The worst of the financial crisis is past. The U.S. economy is slowly recovering, home prices are rising and the stock market has had a strong run. But two Wharton faculty members warn that there is still plenty to worry about — in the U.S., Europe and the emerging markets.
Kent Smetters, professor of business economics and public policy, says the U.S. must come to grips with looming problems in Medicare, Social Security and other entitlements. Raising taxes on the wealthy will not produce enough new revenue to solve the problem, Smetters notes. Nor will counting on an economic rebound. Instead, the U.S. will have to look at painful options like raising taxes on the middle class or trimming entitlement benefits, or both.
Management professor Mauro F. Guillen says that Europe’s debt crisis is a long way from being over — a problem likely to dampen economic growth worldwide. In addition, he notes that emerging markets such as India, China and Brazil are not the growth engines they were a few years ago. The world, according to Smetters and Guillen, is in better shape than it was during the depths of the financial crisis, but is not likely to see a dramatic recovery in 2013.
Edited transcripts of both interviews appear below.
Interview with Kent Smetters:
Knowledge at Wharton: What is the state of the economy? It certainly seems to be a little bit better, but no one’s really bragging about it. Is it going to get better, sputter along or get worse? What do you think?
Smetters: I think it’s going to sputter along. And I think we’re in this for a while. A lot of the projections that people have about a turnaround in 2013 or 2014 are probably optimistic. Historically, since 1980, fixed private investment has hovered around 16%-17%-18% of GDP. And that’s gone way down. It went down to about 10%-11% during the Great Recession. It’s slowly climbing its way up, but it really has not come back to where we need it. And the job market is still really bad: Job creation is barely keeping up with the growth rate of the population. At this rate, we won’t be back to the natural rate of unemployment for another five years at least. In fact, most of the changes that we’ve seen in the unemployment rate recently have actually been just because of people [halting their search] for jobs rather than real jobs being created.
Fundamentally, in this country — and this is the big issue a lot of people aren’t talking about — we really have an education problem. If you look at the unemployment rate for college graduates, it never got that high, even during this Great Recession. It’s been a lot of people who do not have a college degree. [The unemployment rate is] still in the double digits for that group; for blacks and minorities, the rate is still in the double digits. That’s the big problem — the world is changing, and there are big returns to education. A lot of people don’t have it. That’s what we really need to be focusing on.
Knowledge at Wharton: For those who don’t have a college degree, I hate to be pessimistic, but is there any real hope other than going back to school? But what if you’re in your 30s or 40s or 50s and you don’t have much of an education?
Smetters: The truth is that there really is not a lot of hope unless they obtain new skills. So I think the approach for education is multi-faceted. We need to have much better public schools. Public schools should be focused on educating kids…. Schools should [give] more power to the kids and less power to the teachers unions. Of course, there are more issues involved than just that. We’re spending a lot per capita on kids in this country in terms of education. We’re one of the highest in the world. But we’re getting very little return for it. So we need to fix public schools. But we also need to get better training for people in their 30s. They can acquire new skills. But the bottom line is that a college degree is still the big differentiator in the labor market today.
Knowledge at Wharton: While we’re on public schools, one of the obvious problems is kids dropping out. They’re really not getting an education. But for those who remain, do you think that the schools are focusing on the right skills, the right subjects?
Smetters: No, I don’t think so. There has to still be more reward for getting people to understand a lot of the basic fundamentals of reading, writing and arithmetic. We have a shortage still of engineers, of even computer science professionals in this country. We still have kids who are graduating who really can’t comprehend reading and can’t write. Those skills are huge advantages in the labor market.
Knowledge at Wharton: When you look at the economy, aside from the things we’ve mentioned, what do you see as the key issues that are overhanging right now, that will either push it ahead or could send us back into a bigger slowdown?
Smetters: I think education reform is a long-term investment. Another long-term investment that we’ve got to be making right now is entitlement reform. There is this belief, this myth, out there that we don’t have to take any big hits right now until we get the economy back in shape. It’s “Let’s just get the economy back to full employment and then we’ll take our medicine.” That’s the big problem that we face right now because that’s just a myth. In particular, we’ll never get people to make large investments in this economy when they face tremendous uncertainty about whether they’re going to get taxed to death later on.
