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Facing Up to the Economy's Problems

How everyday citizens still hold the key to the country's economic future.

Peng Chen, 05/04/2010

Charles Wheelan, Ph.D., is a senior public policy lecturer at the University of Chicago and the author of Naked Economics: Undressing the Dismal Science (W.W. Norton & Co., 2002). He gave the keynote address March 4 at the Morningstar Ibbotson Conference. Peng Chen, the president of Ibbotson, sat down with Wheelan after his speech to discuss whether the government (and we citizens) is up to the challenge of solving the problems that confront the U.S. economy.

Peng Chen: With the large deficits on our government's balance sheet, it seems inevitable that taxes will have to be raised at some point. In fact, there are tax proposals already on the table to help pay down the deficit. What is your view on these proposals? What's the most likely outcome?

Charles Wheelan: The scariest outcome is doing nothing. It's a simple equation. You've got spending, and you've got taxing, and they need to balance. We are locked in this ideological battle over whether we want a smaller government or a bigger government, and we've compromised by having small revenues and big spending, which is not a compromise that works. At the same time, as much as we talk about spending, we seem unwilling to cut much there. If you look at where we spend money, which is entitlement programs, defense, and interest, there are not a whole lot of options. We can't cut our interest payments. We've got two wars going on. And people seem unwilling to reduce health-care spending and to raise the retirement age.

So I suspect we're going to have to do something on the tax side. If I were a betting man, I'd say that five or 10 years from now, tax rates are going to be higher than they are now. As an economist, my admonition is that we need to pay a lot more attention to the kinds of taxes that we're imposing, and a lot less attention to what's the total amount that's coming out of your pocketbook. The most important thing to think about is that taxes raise revenue, and they change behavior. If we have to raise revenue, or even change the composition of our current revenue, I would strongly favor moving toward taxes that discourage activities that we don't think are socially beneficial. We do it with smoking. I would like to see it at the global scale; tax things like carbon that have an adverse environmental impact. Therefore, we would not have to raise taxes on capital investment, on labor, on other kinds of things that actually have positive spillovers.

PC: Things to encourage economic growth.

CW: Absolutely. I'd like to see this discussion focus more on specific spending cuts, which I think we're going to have to do, and more on the kinds of taxes that would not only have the least negative impact on the economy, but would also be positive in the long run.

PC: From an investing perspective, then, financial advisors and individual investors should look at ways to position their portfolios to be even more tax-efficient, on both the equity side and the bond side.

CW: Yes, you probably should expect that you're going to have higher taxes down the road. And I'm not sure you should count on policymakers doing what I think is a good idea, which is taxing things like carbon and so on, which would not have a terribly pernicious effect on your portfolio. They will go back to the standard taxes that we use, which are income, sales, property, and so on, none of which are particularly good taxes in terms of behavioral outcomes. Grading the Bailout

PC: Let's take a step back, and look at how we got here. The past couple of years have been very dramatic, with the financial crisis, the government's reaction to it, and now the policymaking around it. I gather from listening to your speech today that you believe that we tend to do the right thing when the garage is on fire--which seems to indicate that you think that the bailout package and TARP were the right things to do.

CW: Yes. Broadly speaking, I think they both had to be done. If you go back 15 months, there was the potential for this to spiral in a really nasty direction. What I fear most, as somebody who watches human behavior and finance, is a series of negative feedback loops, where you stop making mortgage payments, your bank fails, you stop making loans to healthy firms, you lay off people, you go into default, and it just all feeds on itself.

Nobody knew exactly what we had to do, and at that point, you err on the side of action. I actually felt very comfortable with Ben Bernanke at the Fed, which is not to say that everything he did was perfect. But he certainly is one of the most informed people in financial crises that you could have at the helm.

Government had to step in. The problem is how should they step in. My great disappointment with the stimulus was that the investments weren't better targeted. We shouldn't have spent money on anything that didn't make sense in the long run. I was disappointed that we didn't do more in transportation infrastructure and basic research in alternative energy, in human capital-- I mean, all this stuff that will not only deal with the short run but also position us to get to a better place. Worst case, pay people to dig holes and fill them in. That actually has some positive effect, if the economy is bad enough. We did that in the Great Depression.

