Highlights

• Announcement of a comprehensive plan for the euro-zone extended the rally in world equity markets in October, culminating in the biggest monthly gain in U.S. stocks (13%+ as of Friday’s close) since 1987 and moving the market back into positive territory for the year.
• Yet many prognosticators are skeptical as fundamental issues are still unresolved. Nonetheless, Europe’s policymakers succeeded in negotiating a 50% “haircut” on Greek debt without provoking a run on European banks. This suggests the crisis atmosphere of the past three months could lessen.
• Looking ahead, the key uncertainties are (i) whether the planned recapitalization of European banks and the leveraging of the EFSF “bailout facility” will bolster confidence in European banks and in countries such as Italy and Spain and (ii) whether Europe can avert recession. Italy is in the spotlight now as government bond yields surged above 6.0%.
• Regarding investment portfolios, we did not over-react to the steep sell-off in August by selling securities where we saw long-term value, and we do not foresee making significant changes now in the wake of the rebound in risk assets.  My call is that the U.S. stock market will likely stay within the 2011 high-low ranges that have been established thus far. Read the rest of this entry »

Enhancing Financial Literacy in the Public Policy Agenda[1]

Dear Chairman,

Thank you very much for the opportunity to discuss the role of enhancing financial literacy with respect to public policies. This topic is of interest to me given my background as an international economist and global money manager. My jobs required that I be able to communicate important financial issues in a way that could be understood by those without formal training in finance or economics.

One of the lessons I gleaned from making presentations was to first dissect complex issues into their most salient points.  The second lesson was to explain these key points in lay terms, rather than hide behind technical jargon that professionals typically use. I found that when I did this, I could help nonprofessionals understand the essence of an argument while not falling into the trap of over-simplifying an issue.  One of the most gratifying results is when someone tells me I helped them understand an issue better.

The U.S. Budget Impasse

With that perspective in mind, I will begin by discussing a public policy issue that is near and dear to most Americans – namely, the difficulty in reining in a massive federal budget deficit that has been running close to 10% of GDP for several years. Until recently, most Americans ignored this issue for a simple reason: Politicians did not appear to be concerned about it, so why should they care?

The circumstances changed abruptly this summer, however, when the Republican leadership in Congress decided to take a stand on the extension of the federal debt ceiling. Normally this process is completely routine and one in which the public and markets have little interest.  However, this time the Republican leadership indicated it would only vote for an extension if there were accompanying cutbacks in projected government spending in the next 10 years.  As a result, the stage was set for a high stakes drama in which the U.S. government conceivably could have defaulted on some of its obligations.

As we all know, a crisis was averted when a compromise was reached at the 11^th hour.  Nonetheless, the chaotic process took a toll on the markets, especially when Standard & Poors downgraded treasury debt from AAA.  Moreover, there is still no resolution to this issue, as a special committee of Congress has been convened to identify a second round of deficit-reduction measures totaling $1.5 trillion. Even if this goal is attained, it will make only a small dent in slowing the growth in net government debt outstanding, which is projected to rise from 70% of GDP today to 100% of GDP by 2021.

I would point out here that several bipartisan commissions already have reviewed what actions are necessary, and they have all arrived at the same conclusions. First, the rapid growth in entitlement programs, especially Medicare and Medicaid, needs to be curbed to make them actuarially sound.  Indeed, they are the principal source of increased

government spending for decades to come. Second, on the revenue side, the tax code needs to be simplified by eliminating loopholes. Importantly, this would enable marginal tax rates to be lowered, which could lay the foundation for a resumption of economic growth.

This begs a question that many people have been asking, “Why can’t we fix this problem?”

An Uninformed Electorate 

Part of the reason the deficit problem appears intractable is the American people are woefully uninformed about the nature of the problem. For example, a February 2011 Wall Street Journal/NBC news poll found that only 18% of respondents thought cuts to Medicare were necessary to “significantly reduce” the deficit; only 22% said cuts would be needed in Social Security.[2]  The same poll found that even Tea Party supporters, by a nearly 2-to-1 margin, felt that significant cuts to Social security were “unacceptable.” Further complicating the politics is the generational element: 84% of respondents 65 or older said Medicare and Social security were “central to their financial security” while only 46% of adults under 30 responded as such.

Who, then, bears the responsibility for educating the public on these and other critical issues?

A colleague of mine, John O’Connor, has heeded the challenge by providing a survey for our clients that lists the cost savings associated with 35 actionable items.  The survey enables participants to vote on which items they favor to significantly reduce the deficit, if not to eliminate it altogether.[3]

While such an undertaking is admirable, I believe the responsibility for educating the public at large ultimately rests with our political leaders. Ideally, there should be a cogent debate between the political parties over these issues, and the electorate could then decide which view they shared.

Unfortunately, this is not the way the political process works in the United States today.  In the controversy over the deficit, for example, President Obama has not explained to the electorate why entitlement programs cannot be sustained at the projected rates.  Nor have the Republican leaders explained to constituents why tax loopholes need to be closed to allow marginal rates to be lowered. The end result is gridlock and confusion at a time when people need to be reassured that the government is committed to tackle the deficit problem.

Towards a Resolution of the Problem

Does this mean that there is no resolution to this problem? My answer is “not necessarily.”

One reason is I draw comfort from the experiences of other countries who have hit the debt wall. Canada, most notably, was in crisis in 1993, when the Liberal party, led by Prime Minister Jean Chretien and Finance Minister Paul Martin assumed power. The government’s share of the economy then had risen to more than 50% from 28% in 1960, while government debt hovered at nearly 70% of GDP, roughly the level in the United States today, while interest payments consumed 35 cents of every tax dollar.[4]

What happened over the next five years is remarkable: With decisive action, Canada was running a budget surplus by 1998, with the ratio of spending cuts to tax increases nearly 7-to-1.

One of the lessons from the Canadian experience is that austerity programs typically encompass a period of pain before the benefits are evident.  Canada’s economy, for example, grew by a full percentage point below the trend in the prior two decades.  But the program was also able to achieve a significant reduction in the country’s core rate of inflation, and Canada was able to regain its AAA rating. This paved the way for lower interest rates.

In the current environment, the United States and other deficit countries confront a more delicate balancing act, because there is little or no growth in the developed world.  On one hand, the high-deficit countries must initiate long-term programs to convince the public that they are on a sustainable path of deficit reduction. But they also must have a safety net is in place to ensure that their economies will not slide into deep recession.

Clearly, this is not a simple message to deliver that can be grasped by sound bites over the media:  It will require that our political leaders are up to the task of educating the electorate on the need to address long-term problems and lay out clear choices about how to proceed.

Finally, while I am discouraged by what is happening today, I also take comfort from the ability Americans have demonstrated to rise to the occasion when the stakes are high.  In the words of Winston Churchill, “Americans can always be counted on to do the right thing…after they have exhausted all other possibilities.” But I am also a realist: I accept that we may have to wait for the next presidential election for the electorate to decide this critical issue.