And we really have to resolve the long-term financing problem. The government can encourage people to make the big bets. We’ve already seen this in the area of biology right now. Investment in that area has gone way down, lots less investment in pharma, large molecule and small molecule therapies and so forth. [These have decreased] over time because they’re long-term bets, and no one knows what that world is going to look like 10 years from now. And given the low probability of success, people are starting to shift toward less risky things. That’s a big problem. The government needs to create much more clarity for investors and people making big sacrifices — what that world is going to look like a decade from now. We’re just not doing that.
Knowledge at Wharton: A lot of the discussion about entitlements of course centers around Medicare as the real big one that is a major, major problem. You hear remedies proposed like raising the eligibility age by a year or two or clamping down on the payments to doctors and hospitals. Are those really enough? Or does there have to be something much more sweeping than that to make this work?
Smetters: It has to be fundamental reform. Those are not going to do much. Increasing the entitlement age, the retirement age, is not going to do much. Reducing reimbursements to doctors just means fewer doctors are going to take Medicare. What really has to change is that we need to [move] away from the fee-for-service model that we have now, and more toward per capitation — or having people understand the marginal costs of the medicine that they are getting. Various plans out there, bi-partisan plans like the Ryan-Rivlin plan and other plans that have tried to move the conversation in that direction, have been kind of demagogued by all sides. But that’s the conversation we need to have. If we fix everything else and don’t touch Medicare, we’re doomed. And if we screw up a lot of things, but fix Medicare, Medicaid and Social Security, we’re in pretty good shape. So it really comes down to those.
Knowledge at Wharton: And Social Security — my impression is that it is a problem, but not as big a problem as Medicare. Is that correct?
Smetters: It is. It’s a much smaller problem, both in size and in the nature of the problem. In size, it’s probably one-sixth the problem of Medicare. And in terms of the nature of the problem, at least with Social Security benefits it’s a dollar benefit, so you can decide who to give fewer dollars. Lots of plans out there are about keeping the poor out of poverty, but maybe reducing some of the benefits that go to higher income classes and so forth. With Medicare, it’s a much higher, harder problem. Because what do you do? You say, “We’re not going to pay for half of this open heart surgery and you pay for the other half?” That is a much harder problem to fix.
Knowledge at Wharton: I gather that raising the eligibility age or the starting age for Medicare doesn’t mean much because those are the healthier people in their 60s.
Smetters: Right.
Knowledge at Wharton: It’s the people in their 80s who are really costing a fortune.
Smetters: That’s right. Almost all of the Medicare spending — I shouldn’t say all, but the vast majority of it — is done in the last two or three years of life. So increasing the eligibility age has very little impact.
Knowledge at Wharton: Looming over all of this of course is the question of the debt, the deficit and the debt ceiling. How important is it that we get some sort of long-term solution to these problems?
Smetters: It’s critical. No one’s going to make an investment, entrepreneurs are not going to make the sacrifice, until they know what the long run looks like. And the signal so far from Washington has been entrepreneurs and people who have invested and succeeded, they’re going to be the ones who we go to for getting the money to solve these problems. Until you create that type of certainty about what the future politics is going to look like by having us on a long-run sustainable path today, we’re not going to make any real headway.
I think the biggest myth that really needs to be dealt with is this idea that we can just balance all of these problems on the backs of the rich: That has been the group who we have gone to in the past, and that we can just pile some more on. Right now, we’re carrying a national deficit of $9,000 per every U.S. household. If the Bush tax cuts had expired, and taxes went up for everything, taxes would have only gone up about $2,000 per household. That’s what everybody was calling the fiscal cliff. And, of course, that couldn’t possibly happen.
There is this big view in Washington, really on both sides, that the middle class should not be hit — whether it’s higher taxes or lower benefits. And they should be participating in this whole debate, where it’s just mathematically impossible to do something meaningful without them participating, either in the form of higher taxes, a broader base or lower benefits. The most recent tax increase on the rich will close about 6%-7% of the annual deficit this year — a trivial amount. We need to have a broad-based discussion.
Knowledge at Wharton: Is there any way to deal with these problems without a lot of pain for the middle class and for others? Are there any technological breakthroughs or “dream solutions” that we haven’t thought of or that may come along?
