Response to

The Keynesian Anti-Recessionary Analysis
of Willem Buiter

Edward J. Dodson

[What follows is a commentary posted on 2 October 2009 by Professor Willem H. Buiter, of the London School of Economics, to which I offered comments. Professor Buiter did not respond to my comments but two other persons did, and their statements are included below]

A Stronger US Economy Requires a Weaker Dollar

By Willem H. Buiter, London School of Economics / 2 October 2009

Sometimes economics can be helpful even if it does not allow you to make point predictions with any degree of confidence. This is the case, for instance, when it can rule out certain combinations of outcomes for different economic variables as unlikely or even nigh-on impossible. An example of such an unlikely configuration of outcomes is (a) a strong and sustainable recovery of the US economy and (b) a strong (let alone a strengthening) US dollar. A very similar statement can be made about the prospects for a speedy recovery of the UK economy. …

I start from the assumption that today and for the next two or three years at least, output in the US economy will be demand-constrained. There is large and growing excess capacity in the form of idle labour and capital resources. I cannot relate in any way to those who view the Great Depression of the 1930s as the Long Vacation, or who argue that the increase in the US unemployment rate from 4.4 percent of the labour force in March 2007 to 9.7 percent of the labour force in August 2009 represents an increase in the demand for leisure by the US proletariat and salariat or a particularly nasty exogenous shock to labour productivity. …

There is, of course, no labor market tautology saying anything like that, unless you also assume that actual employment always has to lie on the marginal productivity schedule of labour. I consider such a view to be bonkers. But nuff said.

For me, an unreconstructed Keynesian when it comes to the interpretation of the drivers of business cycle fluctuations, the key question concerning the speed of recovery from the Great Recession of the Noughties, : where will the demand come from.

Let's consider the drivers of domestic demand. Private consumption is dead in the water and likely to remain so for quite a while. US households still have a debt-to-annual disposable income ratio of around 150 percent, which, if the debt is hard (that is, not easily repudiated) is a source of vulnerability that can encourage precautionary saving as well as saving for life-cycle or other reasons. The US consumer has by now been cured of the previously well-entrenched belief that saving is for sissies because real men count on capital gains on homes and equity to see them through the night.

It is, of course, very easy to walk away from personal debt in the US. Mortgage debt is overwhelmingly non-recourse, so the rational response to negative equity is to send the key to you home back to the mortgage lender. As regards other consumer debt, personal bankruptcy is just a couple of phone calls and a quick court judgement away. Shame and feal of stigma appear to be rapidly weakening deterrrents to such a course of action.

So is US household debt not a drag on demand? If the debt can be repudiated swiftly and at little cost to the debtor, US household debt won't be much of a drag on consumer demand. The creditors will, of course, take the blow. Given the precarious condition of the US financial system, the negative effect on demand (through the credit channel and other financial linkages) of large-scale discretionary default on housing debt is likely to be non-trivial.

Government spending on goods and services (both current and capital) will remain strong for at least the first half of 2010, because most of the Obama fiscal stimulus plan is still in the pipeline. But in the second half of 2010 that stimulus will wear off and the US administration simply does not have the fiscal means to implement a further fiscal stimulus without seriously spooking the financial markets. The US has to commit itself soon to a severe future fiscal retrenchment (tax increases and/or public spending cuts) if the government is to retain (or rather regain) its reputation as a solvent entity and the Fed its reputation for taking inflation seriously.

Inventory accumulation will no doubt bring joy to the US and other overdeveloped economies for two or three more quarters. One of the nicer non-linearities is economics comes from the robust empirical observation that stocks cannot be negative. Inventory decumulation (de-stocking) therefore grinds to a halt at some point, often quite early in a recession, and restocking will take its place, making for a nice little recovery while it lasts.

Unfortunately, businesses build stocks in the hope and expectation of future sales. Unless final demand picks up, the lift given to economic activity by re-stocking will peter out again. Private consumption and public spending (consumption and capital) are not going to provide any material stimulus. That leaves private investment and net exports.

Investment in residential housing is unlikely to bring much joy even if home prices continue to stabilise and recover further, because massive excess capacity has been built up and depreciation rates on housing are low. Commercial property makes residential housing look like a growth industry. That leaves business fixed investment and next exports.

