December 12, 2006

Unmeasured Savings

Yesterday a reader sent a link to a Wall Street Journal commentary, perhaps hoping to jolt me out of a flu-induced haze - it did the trick. Reading Five Macroeconomic Myths ($) by Nobel Laureate Edward Prescott is further proof that much of mainstream economic thought today is profoundly based on ever-rising asset values at any cost.

For better or worse.

The WSJ article was derived from this presentation made at the Economic Club of Phoenix a couple weeks ago where, curiously, there used to be seven myths. Whatever the number of myths, a closer look at a few of them is clearly warranted.

Myth 1: Monetary policy causes booms and busts
One of the mysteries of the 1990s is how to explain the economic boom when the increase in capital investments -- as measured by the national accounts -- grew at a subdued pace. The numbers simply don't add up. However, it turns out that something special happened in the 1990s, and it wasn't monetary policy. In a recent paper, Minneapolis Fed senior economist Ellen McGrattan and I show that intangible capital investment -- including R&D, developing new markets, building new business organizations and clientele -- was above normal by 4% of GDP in the late 1990s.

This difference is key to understanding growth rates in the 1990s: Output, correctly measured, increased 8% relative to trend between 1991 and 1999, which is much bigger than the U.S. national accounts number of 4%. Associated with this boom in unmeasured investment is the huge amount of unmeasured savings that showed up in the wealth statistics as capital gains. This was the people's boom, the risk-takers' boom. We should hang gold medals around these entrepreneurs' necks.

Well it's nice to see that financial dark matter has uses in addition to rationalizing the trade deficit. Left unsaid here is that during the 1990s, the value of intangible investment like patents, brand names, R&D, and "unmeasured savings" (more on that in a minute) all rose at a pace nearly equal to stock prices.

It all makes perfect sense when you think about it - just like housing today, if you try hard enough you can convince yourself that assets are properly valued.

Actually, aside from the dark matter rationalization, it's hard to disagree with the refuting of this myth - it's not a matter of causation, but rather, enablement. Had money been tighter - margin lending, venture capital, you name it - the internet boom may have been a long gradual affair rather than a mad dash to the 2000 tech wreck.

Unmeasured Savings

It was hard to select a title for today's post until this phrase was looked at a few times - unmeasured savings. What will they think of next? It is reminiscent of the phrase from the Chicago Fed from just a couple months ago explaining how wealth creation technology in the form of "innovative" lending, and not loose monetary policy, caused the housing boom.

In fact, the two should probably be combined - contemporary mortgage lending could be more properly characterized as "savings creation technology".

Myth No. 3: Americans don't save. This is a persistent misconception owing to a misunderstanding of what it means to save. To get a complete picture of savings we need to investigate economic wealth relative to income. Our traditional measures of savings and investment, the national accounts, do not include savings associated with tangible investments made by businesses and funded by retained earning, government investments (like roads and schools) and business intangible investments.

If we want to know how much people are saving, we need to look at how much wealth they have. People invest themselves in many and varied ways beyond their traditional savings accounts. Viewing the full picture -- economic wealth -- Americans save as much as they always have; otherwise, their wealth relative to income would fall. We're saving the right amount.

Actually, the misconception comes from the Commerce Department that continues to report a negative personal savings rate - a condition that persists when consumers' expenditures exceed their income. Of course, the difference is made up primarily by borrowing against the rising value of real estate - something that works well until real estate values stop going up.

It's hard to believe that something once shunned - borrowing against your house - is now a way of life for many homeowners, especially senior citizens.

It's also hard to believe that the entire second paragraph above could be written without using those two words - "real estate". That's where the lion's share of the "wealth" has come from in recent years, wealth that now seems to be disappearing in many parts of the country.

Apparently even a Nobel Laureate economist thinks that people don't have to save the old fashioned way anymore, that rising asset prices will do the heavy lifting. Amazing.

Gubment Debt

As if the rationalization of wealth and savings wasn't enough, government debt is first defended as being "not large", then as possibly "too small". It helps to make this case if you can exclude large chunks of the debt.

Myth No. 4: The U.S. government debt is big. The key measure here is privately held interest-bearing federal government debt, which includes debt held by foreign central banks, and does not include debt held by the Fed or government debt held by the government. So let's turn to the historical data once again.

Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. This debt level was not alarming then, and it is not alarming now. From a historical perspective, the current U.S. government debt is not large.

According to the Treasury Department, in just the last ten years debt held by the public has increased by 28 percent while intragovernmental holdings have increased by a whopping 125 percent. For most of the last three decades intragovernmental debt was insignificant compared to the public debt - now they are almost equal.

To say that only debt held by the public matters when assessing the size of the debt is the height of hubris.

It fails to consider what happens when the debt comes due, as many future Social Security recipients are expecting, and it also pays no heed to the likelihood that current holders of public debt may ultimately balk at continued monetization of new debt.

It sounds almost too good to be true - that the country can continue to borrow and print money like a banana republic forever, with no consequences.

Grandkids, Don't Worry

There is much more here - most of which would make little sense to anyone other than another economist, and maybe not even then. The reassurance provided to future generations regarding the debt of the current generation is priceless.

If we should worry about our grandchildren, we shouldn't worry about the amount of debt we are leaving them. We may even have to increase that debt a bit to ensure that we are adequately prepared for our own retirements.

Something about insufficient productive assets to meet the needs of future retirees leads the casual reader to believe that reliance on ever-increasing asset prices to assure a sound financial future are again somehow involved.

Can asset prices really rise in perpetuity? We'll probably find out in the next five years.

Will there be consequences to supporting ever-increasing asset prices with an expansion in money and credit that seems to know no bounds? We'll see.

That seems to be the assumption that is central to nearly all of contemporary economic theory - keep asset prices rising, whatever it takes.

If the unfolding aftermath of the housing boom that followed the stock market boom is any indication of what lies ahead, today's youth can only wonder what they will find as they approach their golden years.