Smetters: No, no. We’re just way over-consuming right now. We’ve gotten a very rich appetite, and it’s going to be painful for people to think about [cutting] back. But right now as a nation we’re spending much more than what we can. As a result, we’re not saving for the future, and we’re on a path that is just completely unsustainable. The middle class has to be part of the solution.
Knowledge at Wharton: I think most people would say — if you asked them what they want out of the economy — that they want an improved standard of living, better prospects for jobs and a comfortable retirement — it sort of boils down to those. What are the prospects for getting all of those in the next 10, 15 or 20 years?
Smetters: They’re not good, at least on our current path, simply because we’ve already consumed a lot of that. We have saved very little for the future. The average U.S. household has saved very little. Our government has overspent, and we’re simply not going to grow fast enough in order to allow us to grow our way out of this problem. Keep in mind, certain benefits like Social Security and Medicare, in order to keep up with technological progress, they keep up with the average wage rate. It’s not something that we can easily grow our way out of, and so real fundamental choices are going to have to be made. This is why it is really important that we make hard decisions about saving more today.
And the tone of Washington has to completely change. Right now, the President is essentially taking advantage of the weakened position that Congress has, especially in the public limelight, whereas the President really needs to shift focus and say, this is a national problem, it’s a bi-partisan problem. We’re here because of both political parties, and we need to have a fundamental reform to our tax code and our entitlement problems. But this is going to involve everybody’s participation. This idea that we can finance this off the backs of a few, it’s just mathematically impossible.
Knowledge at Wharton: Well, it’s grim but I guess we knew we had to hear it. So we’ll hope things turn out better. But thank you very much. We’ll talk about it again.
Smetters: My pleasure.
Interview with Mauro F. Guillen:
Knowledge at Wharton: We want to talk about the state of the economy and the state of the world for 2013. I would like to start with the emerging markets. We often think that this is where the future is, and where the great growth potential is. At the same time, if you are an investor, you see a lot of volatility, and you know that there are a lot of ups and downs in these countries. What is the state of emerging markets today?
Guillen: It’s not as good as we would like it to be here in the United States or in Europe or in Japan, or in the other parts of the world that are not growing that much. Let me explain: I think most people would like the emerging economies to become the locomotives of the global economy, but in recent months — over the last year or so — emerging economies have also begun to slow down a little bit. They’re still growing. China’s growing at 6% or 7%. India is growing at maybe 5%. But Brazil is barely growing. It has been growing at less than 1%. This slowdown in the emerging economies actually comes at a bad point in time because we would like them to be a little bit more dynamic than what they are right now.
Knowledge at Wharton: Is this a result of what has happened in the rest of the world spilling over to them? Or do they have their own factors that are causing this?
Guillen: The answer is yes to both. The emerging economies export their manufactured products and some of their energy or other commodities to Europe or to the United States. If growth here or in Europe is not as strong, then these economies suffer. Second, they also have problems of their own. Brazil has encountered a number of bottlenecks in its economic development, in its growth over the last three or four years. Interest rates were too high because they were keeping inflation down, but that meant that local businesses didn’t have enough credit at an appropriate price to invest and to create jobs and to grow. India [is] also famous for the many bottlenecks in infrastructure, in the legal system and so on. In one emerging economy after another, what we see is that because of both domestic reasons and global reasons, they’re starting to grow less rapidly than they used to.
Knowledge at Wharton: And what is going on with China, which was such a powerhouse for a while? It seems to be slowing down.
Guillen: In China we’ve had a leadership transition that it still going on in terms of filling in the various positions in the government, so there’s some uncertainty regarding that. Then, of course, we have the problem with exports to Europe and also to the United States, even though the U.S. economy is growing faster than European economies, which are not growing at all, except for Germany and a couple of others. And then thirdly, of course, China has the challenge of initiating an economic transformation right now. It is an economy that has been investing a lot in infrastructure. It has been growing in terms of exports. But it is an economy that now needs to switch to the creation and the growth of a domestic consumption market. So again, these transformations, these transition phases are difficult. And I think China is now essentially wrestling with those issues.
Knowledge at Wharton: How does this affect the developed countries? Does this make them more competitive or is this hurting them? Why should we care other than that they’re our fellow citizens of the world?