These two hang together. Business fixed investment growth requires healthy growth of net external demand. US production has to shift from non-traded goods and services to traded goods and services, both exports and import-competing goods and services, at the same time that the national saving rate rises. That will happen only if the rest of the world grows healthily and if the dollar takes a beating - by about 30 percent in effective (trade-weighted) real terms on my back-of-the envelope calculations. Because this depreciation in the US real exchange rate has to happen swiftly if the country is to experience a health recovery rather than an anaemic stroll through 10% plus unemployment territory, most of the real exchange rate depreciation will have to come through a nominal depreciation.

Which currencies would the dollar depreciate against? Not the euro, surely, which has been too strong for compfort since before the crisis. Not against sterling (the UK is pretty much in the same boat as the US, with the balance sheet position of the household sector if anything worse than in the US), and certainly not against the yen. The US dollar will mainly have to depreciate, if a long spell of over-capacity, high unemployment and low growth is to be avoided, vis-a-vis the currencies of the roughly 50 percent of the known economic universe that we call emerging markets and developing countries. China is the largest of these, but amounts to only about 6 or 7 percent of global GDP.

China, India, Brazil, Turkey and a dozen or more other EMs are providing the kind of domestic demand-driven growth stimuli that could drag the US along in its wake. But the key relative price adjustment has to occur also: there has to be a real depreciation of the US dollar and a real appreciation of the EM currencies.

Because I consider it likely that too many EMs will continue to be reluctant to let their real and nominal exchange rates appreciate sufficiently, I consider it unlikely that the external stimulus to the US recovery will be sufficient to close the US output gap swiftly. I hope to be proven wrong.

While I find myself in broad sympathy with Michael Mussa's approach to the drivers of the US (and global) economic recovery in his recent IIE paper (Michael Mussa, "Global Economic Prospects as of September 2009: Onward to Global Recovery", Peterson Institute for International Economics Paper presented at the sixteenth semiannual meeting on Global Economic Prospects, September 17, 2009), I disagree with his numerical/quantitave calibration, which I consider to be too optimistic, especially for the overdeveloped world. Mussa underestimates the domestic-demand dampening effect of the financial crisis and the bad/disastrous balance sheet configurations of the US household sector, banking sector and government sector. The V-shaped recovery and Victor Zarnovitz law, the deeper the recession - the steeper the recovery, are unlikely to be relevant for a deeply financially challenged economy like the US, where massive financial damage was done before the recession - and where this financial collapse was indeed the cause of the recession. The recession continues to feed back adversely on an already impaired financial sector, further undermining its capacity for lending and other intermediation. Mussa could turn out to be right, but if he turns out to be right, it will be because he is lucky.


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A Response to Professor Buiter

By Edward J. Dodson

To more fully understand what triggers cycles, I point Professor Buiter to Ricardo. Ricardo did not extend his analysis of ground rents to locations in cities or to residential property markets, but he provided keen insights that (for the most part) have been given little attention by modern economics.

What Ricardo understood is that credit acts as an accelerant on the natural tendency of investors to speculate in locations. Far better to use leverage and risk someone else's assets in speculation than one's own. The use of credit by investors in the property markets is normal. What was not normal in this land market cycle were the aggregation of externalities -- most importantly the bypassing of the GSEs as the core secondary market controls over the quality of collateral going into mortgage backed securities. Wall Street packaging of loans and investors looking for high nominal rates of return stimulated the production of mortgage loans made without verification of income, employment or even creditworthiness -- often with fraudulent property appraisals. A high percentage of second mortgages were originated under predatory terms with even greater incidences of fraud.

What happens whenever the pool of potential borrowers or homebuyers expands is that market forces capitalize the change in equilibrium into higher land prices. The mortgage lenders responded by a combination of raising maximum loan limits, reducing down payment requirements, extending mortgage terms, creating interest only mortgages, permitting negative amortization and offering ARMs with low "teaser" rates for the first six months or year of the loan.

Those of us in the industry who saw all this developing and feared the worst observed that on a higher percentage of property appraisals the land-to-total value ratio skyrocketed in many markets. By the early 2000s, the loans we were purchasing involved financing for more and more land and less and less housing.

Similar problems were operating in the commercial real estate sector. Here, investors ignored current cash flows and entered into bidding contests for properties they expected to flip after a few years to take advantage of rising land prices. Banks accommodated their speculative investments by making poorly underwritten loans and passing on the default risk to investors who purchased CMOs (i.e., collateralized mortgage obligations).

