that bubbles always last a lot longer than anyone thinks they will. By 2008, ten years after the Euro’s launch, sovereign credit spreads among EMU signatories slowly began to diverge when, amid the global financial crisis, the realization dawned that the monetary union’s peripheral members had done nothing to improve their economic competitiveness, while their debt profiles had weakened considerably. An important turn unfolded in November 2009, with the revelation that Greece had misreported its official economic statistics to hide its true level of borrowing. In one day, Greece’s estimate of its annual deficit changed from 6.7% to 12.7% of GDP, and its total debt to GDP ratio from 115% to 127%. Europe orchestrated its first debt bailout of Greece in May 2010, extending €110 billion in loans in exchange for assurances that the country would implement strict austerity measures to reduce its deficit to under 3% of GDP by 2014. By Spring 2011, with Greece continuing to miss austerity targets contemplated by the May 2010 bailout and a return to capital markets to roll Greek debt impossible, it became clear European authorities would need to undertake a second bailout or risk disorderly outcomes.

We might not be in the position we find ourselves in, had European leaders recognized in 2009 that Greece was bankrupt and had organized a debt default that brought down its debt to GDP ratio to 50% with the imposition of structural reforms to make sure Greece did not end up in the same situation again. Instead Europe treated a solvency issue as a liquidity issue to further the illusion that no European country will be allowed to default. This not only kicked the proverbial can further down the road, but made it much heavier and harder to kick in the future. In the end it was all for naught as European leaders recognized that Greece had to restructure its debt. However, too little debt was written off which did not fundamentally help Greece, but shattered the illusion that no European country would be allowed to default. Like the US crisis which started once the illusion was shattered that real estate prices could not fall, the shattering of this illusion that European countries cannot default extended the crisis from Greece and the countries that “look” most like it, Portugal and Ireland, to Spain and Italy.

On Sunday, July 10, 2011, the Financial Times reported that European policymakers, in a circling of the wagons, had decided that a selective default in Greece could not be avoided. Private sector holders of Greek sovereign obligations would be required to accept “haircuts” on their bonds as part of the second bailout package European authorities would extend to Greece. In one fell swoop, the implicit guarantee of the EMU – that no member would be allowed to default – was proved false.

The importance of this development is difficult to overstate. It required the market to price a risk premium back in to individual Eurozone countries, and for sovereign spreads to diverge at least back to where they were pre-EMU (“at least” because members are today significantly more indebted). The convergence toward German Bunds that allowed all other EMU members to enjoy such low borrowing costs for years must now necessarily unwind. Herein lies the explanation for why Italy’s spreads, which had traded within a stable range throughout prior stages of the European crisis despite Italy’s 120% debt to GDP ratio, suddenly blew out – with 10 year borrowing costs exceeding 6% – on July 11th 2011, the first trading day after the Financial Times story. For months before then, ECB President Trichet had sought to avoid the outcome the FT reported, insisting that no Eurozone member be permitted to default even “selectively.” He lost the fight to Chancellor Merkel. There is no going back.

A country’s fiscal deficit typically becomes unsustainable when the long-term interest rate on its debt exceeds its long-term GDP growth rate. Under such circumstances, a country can’t reach the escape velocity required to grow its way out of the problem, and instead falls into what George Soros has called a “death spiral.” It can theoretically escape the death spiral arithmetic by running sustained primary budget surpluses for years, but this is a trick no deeply indebted sovereign has accomplished in modern times. The politics of austerity tend to be too tough. Furthermore, for those few countries willing to try it in earnest, austerity generally comes too late, resulting in higher deficits and debts as its impact on growth outweighs the benefits of spending cuts. The remaining options are default, restructuring, or inflation – a camouflaged form of default.

Italy is the world’s seventh largest economy and the Eurozone’s third, after Germany and France. As mentioned, its public debt to GDP ratio currently stands at 120%. Over the past decade, the country’s real GDP growth rate has averaged less than 1% p.a while nominal GDP growth has averaged 2.9% p.a. Apart from fine leather goods, high fashion, and its cuisine, Italy is also well known for labor unions rivaling Britain’s pre-Thatcher and for a culture of tax evasion that rivals Greece’s. For a country with Italy’s level of indebtedness, growth profile, and resistance to structural economic reforms, a fiscal deficit that is barely sustainable funding near German Bunds becomes untenable funding at 5 – 6%.

Liquidity support from the ECB or the European Financial Stability Fund (EFSF) can provide a Band Aid, but cannot fix what is at the crux a solvency problem. Italy now finds itself in a situation akin to a subprime or Alt-A borrower who took out a floating rate, interest-only loan that they could afford at the “teaser” rate in an environment where home prices were rising, but cannot afford once the loan resets and their home equity is under water. This ticking debt bomb is the ultimate relevance of the decision to permit a selective default in much smaller Greece: by exploding the myth that there can be no defaults in the EMU and forcing the market to re-price sovereign credit risk throughout Europe, the decision to “let Greece go” has raised borrowing costs for other peripheral European economies, notably Italy, to levels that make it impossible for them to repay their debts. Because, post Greek default, Europe’s remaining peripheral economies face long-term funding costs that exceed their GDP growth potentials, default or restructuring has become inevitable for them.

The current patchwork approach to solving the problem is only extending the pain and making it worse in the future. The issue is that there is no political will to do what it takes. Except for the recent Greece elections, incumbents like Sarkozy have been repeatedly voted out of office. Populist anti-European parties are gaining votes across Europe. There is a revolt in Greece and Italy against austerity even before the any of the more severe austerity programs have taken effect.