Guillen: The [emerging] economies are a very important part of the global economy. They account for nearly half of the global output and also at least 40% of the global market for consumer goods. So if things don’t go well in the emerging economies, it affects everyone, not just them. Twenty years ago, the emerging economies were at most 15% or 20% of the global economy. The bulk of economic activity and the bulk of consumption were in Europe, the United States and Japan. But that’s no longer the case. Now we cannot really afford for emerging economies not to play their role in the global economy, which is to grow quickly. The up-and-coming economies are supposed to grow quickly. They’re not growing as quickly as they once did. And that’s a problem.
Knowledge at Wharton: Now you’ve mentioned the major ones — China, India, Brazil — what about some of the other countries? There are other Asian countries that were once known as real up-and-comers. What is happening with them?
Guillen: In the emerging world, we have new countries that have now become hot and attractive for investment, and they’re growing quickly. For example, in Latin America there are two of them — Colombia and Peru, which are clearly doing really well, especially compared to 10, 15 or 20 years ago. If you go to Africa, there are also two or three economies that are doing better than in the past, even though there are many problems, of course, that continue to limit growth in Africa. In the Middle East, we have Turkey, which is doing pretty well. But then right next to it we have Egypt, which in the wake of the Arab Spring has actually gone through a period of enormous difficulty from an economic and financial point of view for a variety of reasons.
And then in Asia, we have Pakistan, which is actually doing pretty well. It is growing at about the same pace as India. This is a very large country as well. And in Southeast Asia, we have Indonesia doing relatively well, and Malaysia, which seems to have finally recovered from the difficulties of 10 years ago or so…. But we have other economies in the region that are not doing as well, so it’s a mixed bag; it’s a mixed picture. Some countries are doing better than we were expecting them to do, and others are not performing as well. But on balance, I would say that we’re worse off in terms of growth in the emerging economies than we were two or three years ago.
Knowledge at Wharton: Is there anything that the international community could be doing to make this situation better — wealthy Western countries or major agencies, such as the World Bank or other organizations like that?
Guillen: We have way too many question marks in the global economy right now. Just to give you a short list, we have the euro crisis in Europe. It seems as if over the last couple of months, the problem has stabilized a little bit. But that doesn’t mean things are going okay in Europe. In fact, we have a recession going on; the double-dip recession, the second dip in this recession, has been declared as of six weeks ago. So, we have these very big problems in Europe. And let’s not forget that Europe is still 25% of the global market.
And we have the continuing fiscal crisis in the United States, which for the most part is self-inflicted at this point. And we have, of course, Japan, which doesn’t seem to be able to find its way out of its own 20-year quasi-recession, although the new prime minister seems to be very adamant [about wanting] to change things. Let’s see what happens.
Those are the bigger problems. But if you shift the level of analysis a little bit and you think about the global economic and financial infrastructure, what we have right now is very little collaboration among governments in terms of what should be done. In fact, what we have is governments trying to take advantage of one another. We have all of these currency manipulations going on. China has for a long time been accused of being a currency manipulator, but it’s not alone. Over the last year or so, Japan has also tried to reduce the value of the yen so as to remain export competitive. So has Switzerland. And so has the United States. In the United States, we have printed a lot of money, and that has put downward pressure on the dollar. That has made possible the revival of U.S. manufactured exports.
Everybody is trying to look after their own interests. I see very little collaboration among key governments around the world. And I think this is also something that adds to the uncertainty out there.
Knowledge at Wharton: If there were to be more collaboration, which country or organization is likely to lead that?
Guillen: There are three or four, maybe five, countries in the world that really matter right now, that have something to say about a possible way out from this big global slowdown that we happen to be trapped in — certainly the United States, and certainly China. Those are the two biggest economies, and they are very important from a financial point of view for very different reasons. Then we have Germany, which in my view should perhaps be the representative from Europe, as opposed to having the European Union as such. Germany is the world’s fourth-largest economy, and it is the second most important export power. And then of course you have Japan and possibly the U.K. But that’s about it. I don’t think countries such as Mexico, Brazil, Argentina, Colombia, Indonesia or Turkey should be sitting at the table trying to make decisions because then the table gets too big. We have too many people negotiating. What I think we need is four or five key countries sitting at the table and helping us overcome all of the complexities that we’re facing right now in the global economy.