What economists ought to immediately understand is that at some point the accumulative financial stress on businesses and residential property owners always brings on a collapse in property markets (with bank failures as collateral damage).

Business profit margins are reduced by rising land acquisition costs (pushed forward to increases in the cost of leasing space in office buildings, retail shopping centers, etc.). So, businesses look for ways to reduce costs of doing business. When business relocations begin and vacancy rates increase, this is a clear indication that a crash in the property market is on the horizon. In the residential property markets, the end comes when property (i.e., land) prices become too high for first-time homebuyers to enter the market even with the exotic mortgage offerings provided by lenders. The continuation of the cycle depends on the ability to pass on rising land costs to others.

By 2004-2005, the capacity of millions of U.S. households to carry housing debt on top of other debt and expenses had reached its maximum. Household incomes were stagnant or declining, household savings had disappeared for many, and interest rates could not be lowered (in part because the U.S. government needed to offer foreign investors some level of return to attract sufficient funds to meet government expenditures).

It is too late to prevent the economic crisis. At best, what governments around the globe will do is mitigate the depth and duration of the depression. The land market cycle will begin again when businesses see the opportunity to invest (or, more accurately, to borrow and invest) in new capital goods creation and once again generate profitable sales.

Among the numerous reforms we need is regulation that prohibits banks from extending credit for the purchase and/or refinancing of land. This will require investors and homeowners to come up with cash down payments from savings or other sources that do not put the financial system at risk. Removing credit as the accelerant for land speculation will not solve the problem, but it is an important first step. Government also must examine the various ways it chooses to raise revenue. Our boom-to-bust economic structure is fueled by the capitalization of imputed and actual "rent" flows (i.e., income derived from the holding of locations in our cities and towns, in natural resource-laden lands, in the broadcast spectrum, in landing "rights" awarded to airlines, and other forms of economic licenses the value of which comes to be saleable). These values -- the rents -- are societally-created and should be a primary source of revenue to pay for public goods and services. They are, at present, largely privatized. Government still needs revenue, and so taxes earned income flows, real assets and commerce, essentially penalizing productive economic activity to the benefit of speculation and hoarding. Sustainable economic growth will never occur until these counter-productive policies are changed.


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Comment by Hendrik Verroken

I totally agree with Mr Dodson, I think; and it gives me a "deja vu" when i remind my recent lecture of Galbraith on the great depression of 29. The resemblance is striking to my opinion with the Florida Boom in the days before the crash of 29.

Comment by an anonymous respondent

Thank you very much, Professor Buiter, for yet another excellent, cogent and lucid summary of the situation. It would appear that the arsenal of credible policy options is alarmingly small - I am not quite certain whether responsible officials fully comprehend just how few options remain. On the assumption that the EMs will not torch the carcass of "Bretton Woods II" (because they are themselves conscious of their inability to restructure their economies with sufficient rapidity to avoid a dramatic shock), I wonder whether the US authorities will at some point be constrained to adopt a more explicit policy of inflation in order to spite the EMs for their failure to co-operate adequately in the appreciation of their exchange rates.

Thank you also to Mr Dodson for his post, which I think is so good that I feel I must comment. As far as the UK is concerned, there is very clear and direct causal link between the relentless and pernicious increase in house prices over the past forty years and the failure to tax the assumed "rent" on residential property. As far as I can recall, the revised income tax of 1803 devised by William Pitt the Younger (who was chancellor of the exchequer as well as premier) contained a Schedule A, which taxed the assumed or "notional" rental income on land - this was to replace the land tax which had been introduced by the Stuarts, but which had become less efficient as the eighteenth century progressed. Schedule A worked very well, with cinquennial valuations conducted by land agents/surveyors. This was high volume, low margin work for them, but it was comparatively simple and inexpensive to do. This system helped to ensure that the UK experienced comparatively little of the sort of land speculation noted by Henry George in late nineteenth century California (please note - I am not a Georgist).

Schedule A worked quite well, although rising rents in the 1900s led Lloyd George (inspired in part by his namesake) to introduce the concept of LVT - though this was aborted because of World War I. However, it was World War II which wrecked Schedule A. The last cinquennial valuation was (I think) in 1935 - of course, by 1940 many British cities were in flames. The valuation due that year was not carried out, as surveyors were more than fully occupied in assessing claims for war damage. The same was true of 1945 and at least for several years thereafter, as there was such a massive backlog of claims. The loss of about a sixth of the housing stock to enemy action, wartime/postwar inflation and the return of large numbers of servicemen guaranteed a mini-boom in house prices in 1948-49.