For those optimistic about the prospects for European fiscal unity, American history offers an illuminating counterpoint. In the 1790s, after the Revolutionary War and the formation of the United States, Treasury Secretary Alexander Hamilton had to wage a grueling campaign before he succeeded in creating a Federal bond to help relieve the unsustainable war debts of individual states. Hamilton’s proposal was voted down five separate times by the House of Representatives before he finally prevailed. One can only imagine what kind of havoc this would have wrecked in today’s complex, highly levered capital markets. Two centuries later, one of Hamilton’s successors, Treasury Secretary Hank Paulson, faced a similarly precarious struggle convincing Congress to approve the TARP emergency bailout of the U.S. financial system amid the worst economic crisis since the Great Depression. Few people recall that Congress actually denied Paulson’s request the first time he asked. It took another 7% leg down in the stock market, and a second, private plea directly from Paulson to House Speaker Nancy Pelosi, before Congress approved TARP. These episodes highlight how difficult it is to effect major fiscal transfers even in a single nation that already shares a common polity, a common treasury, and a common language – a nation in which the motto that appears on the currency is E Pluribus Unum, Out of Many One.

But Europe has no E Pluribus Unum. The EMU consists of 17 distinct nation-states with no common polity, no common treasury, and no single shared language. For most of the past six centuries, the peoples inhabiting the geography of Europe have engaged in serial wars. In this context, the post World War II era of relative tranquility in Europe is a historical anomaly, not the norm. Political leaders from Napoleon to Hitler and on have dreamt of unifying Europe under one vision or another. We would not wager that the likes of Jean-Claude Trichet and Angela Merkel will succeed where the others have failed. Voters on the Continent seem to have other plans.

At this juncture, austerity only makes the debt problems worse. As the Greek case demonstrates, the northern European countries (led by Germany), the ECB, and the IMF have all insisted on immediate, severe fiscal austerity measures as a precondition for helping the PIIGs avert default. This anti-Keynesian medicine is virtually assured to worsen the debt crisis, not improve it. The reason is straightforward: all of the PIIGs economies are now well below “stall speed,” that is, the speed at which austerity produces bigger deficits because its adverse impact on growth outweighs the effects of spending cuts. For austerity to work, it needs to begin at a point when Europe’s peripheral economies are growing at nominal rates of ~4 – 5% per annum. Such growth rates would provide enough of a buffer to allow spending cuts to take place without resulting in a recessionary tailspin that would only increase deficits as well as debt ratios. Of course, nominal growth in the countries in question is flat to negative. Counter-intuitively, what the PIIGs need in the short term is stimulus accompanied by structural reforms to enhance their competitiveness and help sustain growth. The austerity being forced on them instead will likely yield precisely the opposite of its intended result while exacerbating the animus between voters in Europe’s south and north. We are risking the dissolution of the political center in Europe. The rise of extreme left parties like Syriza and extreme right parties like the Front National could actually end Europe as we know it. Europe would face another grave crisis should Monti fall in Italy with no one viable to replace him.

Moreover, none of the “solutions” being discussed address the root causes of Europe’s problems. Albert Einstein remarked “you cannot fix a problem with the kind of thinking that created it.” At the roots, Europe suffers from three structural economic problems: (a) too much sovereign debt, (b) a lack of competitiveness in many of its peripheral as well as core countries, and (c) a poor actual fit for the optimum conditions of a currency union. None of the “solutions” talked about by politicians or the major media outlets come anywhere close to addressing these problems. Instead, they all exemplify the kind of thinking that created the problems in the first place. Expand the EFSF? This does nothing to meliorate the root problems and could actually worsen them if the bailout funds add to the PIIGs’ existing debt tabs and/or prime existing debt-holders. Adopt Eurobonds? This is likewise orthogonal to the root problems, and likewise risks making the ultimate denouement worse by spreading debt contagion to Europe’s strongest remaining balance sheets, Germany and France. Enforce immediate fiscal austerity? This strikes us akin to the Medieval practice of bleeding sick patients into a bucket to “rid” them of their diseases. Until political leaders begin to propose solutions that engage with the root causes – e.g., a Brady bond program tailored to Europe, debt forgiveness, engaging in conversations with voters to present the case for structural reforms – the crisis will persist.

C.The consequences of a Greek exit from the euro could be worse than most suspect

Should Greece exit the euro and reintroduce the drachma, it would probably fall 50% upon introduction and Greek nominal GDP would probably fall by a similar amount. Greek banks and companies with obligations in euros, but revenues in drachma would default. Given the inter-relatedness of the global banking system, any bank with a whiff of Greek debt could soon find itself cut off from global credit creating a global credit freeze. In effect this would be like what happened after Lehman Brothers in 2008 – times 10 because such a crisis would hit at a time when the global economy and government balance sheets are very weak. Having thrown everything at the last crisis including the kitchen sink, there is little they could do! This credit freeze alone could push Portugal, Spain, Italy and Greece in default. Then again, a bank run in those countries as people remove their euros from banks to avoid the risk of a forced depreciation might very well tip those countries banks and hence the countries themselves into default first.

That is not to say that a Greek exit would inevitably lead to a global credit freeze and automatically domino to Portugal, Spain, Italy, etc. However, to prevent that from taking place the ECB would have to rapidly and decisively flood those markets with unlimited liquidity and provide blanket deposit insurance to forestall bank runs.