But why do that, when you can pay people to do high-speed rail in the Midwest, or research in California on solar energy, or go back to get a GED, or go to graduate school. Those are all things that also create demand, but at the end of 20 years, you don't have holes that were dug and filled in; you have a more productive, better-educated population.

Investing in Education
You mentioned human capital, and you also talked a lot about human capital in your book. Can you elaborate on that a little bit? I think a lot of what you mean is about real education and increasing the size of human capital in society.

CW: Exactly. Education is at the core of anyone's human capital, but there are related skills: job experience, your willingness to work hard, gumption, entrepreneurial spirit. It's the package of what you bring to a job or to life. We're talking about it in an income and investment climate, but, actually, it makes you a better parent, it makes you a better citizen. There are a whole bunch of reasons that you want more-informed citizens.

What's striking now is that here we are with unemployment lingering near 10%. For college graduates, it's still only around 4% or 5%, which is terrific by global standards and by historical standards. Highly educated people do well in any climate, even this climate. In a better climate, it's going to be 1.8%-2%.

The other thing that's really interesting is there's now pretty good research that there are very important spillovers among highly educated people. That's why everybody is here in Orlando. If you're smart and I'm smart, and we have lunch together, it actually could collectively increase our productivity. Silicon Valley is a perfect example of this. Not only are you more productive as an individual when you're highly skilled, you make other highly productive people around you also more productive. My fear is that at the individual level we have a large group of people in this country who are dropping out of high school or starting college and not finishing in a climate where human capital is almost determinative, in terms of your economic future.

As somebody who believes that people by and large act rationally, I don't understand it. I do not understand why somebody drops out of high school, given that you've got 40 years of competing against technology and immigration and trade and a whole bunch of things that are not going to make your economic life very good.

PC: This coincides with some of the things that we talk about in terms of the impact of human capital on investment choices. When we look at an individual investor's portfolio, not only do we look at his savings, 401(k)s, IRAs, but we also look at his human capital and how it is part of his investment portfolio.

CW: I never thought about it that way, but that's exactly what it is. So if you're advising somebody who's 22, it's not stocks or bonds, it's stocks, bonds, or graduate school.

PC: That's correct.

CW: And I can tell you that the return on graduate school is going to be higher than stocks or bonds.

Economic Maturity Levels
Let's change gears a bit. Europe is somewhat in a similar economic situation as the U.S., but about emerging markets, there's been a lot of talk that they're in much better shape, especially from the balance-sheet perspective. Can you talk a little bit about emerging markets and, in particular, China? The reason China is interesting is that not only the economy is booming and their balance sheet is strong, but politically, it's a very different regime. For people living in this country, it's hard to figure out what's going to happen and how it's going to happen.

CW: If you think about it from the standpoint of a lifecycle, Europe is a mature democracy, and the economics problems they face are a function of that. There are demographic problems, where their entitlement problems are in worse shape than our entitlement problems, because you've got an older population retiring younger, and so on. They've got to get a grip on that. We're seeing what's happening in Greece, but that really is the tip of the iceberg in terms of the expenses that are coming down the road. They're not going to have the birthrate to generate workers; they're going to have to deal with immigration issues, and so on. It's a big challenge.

China is curious in that it's almost like you've got adolescent problems--you're young and growing and have this stunning potential, but you haven't figured out in what direction you need to go yet. You mentioned the strong balance sheet. Curiously, the balance sheet may be too strong. I worry about this fiscal imbalance between China and United States, where we're locked into this relationship where we depend heavily on borrowed capital from China, and that has become recycling export earnings back into the United States. It's become this dependent relationship where it helps to support export industries in China, and it helps to pay down the debt in the United States.

Both parties, in the short run, are benefiting, but they're both enabling things that probably need to evolve differently in the long run. That relationship has got to mature, hopefully in an economically constructive way, because if it unravels quickly, it actually could be quite devastating.