Knowledge at Wharton: We’ve also been hearing about fiscal imbalances. Explain a little about what that means and why it is a problem.
Guillen: We have all sorts of imbalances in the world. You mentioned fiscal, which means governments are spending more money than what they take in in the form of revenue and taxes…. We also have other kinds of imbalances — financial imbalances, trade imbalances and so on and so forth. But focusing on the fiscal imbalances, the problem of course is that, as you know, investors no longer believe that some governments in the world can pay them back. And so what we’ve seen is interest rates on bonds, government bonds, go through the roof for those countries that have lost the trust of investors.
The other side of the equation is that we have other countries that can pretty much borrow at zero interest rates. That includes certainly Germany, but also Switzerland and — at least up until now — the United States. These are countries that still are perceived as being solid and capable of returning the money that they are asking investors to give them.
In the U.S., I mentioned earlier that most of the fiscal problem is self-inflicted, because the upcoming battle now in the month of February will be the debt ceiling. Of course, this is an artificial thing. I’m sure there is going to be quite a bit of political fighting about it. But the global economy and the investors know that the U.S., at least so far, is a government that can pay its debts, unlike other governments around the world that cannot right now.
Knowledge at Wharton: I remember — I think it was about 18 months ago — when we lost our credit rating, our top rating, and everybody said this will be a catastrophe. And now, interest rates are lower than they were.
Guillen: I think that was a signal to the politicians in Washington, D.C., that they shouldn’t do anything crazy because although the U.S. continues to be the largest economy and it is the most important financial power in the world, its strength is not unlimited. But the U.S. has one big advantage, which is that the dollar continues to be the most important reserve currency — about 70% of all allocated reserves in the world are in dollar-denominated assets. This gives the U.S. quite a bit of leeway, a lot of breathing room with which to play because, once again, there is a big appetite for U.S.-denominated dollars. And the U.S. can therefore play a different role in the global economy than other economies that don’t have that kind of a privilege.
Knowledge at Wharton: It looks like investors around the world simply don’t believe the U.S. will ever default on its debt. Is that what these numbers tell us?
Guillen: I would never say that we will never, ever default because obviously, what is the time horizon here? Is it 20 years, or is it 50, 100 or 200 years? If history is any guide, I would definitely bet my pension fund right now by saying that the U.S. will default within the next 500 years. I don’t think it will default within the next five years or 10 years or 15 years, [or] in the foreseeable future.
But a lot of that depends also on what happens to China and whether China takes more steps in the direction of playing an active role in global finance. And, of course, a very important element in all of this will be Beijing. What happens to the Chinese currency? Is the Chinese currency going to become at some point in the near future another reserve currency? And then once it becomes a reserve currency, I think the prediction is that it will probably become an important reserve currency. I don’t think it will displace the dollar, but it will become an important reserve currency, maybe at the same level as the euro — 15% or 20% of all currency reserves in the world. But we’re still at least five, seven, 10 years away from that.
In the meantime, the U.S. continues to be the most important economy in the world from the financial point of view, and it will continue … to have the most important reserve currency.
Knowledge at Wharton: Let’s just finish with a projection for 2013. Do you think that at the end of this year, conditions will look much different from the way they are now — either better or worse?
Guillen: Twelve months down the road, if we go region by region, I think things will look much, much better here in the United States, unless of course something really weird happens in Washington, D.C., over the next two or three months regarding all of these fiscal negotiations.
Europe is not going to be seeing the light at the end of the tunnel yet — [or by] the end of 2013, because they seem set on an array of austerity measures, and these austerity measures may, at some point, be effective, but it’s not going to be any time soon. If that is the way they want to overcome their problems, it’s going to take a while. And, of course, unemployment in the meantime will be very, very high.
The big question mark is where we started this conversation: It’s with the emerging economies. Will the two that worry me the most — India and Brazil, because of their size and because of some of the problems that they are encountering — manage to reverse the decline in their growth rates? This is a very urgent question, especially in the case of Brazil.
I think emerging economies — hopefully, and more likely than not — will be better off at the end of this year, but certainly not Europe, and hopefully the U.S. will be better off.
Knowledge at Wharton: Well, we’ll come back in a year and see how it turned out. Thank you very much.
Guillen: Thank you for inviting me.