It’s also unclear a Greek exit would benefit Greeks in the long run. If it was accompanied by fundamental structural and tax reforms, the renewed competitiveness would put it on a sustainable growth path. However, given the current mood in Greece, the more likely outcome is for the benefits of the depreciation to be inflated away. After a few years of nominal GDP growth, Greece would find itself once again uncompetitive, but probably with a GDP that is 20% lower than it is today.

D.Other Considerations: Challenges to Democracy, Global Growth, and Stability
Worse, beyond the potential economic stagnation and meltdown that the world is facing because of the deleveraging process, the West is facing other large economic and non-economic challenges.

1.Challenges to Democracy

The relative economic decline of the West in comparison to the growth in China is leading many people in the US and Western Europe to believe that the “Washington Consensus” should be replaced by the “Beijing Consensus.”

The term Washington Consensus was coined in 1989 by the economist John Williamson to describe a set of ten relatively specific economic policy prescriptions that he considered constituted the “standard” reform package promoted for crisis-wracked developing countries by Washington, D.C.-based institutions such as the International Monetary Fund (IMF), World Bank, and the US Treasury Department. The prescriptions encompassed policies in such areas as macroeconomic stabilization, economic opening with respect to both trade and investment, and the expansion of market forces within the domestic economy.

By contrast, in his January 2012 article in Asia Policy, Williamson describes the Beijing Consensus as consisting of five points:

  1. Incremental Reform (as opposed to a Big Bang approach)
  2. Innovation and Experimentation
  3. Export Led Growth
  4. State Capitalism (as opposed to Socialist Planning or Free Market Capitalism)
  5. Authoritarianism (as opposed to Democracy or Autocracy).

In general the sense that capitalism is killing democracy and that democracy inhibits economic growth is gaining credence, as illustrated by the proliferation of books like Robert Reich’s Supercapitalism: The Transformation of Business, Democracy and Every Day Life.

2.The Risk of a Chinese Hard Landing

Regardless of the long term merits of the Chinese approach, to date the Chinese economy, and emerging market economies have been a bright spot in the world helping push the world GDP growth to 5.3% in 2010 and 3.9% in 2011. A small chorus of market pundits, including Nouriel Roubini, has warned that China could be in for a hard landing, putting under threat the seemingly last remaining engine of economic growth.

Their argument is centered on the popping of a real estate bubble in China: In 2009, during the financial crisis, China unleashed hundreds of billions of dollars — over a trillion yuan — in stimulus aid to keep the economy flourishing as its major trading partners in Europe and the U.S. were in recession. Billions went to fixed asset investment across the country, from roads to new buildings. China’s middle class and especially the rich invested billions in real estate, not only as a store of value, but also as a means of speculating on the urbanization trend. Less than 50% of the population lives in cities and urbanization continues, but its pace has not kept up with the real estate development creating surplus housing. Aware of the dangers of a real bubble, the government has also introduced policies to limit further appreciation.

Chinese excess savings may be a bigger threat to the global economy that the popping of its real estate bubble. The anticipated shift from savings to consumption, on which most global growth models are predicated, is not happening.

In general, some of the recent statistics are worrying:

  • Exports rose 4.9 per cent in April, which was weaker than expected.
  • Industrial production rose 9.3 per cent in April, the lowest level since early 2009.
  • Housing inventories are high, and prices fell in April over last year, for the second straight month.
  • Electricity production/use rose just 0.7 per cent in April, the slowest pace since 2009.
  • Rail freight volumes have slowed to a trend rate of 2 per cent to 3 per cent, down considerably from last year.
  • Loan demand in April missed expectations, suggesting that access-to-capital difficulties continue.
  • Government revenues rose just over 10 per cent in the first quarter, over last year. That’s the slowest pace in three
    years and down from revenue growth of more than 20 per cent in last year’s first quarter.

The current debate on a hard landing also ignores the risk of political, social and religious strife that seems inevitable in the long run and is more likely to occur in an economic downturn. This is not to say that a hard landing is inevitable. China has a number of policy options at its disposal, but still faces the hard task of rebalancing its internal economy towards consumption.

3.Malthusian Constraints

With record oil, gold, commodity and food prices, Malthusian concerns are coming to the forefront. Prices for oil, corn, copper and gold all tripled or more over the last 10 years. The high commodity prices are not Malthusian per say but raise Malthusian fears that we are running out of the resources necessary to run our economy which has been based on the availability of cheap energy and to feed ourselves as the world population is expected to reach 10 billion.

Many believe that these prices seem will remain high for the foreseeable future. We may be at Peak Oil. The increasing investment in harder-to-reach oil is a sign of oil companies’ belief in the end of easy oil. Additionally, while it is widely believed that increased oil prices spur an increase in production, an increasing number of oil industry insiders are now coming to believe that even with higher prices, oil production is unlikely to increase significantly beyond its current level. For now, alternative, ecologically-friendly sources of energy provide no panacea; not only is the supply unreliable and inadequate but their average per KW-hour cost remains well above that of oil.

4.Risks of Military Confrontation

Those Malthusian fears may also be increasing the risk of a future US / China conflict. Chinese government-owned companies have been acquiring access to natural resources at a record pace. China has intensified its long-standing claim to virtually all of the resource-rich South China Sea and is building up both its navy and its anti-navy missiles to push the US navy further out from its coast.

Throughout history, the rise of new economic and military powers has often led to conflict with the incumbent nations. History has repeatedly showed that relations between great powers cannot be sustained by inertia, commerce, or mere sentiment. They must rest on some convergence of strategic interest, and preferably on “a joint concept of world order.” Yet those are precisely the ingredients that have been lacking since the early 1990s.