These factors made the 1935 valuations seem absurd (not unlike Council Tax today) and during the 1950s the Royal Institute of Chartered Surveyors (RICS - conveniently located opposite HM Treasury on Great George Street) began to lobby the Conservative government for its abolition - for many surveyors felt that there was too much work to be done in order to reconstruct a credible set of valuations, and the margins would not make it worth the effort. The surveyors were soon joined by the representatives of the accountancy profession and the Institute of Taxation. The government proved a willing listener - the voting strengths of the two main parties were quite evenly matched, and many Tories had bought into the concept of a "property-owning democracy" first advanced in 1924 by the Scots Tory MP Noel Skelton (1880-1935). They thought that a large cadre of micro-capitalists would act as a bulwark against socialism, and that this was a perfect opportunity to steal a march on Labour. The phrase "property-owning democracy" was used frequently by Sir Anthony Eden in the 1955 election, and may have helped to secure victory for the Conservatives. Conscious of the threat to their electoral bases, Labour and the Liberals also began to agitate for abolition.

The Treasury, however, was reluctant to do away with Schedule A - but by the end of the 1950s the 1935 valuations had become so obsolete and its relative yields (accounting for the cost of collection) had so diminished that the powerful chairman of the board of the Inland Revenue, Sir Alexander Johnston, began to lobby hard for its abolition, though his arguments did not initially convince other officials or the chancellor, Derick Heathcoat Amory (1958-50). The rather weak chancellor, Selwyn Lloyd (1960-62) was also reluctant to agree to abolition, but was persuaded by: (i) his officials, like Johnston; (ii) the idea of a possible substitute capital gains tax; (iii) the overwhelming enthusiasm of the Tory rank-and-file for abolition, demonstrated abundantly at party conferences in 1961 and 1962; (iv) the growing unpopularity of the Tory government, and the need to attract votes; (vi) the "moral" argument against Schedule A - that it was "unfair" to single out real property over other assets; (vii) the "administrative" argument - that it had become too obsolete, complex and cumbersome to reform; and (vi) the influence of his premier, Harold Macmillan, who was desperate for some sort of political break. Lloyd relented in his budget of April 1962, though Macmillan sacked him anyway in the "Night of the Long Knives".

Schedule A was phased out between about 1963/4 and 1966/7. The Labour government of Harold Wilson had been elected with the assistance of middle class votes in 1964 - it had a tiny majority, so did not want to alienate this constituency. So, when capital gains tax was introduced in 1965 by Jim Callaghan, it crucially did not tax unearned increases in the value of the primary place of residence. House prices started to pick up after 1968/9 as a hedge against rising inflation. Edward Heath/Tony Barber poured lighter fuel on the fire in 1971 by significantly relaxing controls on credit. The slump in house prices in 1973/7 was forgotten by the Conservatives in the 1980s, who removed virtually all remaining controls.

So since the abolition of Schedule A (which was killed off by a mixture of ideological fervour, political opportunism and professional lobbying) Britain has experienced a rakes' progress - with long, near-parabolic episodes of house price inflation punctuated by occasional, savage corrections. Housing has, in this context, become a sort of cultural/financial shibboleth. All the while resources have been grossly misallocated at every level - and I do not think that most policymakers truly appreciate the degree to which the absence of Schedule A (or an equivalent), allied with the liberalisation of credit, has adversely affected the well-being of the UK and has acted as a drag on investment and productivity. Its abolition was a major factor in the UK moving from a "prudential" to a "visceral" model of economic management (to use Aver Offer's terminology).

Aside from the LVT crowd (who occasionally surface in blogs), and some typically wise comments from Martin Wolf (going back to about 2003), the idea of taxing unearned "rent" is never discussed. Even if it were, it would never be contemplated by any practical politician, as public resistance to the "confiscation" of a presumed free lunch would be overwhelming. The whole process tends to validate Mancur Olsen's theories about entrenched interests in mature economies being a primary factor in their own decay. I guess that we in Britain will just have to learn the (very) hard way. In any event I think that the history of the fiscal causes of our current predicament merits further study.