international analysis and commentary

Resolving broken promises: a recipe for economic recovery


The US economy is growing stronger every month. GDP, total employment, and the stock market index are all rising, while the unemployment rate is finally coming down. Still, despite the good news, there seems to be a notable lack of excitement and exuberance. This good news has been too long coming and the pace of economic growth remains lackluster compared to previous economic recoveries. In addition, many serious problems remain and their solutions still seem out of reach.

For example, the real estate market continues to drag with home prices stagnant or falling and with as many as 22% of US mortgage holders still underwater. Government budget deficits and debt levels at both the State and Federal levels have grown tremendously since the recession began and the prospects for turning these numbers around remain daunting. In addition, a series of quantitative easing episodes by the Federal Reserve and their pronouncements that interest rates will remain low for several more years, have raised inflationary expectations for many observers.

Perhaps the primary reason for the languishing economic conditions is the inability to quickly identify, accept and resolve broken promises. Such broken promises comprise loans made in real estate markets under more favorable conditions but now unlikely to be repaid in full AND government commitments that look increasingly unlikely to be fulfilled completely. Of course the promises have not been broken yet. But merely the potential that they will be broken in the future creates uncertainty, which, in turn, contributes importantly to the current economic drag.

Consider the problem of mortgages to homeowners who owe more than their properties are currently worth. As long as the mortgage holders keep their jobs and monthly payments continue to be made, their promises to repay the loans in full and with interest will be fulfilled. Nonetheless, the precarious financial position that these households are in considerably raises the likelihood that some portion of the loans will not be repaid. Precisely who will default and which investors will be most exposed have not yet been identified. Nonetheless, banks have responded to these conditions by holding more money on reserve and by tightening requirements on new loans. Although these actions slowly reduce the risk and exposure of banks, they also slow the circular flow of money in the economy and prevent the ignition of a rapid recovery.

At the same time, large government budget deficits accumulated in recent years at both the Federal and State levels, have raised concerns about future government spending capacity. At the Federal level, promises regarding future Medicare benefits seem most at risk. The Medicare actuary recently projected that US health care expenditures could rise from about 16% of GDP today to as much as 40% of GDP in 50 years and Medicare would make up an increasing share of that. These budget projections seem even more worrisome when coupled with the social security trustee report that the so-called trust fund will run out by 2036. This will result in unfunded obligations to the US taxpayers under current law of about $18 trillion in present value terms. At the State government level governors are wrestling with budget shortfalls as well, due in part to the stress caused by pension and health obligations to state employees and retirees. Since 2009, 43 States have made changes to their pension plans, either by increasing employee contributions, delaying the retirement age, or reducing post-retirement benefits. State health benefits also remain extremely generous and are contributing to an increase in unfunded obligations when projected into the future.

Of course, one can argue about the true value of these obligations, one can highlight the difficulties in forecasting far into the future, and one can argue that small policy changes in the future can avert disaster. All these cautions are valid. But still, the imbalances are sufficiently large that something has to give at some point. What happens then?

We already have some evidence from Greece, where people are now suffering the consequences of broken government promises. This has led to fears of insolvency and a virtual default on a substantial amount of debt among creditor institutions. It has led to periodic emergency rescue plans, volatility in economic markets and an increase in the unemployment rate to depression levels. It has led to substantial cuts in Greek government spending and the dashing of citizen expectations for future wages and pensions. It has led to mass protests and violence in the streets of Athens and other Greek cities. And it has led to the downfall of one government leader. When change comes – as it must – the ride is extremely volatile.

Imagine for a moment though, a hypothetical situation. Suppose we could assume away the uncertainties concerning the broken promises in the US economy today. Suppose we could identify which mortgages would not be repaid in their entirety and could work swiftly to cancel them and absorb the losses. Suppose seniors and near-seniors could accept that social security and Medicare support would be reduced somewhat in the future. And most importantly, suppose that politicians didn’t use an opponent’s frank discussion of the need to reconfigure future benefit packages as fodder for scare tactics and attack ads jeopardizing their political future. In other words, suppose citizens, businesses and legislators could accept that some past promises were overly generous and would not be fulfilled, and then could work together to reach an authentic and sustainable resolution.

Well, if all these assumptions were valid, we would still have some losses to accept and some economic hardships to endure. But, the prospects for the future would be significantly brighter. Uncertainty about who would lose how much would be resolved more swiftly, reviving the optimism and hope to inspire a resurgence of economic dynamism. Banks could begin lending again as households and businesses adjust their plans for the future based on realistic expectations about what was forthcoming from government. Hope would return.

Of course, in the real world we can’t assume away unfortunate realities like economists do in their models. Nonetheless, this hypothetical exercise can be instructive because we can use it to recognize just how important the pervasive uncertainty regarding the identification, acceptance and resolution of broken promises is to the economy. Solutions that seek to directly mitigate these problems may work better than those that merely push the problem into the future without actually resolving the underlying causes. For example, the initial resolution to the Greek debt problem involved bridge loans coupled with promises to sharply cut the government budget deficit. Although those actions solved the immediate problem of repayment, they did not eliminate the strong presumption of a likely default on Greek debt. In contrast, because the most recent resolution entails a substantial write down of Greek debt, it requires the acceptance by creditors that previous promises will not be honored. As such, the latter deal – even if it doesn’t solve all future problems – should prove more effective than previous deals.

The Greek debt deal takes care of a few hundred billion dollars of broken promises … and that only leaves a few trillion dollars more of outstanding promises around the world. If that resolution happens quickly, then we can expect an economic roller coaster with a series of crises over the next few years. However, quick resolution will also mean a quicker return to more prosperous times. The alternative is a very slow and gradual approach. This kind of outcome is more likely, especially when central banks try to prevent crises with regular increases in liquidity. In this case, the world economy can be expected to languish for a very long time and the heady economic times of the past few decades may not return for another generation or so. Thus, although the recent economic news is promising, too many underlying problems remain for anyone to get too excited about it.