In his brilliant analysis of the “rise of the Anglo-German antagonism,” Paul Kennedy describes how an assortment of factors—including bilateral economic relations; shifts in the global distribution of power; developments in military technology; domestic political processes; ideological trends; questions of racial, religious, cultural, and national identity; the actions of key individuals; and the sequencing of critical events—combined to lead Britain and Germany to the brink of World War I.

It’s unclear how the China / US story will play out and it would take a similar number of factors to bring both countries to the brink of war. Moreover, both China and the US seem keen on engagement and Chinese leaders speak of its “Peaceful Rise.” However a real risk of conflict remains given the weakness of the non-economic ties that bind them and the real risk of misunderstandings on many issues: human rights, Taiwan, Korea, etc.

II. The Optimistic Thought Experiment

This background is depressing and if anything paints a more pessimistic view than the consensus view. Most experts expect us to have several years of Japan-like sub-par growth and high unemployment, but only ascribe a small probability to the risk of a severe double dip recession (most likely caused by the euro-crisis). Even though European politicians have been doing too little too late so far, the bet seems to be that with their backs to the wall, when faced with the potential demise of the euro, they will do the right thing. I ascribe a much higher probability to a more severe downturn – say 35% – because the scale of the problem, voter discontent, the global weakness of sovereign balance sheets and the risk for contagion through the interconnectedness of the global financial system leave us exposed to “accidents.”

Yet, the pessimistic scenario is not pre-ordained. Currently, no one is seriously considering the upside scenario – both in terms of what can go right in the short term and how long term positive trends will eventually outweigh the current economic headwinds. While I ascribe only a 5% probability of things going right in the next few years (versus less than 1% for the consensus), on a 10+ year scale, the optimistic outcome becomes the most probable.

A.There is a solution to the European sovereign debt crisis

In 1985, the G-5 nations orchestrated a concerted intervention in currency markets to depreciate the U.S. Dollar, which, they agreed, had become overvalued after the Volker years in a manner that was hobbling the U.S. economy and creating severe global imbalances. The Plaza Accord successfully de-valued the Dollar ~50% over the next two years without precipitating a financial crisis. The problems in Europe are grave enough that they could prompt another global summit of this kind. For such a summit to be effective it would need to include agreement on several elements that have not yet even made it into mainstream conversations, including:

  • Debt forgiveness that would reduce debt to GDP ratios in the PIIGs to a maximum of ~80%
  • A contemporaneous recapitalization of European and global banks that would enable them to absorb such debt forgiveness
  • Credible structural reforms to non-competitive European economies
  • A mechanism for orderly exit from the EMU as well as pre-agreed criteria as to what would trigger such an exit
  • Forbearance of punitive fiscal austerity measures in peripheral economies until such economies had reached pre-agreed nominal growth levels

B. The Current Economic Problems are more Political than Economic

While the political dimensions of the economic crisis are a cause of concern to many, a problem of political will is actually much better than a problem of ignorance: At least we know what needs to be done. What is interesting is that when you get a group of smart, reasonable people around the table, there is a broad consensus with regard to what should be done. Essentially, we should ease the short term fiscal retrenchment and focus on long term structural reforms and fiscal consolidation, which would include:

1.Capitalizing all pensions, raising the retirement age to 70 and indexing it with life expectancy

Pension systems were originally built with pay-as-you-go systems where current workers pay for current retirees. The system was sustainable while the number of workers was increasing either due to the baby boom, the entry of women in the workforce, or before countries finalized their demographic shift to stable low birth rate, low death rates. However, a combination of lower or stable retirement age, decreases in fertility rate and higher life expectancy (life expectancy in the US went from 60 in 1930 to 79 in 2010) have significantly increased the number of retirees per worker making them unsustainable at the current benefit level.

In 1950, there were 7.2 people aged 20-64 for every person of 65 or over in the OECD countries. By 1980, the support ratio dropped to 5.1 and by 2010 it was 4.1. It is projected to reach just 2.1 by 2050.

The solution is to make people save for their own retirement. Most private employers have already moved from defined benefit to defined contribution pensions. Using behavioral economic tricks such as opt-outs instead of opt-in, it’s actually possible to make people save enough for their retirement. Public pensions should now all be capitalized as well to make them sustainable especially since they currently make payouts with implied 8% returns which are completely unrealistic.

To handle the transition from a pay-as-you-go system to a fully capitalized system, the new generation of workers essentially has to pay twice: once for their own pensions and once for the current workers. The only way for this to be affordable would be to move the retirement age up to 70 and index it to life expectancy. To make it more palatable workers currently aged 55-65 could retire at 65, those 40-55 could retire at 67 and those below 40 could retire at 70.

Note that the move to capitalized pensions is an efficacy suggestion and does not have implied value judgments on equity. The state should contribute a share of the retirement to those who earn too little to save effectively for themselves. Societies should build sustainable and efficient welfare systems and independently decide how generous they should be. The Nordic countries have capitalized their pensions and chosen to be generous with the needy in terms of state contributions to the retirement accounts of low income earners. As such they ended up being more generous to low income earners for much less than the cost of pensions much less generous countries with pay-as-you-go systems.

2.Massively simplifying the tax code, broadening the tax base and lowering marginal tax rates

The tax code in most OECD countries is horrendously complex. The US Federal Tax Code went from 504 pages in the late 1930s to 8,200 pages in 1945 to 71,684 pages in 2010. The compliance cost alone for the Federal Income Tax was estimated at over $430 billion – excluding changes in consumer behavior that diminish overall economic efficiency.

Marginal tax rates move up and down with income seemingly randomly in a totally non-sensical way. Marginal tax rates are too high – an issue given that the dead weight loss increases at the square of the tax rate.

Moreover the tax base is too narrow. 1% of tax payers contribute 37% of taxes federally and as much as 50% for states like California. This is triply dangerous:

  • It leads to wild fluctuations in tax revenues given that the income of the 1% is more volatile than those of the middle class forcing states especially to make counterproductive pro-cyclical cutbacks in recessions
  • It incentivizes the 50% of people who don’t pay taxes to vote themselves ever more benefits
  • It potentially gives political power to a small percentage of tax payers

In addition to Hong Kong and Singapore, most Eastern European countries successfully moved to flat taxes. While a flat consumption tax is probably the most efficient, a flat income tax, as employed in Eastern Europe would be much more efficient than the current system and easy to setup given that people already report their income.

They work by taxing a flat % of all your income at the same rate, after excluding a certain dollar value of income. For instance it has been estimated that a 20% flat tax which would exclude the first $20,000 of income would generate as much revenue as the current federal income tax. Under such a system someone making $20,000 would pay $0 in taxes, someone making $40,000 would pay $4,000 in taxes ($40k – $20k = $20k in income * 20%) and someone making $120,000 would pay $20,000 in taxes.

All exemptions and deductions would be eliminated. Not only do these deductions distort behavior and add complexity to the tax code, for the most part they are a subsidy to the rich given that they benefit those who pay the most taxes. The ridiculous disparity between $1 of income from labor or capital gains would be eliminated. $1 is $1 regardless of how you make it. Policy objectives would be achieved through direct transfers or benefits to those we intend to receive them rather than indirectly through tax cuts. As a result your tax return would literally be one page.

For simplicity and to avoid gaming the system, corporate taxes should be set at a low rate, probably the same rate as the flat tax. In theory there should be no corporate tax as it’s essentially a double tax on employees’ salaries and on shareholder income. However, not having a corporate tax would create an incentive for people to minimize their notional income (salaries) and to receive them indirectly in the form of expenses paid for by the corporation.

Beyond the flat tax, the tax system would be used only in cases where the marginal private cost is below the marginal social cost. For instance a combination of carbon taxes, fuel taxes and congestion charges would alter economic behavior as it would make drivers bear the full cost of their activity. These are much more efficient than providing subsidies and tax cuts to alternatives since politicians are incapable of choosing which technology to back and the subsidies often become unaffordable as the businesses scale as Spain has learned to its expense with its solar subsidies. It has been estimated that in the US the fuel tax should be $1-2 per gallon rather than the 18.4 cents per gallon that it is now.

3.Very liberal immigration policy

Nearly half of the startups in Silicon Valley were created by immigrants, mostly of Indian and Chinese descent. Nowadays, after they finish their undergrad or PhDs, they are sent back to India and China and create companies there. From a global welfare perspective it’s probably net neutral, but from a US welfare perspective it’s completely idiotic.

The reality is that immigration controls have no impact on unemployment be it of skilled or unskilled labor because the demand for labor is not fixed. If the supply of labor increases, the demand for labor increases as well. Those who suggest otherwise commit the lump sum of labor fallacy.

The empirical evidence clearly suggests that immigration even of unskilled labor is a net positive for this country (Immigration and the Lump of Labor Fallacy). This happily ties with my personal value judgment in favor of equality of opportunity and my admiration for those willing to bear the huge fixed costs of immigration – leaving their family behind, coming to a new culture in an uncertain environment – to pursue the American dream in the land of opportunity.

4.Changing the focus of healthcare to preventative care and catastrophic insurance and putting consumers in charge of their healthcare decisions

The US spends an unbelievable 17.9% of its GDP on health care with worse health outcomes than many other countries and 50 million uninsured. The problem largely lies in the way health care is consumed and provided. Shockingly for something so integral to our wellbeing and happiness, consumers are not the primary purchasers of their own health care. Because employers can deduct the health benefits they provide from their taxes, it makes more economic sense for health care to be employer provided. Not only are consumers not the purchasers of their health care, but they suffer a double whammy when they lose their job as they also lose their health insurance coverage.

The reason health care is employer provided is because of a historical accident. Employers lobbied to get health care expenses to be tax deductible during World War II to compete for labor on benefits offered rather than on wages which they were barred from doing because of wage controls. While the wage controls were lifted the tax deductibility of health care expenses remained leading to the structure we see today.

Moreover, the current system looks more like prepaid health purchases than actual insurance. Instead of coming to play only in the case of catastrophes (e.g., getting cancer or a debilitating disease while you are young), every medical procedure is covered with very low copays. Home insurance by comparison is “real” insurance. You are covered in the case of floods, fires, tornadoes, etc. If home insurance was structured like health insurance you would pay extremely high premiums, but in exchange all the maintenance plus all the modifications and improvements would be covered by the insurance – it would be a prepaid construction and maintenance plan with an insurance component. On top of that because consumers are not directly bearing the cost of their insurance, politicians and insurance providers have a real incentive to include more and more services in the “basic” health insurance plan.

Recent studies suggest that we could provide better health outcomes for as little as 10% of the current average monthly cost with a mandatory, individually purchased health insurance plan that focuses on preventative care and catastrophic insurance, with high deductibles for everything else, and better guidelines for appropriate end of life care. Currently, end of life care consumes 40% of all health care expenditures and provides less than a 6-month increase in life expectancy, while often causing patients greater distress!

To give a sense of scale Walmart’s health care plan, which has number of those characteristics costs $30 per month for non-smoking singles and $100 for non-smoking families. Should we have mandatory individual purchases of these plans, the costs would be lower as the costs of providing healthcare to the uninsured would be significantly decreased.

While purchasing a basic health insurance plans would be mandatory, the same way it is mandatory to have a driver’s license to drive a car, the government would make full or partial payments on a means tested basis for those who cannot afford the plan.

5.Increasing competition between schools, raising standards and reforming school funding

There is a huge disparity in the K-12 education outcomes between schools in the US and between countries around the world. Fortunately there has been enough experimentation both in the US at a state level and with charter schools and at the international level for best practices to emerge.

Funding schools through local property taxes is particularly perverse as it entrenches inequality as good neighborhoods get good schools and bad neighborhoods get bad schools. To create opportunity of equality the system would have the following characteristics:

  • School choice such that parents and kids can apply to a large number of school and for schools to compete for the best students
  • Shorter summer vacations – the current vacation schedule is a legacy of our agrarian past where parents needed the kids to toil the fields
  • Longer school days
  • Comprehensive difficult exams on a wide variety of topics making it hard to “teach the test” and create a more well-rounded population

Parents should bear the costs of educating their children directly with partial or full payments by the state on a means tested basis for those who cannot afford to pay.

Interestingly enough, reducing class and school size, which was hailed as the solution to the quality of education problem, proved counterproductive. Reducing the class size from 30 to 15 only doubled per pupil teacher expenses without impacting outcomes. Worse, reducing school size actually decreased quality because the schools no longer had the scale to offer more specialized or esoteric classes or segment classes by ability.

6.Means testing all benefits

It makes no sense for the wealthy to be receiving public pensions, unemployment insurance, etc. Moreover, many benefits that seem like good ideas like “offer free college education to everyone” are actually disguised subsidies for the rich. It is the children of the rich who are disproportionately likely to go to college. To the extent the state wants to provide benefits to those going to college, it makes more sense to offer them on a sliding scale basis based on wealth and income. The state would make the full payment for those who can’t afford it and partial payments on a declining level as income and wealth rises.

In most OECD countries, the state is doing too much for the middle class and not enough for the needy. Instead of focusing on helping the needy, it has taken money from the left pocket of the middle class in the form of taxes and provided it back in the form of services to the right pocket usually in the form of “free” health care, “free” education and many other “free” public services. Given that the exact services are not those that every individual would have bought for themselves it’s much less efficient than just letting most people be consumers of the exact mix of services they want to purchase.

Means testing benefits also has the benefit that it provides political cover for the structural reform to the benefit programs.

7.Eliminate all tariffs and trade barriers

As Ricardo demonstrated two hundred years ago, even if one country has an absolute production advantage in the production of all goods, it will still make sense for countries to specialize to focus on their comparative advantage.

Shielding industries from competition through tariffs or non-tariff barriers to trade is ultimately futile as the protected industries almost never gain competitiveness. It just distorts domestic resource allocation and increases costs to consumers of whatever industry is being protected.

There are more efficient ways to help the workers being affected by international trade. The gains from trade are always greater than the losses incurred even though the winners and losers are different individuals, but it’s possible to compensate the losers. For instance US steel tariffs were estimated to cost over $500,000 per job saved. It would have been much cheaper to retrain these workers and even compensate them for any loss of compensation that might occurred should they be forced to take lower paying jobs.

Moreover, there is something profoundly unfair about depriving poor countries of their comparative advantage. Farm subsidies and tariffs for instance increase the cost of food in the US and Europe, enrich a small number of agri-businesses and deprive farmers in Africa and South America of their livelihood!

8.Eliminating all subsidies beyond societal transfers to help those in need

The aforementioned recommendations have no implied value judgments on equity; they just aspire to make the rendition of government services as efficient as possible. This can be done whether the state choses to be highly redistributive like in the Nordic countries – implying higher tax rates and more generous contributions to the benefits programs mentioned above – or less redistributive like the US currently is. Beyond direct transfers to the needy to serve societal objectives, there is a real opportunity to eliminate various distorting subsidies. As mentioned in the tax reform section, politicians are incapable of selecting winning technologies. Moreover, subsidies to industries or companies distort the allocation of capital.

It boggles the mind that the EU spends 60 billion euros a year, almost 50% of its budget on farm subsidies! Even the US spends $40 billion a year in farm subsidies, 35% of which are for corn. Corn ethanol is an example of the ridiculousness of those subsidies. Corn ethanol which was billed as an environmentally friendly alternative to gas is anything but. On top of that using corn to make ethanol decreases its availability and increases its costs in the food supply chain. We would be much better off importing the environmentally friendly sugar cane ethanol made in Brazil.

In total the US Federal Government spends almost $100 billion corporate subsidies excluding the subsidies implied in all the corporate tax credits and discounts!


These reforms may still be politically unpalatable, but in a few years the fiscal position of the US will be untenable and reform will be inevitable. Let’s hope we start improving before the bond market forces us to!

C.Productivity revolution in public services, health care and education

Beyond policy changes the aforementioned policy changes, the application of technology to public services, health care and education could unleash productivity led growth as it frees up misallocated labor and capital. Government spending ranges from 34% of GDP in the US to 56% in France. Health care spending ranges from 9.6% of GDP in the UK to 17.9% of GDP in the US. Public spending on education ranges from 10% to 14% of GDP. Overall 60% to 75% of the economy has not been touched by the productivity revolution.

The current environment of austerity has been leading states to do less with less, but there are enough global examples of the effective use of technology that we can do more with less. From online voting, online tax returns, to competitive online procurement processes to online bookings to avoid queuing, there are countless examples of the possible use of technology to improvement productivity in public services.

Likewise in the US, we spend $236 billion on health administration and insurance on a $2 trillion total health care spending – 11.8% of the total and $91 billion more than expected. A simple glance at the number of administrative staff in doctors’ offices suggests that something is amiss. The system is drowning in duplicate paperwork, insurance filings, billing, etc.

Education is also ripe for reform. The fundamental K-12 teaching process of a teacher lecturing a class of 20-40 with essentially uniform material has not changed in hundreds of years. Given the wide range in both teacher and student ability this creates numerous mismatches. We already have the technology for the best teachers to teach hundreds of thousands of students online, to segment students by ability and to continuously test and monitor their abilities. Higher education is leading the way with many universities and professors offering massively open online courses or MOOCs through companies like Udacity and Coursera. Sebastian Thrun had 160,000 students sign up for his Artificial Intelligence course on Udacity. Harvard and M.I.T. recently teamed up to offer free online courses. Their first course Circuits and Electronics enrolled 120,000 students with 10,000 making it through midterms. Princeton, Stanford, the Univeristy of Michigan and the University of Pennsylvania have similar offerings through Coursera.

We are in the midst of an experimental learning phase whose conclusion and global deployment both in K-12 and higher education could revolutionize education as we know it.

D. Technology innovation continues unabated

In addition to the growth potential from applying existing technology to sectors that have not adopted them yet, new technologies keep being invented. If anything it feels that the pace is accelerating. The number of patents filed and granted has doubled since 1995 from 1 million and 400,000 respectively to 2 million and 900,000 (source: WIPO). The adoption of technology is more rapid than ever before.

From my personal observation as an operator and investor in the Internet world, the Internet sector is more dynamic than it’s ever been. There are more startup companies being created around the world than ever before and the ideas are more rapidly and fluidly moving between countries. As Eric Schmidt, the Chairman of Google, recently said in the Business Week article It’s Always Sunny in Silicon Valley: “We live in a bubble, and I don’t mean a tech bubble or a valuation bubble. I mean a bubble as in our own little world. And what a world it is: Companies can’t hire people fast enough. Young people can work hard and make a fortune. Homes hold their value.” If anything the technology sector is overly frothy right now as investors are eagerly investing in anything that can generate yield.

Moreover, we are seeing early signs of exponential improvements in several sectors beyond the Internet raising hopes of further innovations. In biology gene sequencing is the most visible example with costs for a human genome sequence dropping from $100 million in 2001 to less than $10,000 in 2012 (source: Solar is seeing similar, albeit slower improvements, with costs dropping from $5.23 per peak Watt in 1993 to $1.27 in 2009 (source: Improvements in 3D printing can let us glimpse in a potential revolution in manufacturing.

The world of tomorrow is being invented today and it looks better than ever!

E. The Beijing Consensus is a short term illusion

1.Capitalism leads to greater freedom.

Capitalism is dependent on the respect of property rights, the dissemination of information and the rule of law. As such, capitalism has not only made China much richer in the past two decades but a lot more liberal than it has ever been. Foreigners and the press essentially have the right to move around. There are thousands of local newspapers who now criticize corruption, cover ups, etc.

2.Capitalism leads to greater individual wealth which in turn leads to demands for democracy.

Capitalism can exist without democracy as it has in China for the past two decades. It also coexisted with dictatorships for long periods of time in South Korea and Taiwan. As Maslow pointed out, political freedom is usually not at the top of people’s priorities when they are struggling to feed themselves. However, as people meet their basic requirements in health, lodging and food, they strive for higher level aspirations and start to worry about political freedom.

Moreover, as a middle class emerges that has a lot to lose from arbitrary rulings and confiscations, it starts clamoring for representation. I suspect that over time, the ever growing middle class in China will demand greater political representation. Baby steps in that direction are already appearing with the welcoming of entrepreneurs and businessmen in the communist party.

South Korea and Taiwan have shown how countries can transition relatively peacefully to democracy as they become wealthier. I hope that the same will happen in China in the coming decades, though I am aware of the risks of internal conflict given the diverse ethnic and linguistic differences in the country, not to mention the old guard’s desire to retain its power.

3.Income inequality is not the issue: in-country income inequality has increased, but global income inequality and quality of life inequality have greatly decreased. The real issue is equality of opportunity.

In the last 15 years in-country income inequality has increased dramatically. However over the same period of time, global income inequality has sharply decreased as GDP per capita has grown faster in developing countries than the developed world. China alone has taken over 400 million people out of poverty. Yet China has gone from being one of the most equal countries in the world to one of the most unequal. However, few would argue against the benefits of its prosperity.

Moreover, quality of life inequality, measured in terms of life expectancy, life satisfaction, height, leisure and consumption patterns, has narrowed dramatically as the gains of the lower classes have been far greater than those experienced by the population as a whole.

The more relevant finding is that inequality is acceptable if there is social mobility. On that account many countries are failing. Around the world, including in the US, elites are entrenching themselves, public education systems are not serving the needs of the lower classes and opportunities for them to climb up the social ladder are disappearing. However, those are not innate flaws of capitalism but rather specific failings in the way public school systems are run and labor markets regulated which can be addressed with the proper policies.


Capitalism is not the enemy of democracy. Quite the contrary, it is its emissary and will lead most undemocratic countries down the path of liberty and democracy.

F. Instead of a Chinese hard landing there is the potential for an upside surprise coming from China

I have argued in the past (What’s going on in China: An introduction to macro-economics), that China will eventually take control of its monetary policy and let its currency float – not because some idiots in the US think that will solve the US current account deficit, it won’t – but because it’s in China’s best interest to do that. The internationalization of the RMB and the opening of China’s financial market and economy to the world would be a very powerful positive force for the global economy.

G. Malthusian Concerns are always wrong

Malthusian type concerns have proven wrong time and time again because they encompass a static view of technology. Malthus originally predicted that the world would face famine because population was growing exponentially while food production was growing geometrically at a time where most of the population worked in Agriculture. 200 years later we have less than 2% of workers in the US producing so much food we are facing obesity epidemics! In 1972, the Club of Rome’s publication of Limits to Growth predicted that economic growth could not continue indefinitely because of the limited availability of natural resources, particularly oil. We now have more known reserves for most resources than we did in 1972, despite 39 years of increasing consumption!

There is a potential for a huge upside surprise due to explosive growth of unconventional oil and gas. The U.S. may actually very well become the first or second largest exporter of hydrocarbons to the world within the next 10 years. Some people understand this about gas; very few, at this point, realize it’s true about oil as well. Leonardo Maugeri — one of the world’s leading experts on oil who was #2 at Italian oil super major ENI for a number of years — is one of the few people who has actually built and studied a global, bottom up E&P database that includes unconventional oil developments. He just published a study that foreshadows this surprising development (Global Oil Production is Surging: Implications for Prices, Geopolitics and the Environment). This trend may very well have a transformational effect on the U.S. economy in terms of a renaissance of American manufacturing!

On top of that we will undergo an energy revolution during the 21st century. Solar is currently following a slow Moore’s law type improvement curve suggesting it will be price competitive within a decade even if you exclude subsidies and a carbon tax and would probably lead to electricity at a near 0 marginal cost in 30 to 50 years. Even barring a breakthrough in nuclear fusion, which is possible in the next 30 years especially from the private funded non-Tokamak projects, we would probably end up with energy that is “too cheap too meter”. When this happens, it’s hard to underestimate the applications it will unleash. Computing really took off once computer power was so cheap that people could “waste it” and create an unlimited variety of applications.

With essentially unlimited energy on tap, fears about fresh water shortages become a thing of the past as you can desalinate the oceans. Likewise high food prices and food shortages will be a distant memory as we will have the ability to grow crops in the desert if we actually wanted.

Moreover, the present high commodity and energy costs are creating incentives for companies to innovate and I am sure we’ll keep improving crop yields, energy efficiency, natural gas extraction, windmill efficiency and will come up with countless innovations we can’t even fathom of today.


Given the backdrop of continued productivity led growth since the first industrial revolution that started in 1750, I can only be optimistic about the long-term future. At times, this productivity growth is outweighed for years by cyclical or structural economic problems, but in the long run it always wins out – when innovation continues unabated. Yet, as Keynes said, in the long run we are all dead. What can we do to help realize positive outcomes sooner and with less pain?

Several secular trends make the optimistic scenario likely over the long term. Among the most important trends favoring global prosperity and individual liberty is the historic relationship between capitalism and greater individual wealth, which leads to demands for democracy. Moreover, the overall reduction in global income inequality is more broadly distributing the benefits of a higher standard, as well as unlocking the human potential in previously impoverished continents. The productivity revolution in public services, health care and education increasingly will allow governments to deliver better services at lower cost. Perhaps most importantly, ongoing dramatic innovation in technology, particularly in the information-based and biotech sectors, will continue to drive breakthroughs we can hardly imagine now – creating real value and proving wrong Malthusian concerns.

But the optimistic scenario is not self-executing. In the near- to medium-term, leaders need to make smart, hard choices to avert a preventable international economic catastrophe and stabilize their domestic economies. To solve the European sovereign debt crisis, there must be debt forgiveness that reduces debt-to-GDP ratios in the PIIG countries, combined with structural reforms to non-competitive economies and recapitalization of global banks that would allow them to absorb such debt forgiveness. Reformers must resist punitive fiscal austerity, which has appealing “get tough” political optics but kills essential growth.

At the domestic level, the United States must work to enhance efficiency and ensure equal access to opportunity. Several key steps that the US should take include massively simplifying the tax code, broadening the tax base and lowering marginal tax rates, which would increase the degree of compliance while lower the costs of compliance by billions of dollars. Tax reform would present the perfect opportunity to eliminate wasteful and economically damaging corporate subsidies, particularly to the agricultural sector. For efficiency and equality purposes, all tariffs and trade barriers should be eliminated as well, including the human trade barrier we call immigration law. Immigration does not create unemployment. Immigration expands the labor pool, as immigrants create businesses and add to aggregate demand. Finally, galloping healthcare spending – a stunning 17.9% of GDP – must be reduced by shifting to preventative healthcare and catastrophic insurance coverage, replacing the current system of wasteful subsidies for procedures that do not improve quality of life or life expectancy. Finally, since innovation arises out of an educated populace, it is essential to raise education standards while reforming school funding away from current mechanisms that entrench inequality.

To me, the question is not whether to be optimistic. It is whether to be optimistic about where we will be in fifty years versus five years. Secular trends alone may take care of the very long term. But I am an impatient optimist! Although debt deleveraging will bring low growth and possibly deep recession for the next several years, we need not wait decades for a good outcome. We can create our own good outcome by taking the right steps now.

Many thanks to Craig Perry, Erez Kalir, Mark Lurie and Amanda Pustilnik for their meaningful and thoughtful contributions to this article.

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