So that's one of the things I think you've got to watch. I know your readers are more interested in the economics of it, but I think there's a diplomatic angle here. China has clearly emerged on the international scene. The question is, what role will China play in dealing with Iran, for example? Being a big player, how are you going to use that role to be an important contributor to the global community? The answer is still evolving, but it's going to matter enormously.

PC: Because everybody's interest is at stake, to some degree.

CW: Yes, everybody has their own little, narrow interest. Unfortunately, at any level of life, sometimes those little provincial interests can derail the big picture, and that's very dangerous.

The Role of Citizens
You have studied public policy for a number of years, and you mentioned that there are three things that individuals can do to have an impact on public policy.

CW: The first is to be aware, be involved, and pay attention. Everybody seems to hate their politicians. I think only 8% of Americans say that they support the current Congress. That's their approval rating, despite the fact that we Americans elected that Congress, right? There's this odd mental disconnect between the politicians we elect and our opinion of them. Everybody claims that they're not happy with the situation, but, of course, we are the ones who create the situation.

The anecdote I used in my speech is that I ran for Congress a year ago for Rahm Emanuel's open seat in Chicago. There were 23 candidates, across the political spectrum--Republicans, Democrats, Green Party candidates. So presumably, there's somebody there for everybody. It was a time of economic turmoil. It was the worst point of the financial crisis. We had just indicted the governor of Illinois, so everybody was particularly angry at our politicians. The last governor had gone to jail. The turnout in our race was 20%.

For all the anger, for all the disappointment, four in five registered voters didn't show up. It's not a Herculean effort to show up and vote. If you're going to complain, at a minimum, you need to engage in the process. I would go further and say if you're really that upset, you ought to be running yourself. If you're not, then maybe you ought to cut the folks who are doing it some slack.

So we, at bottom, are responsible. The second is what I've come to believe is the essence of political leadership. It's what I describe as getting people on the treadmill.

If you want to get wealthy, if you want to lose weight, there's going to be some sacrifice between here and there. It's some of the stuff we've talked about. You want to get rich, or comfortably wealthy, you need to educate yourself, you need to work hard, you need to save a lot. Each of those things involves sacrifice at different points. You want to get in shape, you're going to have to exercise, you're going to have to not eat some things that taste very good, and so on. But at the end of the day, you'll be in better shape.

Public policy is exactly the same. You want to fix the budget deficit, you're going to have to cut some of the spending you've grown accustomed to, or you're going to have to raise taxes. Neither of those options is particularly palatable, but that's how you make the books balance.

Our leaders, if they're going to be successful, have to persuade us to do that. And back to number one, when they do that, when they give us the cold, hard, unpleasant facts, we've got to at least be willing to countenance the bad news. I'm not always sure that we are.

The last one is that we need to be more proactive. This may be human nature, but I think Americans are particularly bad in terms of being reactive.

We mentioned the financial crisis. When the garage catches on fire, we're great. We run out, get lots of people involved, and throw water on it. The problems I think the country faces--things like the debt, our entitlement problem, the human capital deficit--are like a leak in the foundation of the basement. You can ignore them for a while.

I would prefer that we be proactive in fixing the stuff that's going to do great harm. The analogy I use is that this is a great country if you've got a child who falls in a well. Right? The 2-year-old is down there, it'll be on the news, we'll mobilize people, thousands of people will get out there, we'll watch all around the country, and we're going to get that kid out of the well, safe and healthy.

But if someone prepares a report saying that there are 5,000 dangerous wells that kids could fall down, we will do nothing about it. I've seen that with infrastructure. The U.S. Society of Engineers did a report saying that we've got $2 trillion worth of infrastructure needs. By and large it was ignored. But when a bridge falls in the river, then we pay attention.

Revised, but Still Naked
A lot of our readers have also read your popular book, Naked Economics. There's a new edition coming out pretty soon. What are the new things that you address?

CW: The new edition is coming out in April. I did most of the revisions in December and January. It was interesting to see how the book had held up and what had changed. There are a couple of places where I added emphasis. One is behavioral economics, which I think gets mentioned briefly in the first edition, which was written in 2001. But there's been so much interesting research done on the ways in which we make decisions poorly and use information in ways that don't lead us to the right place. It played a role in the financial crisis. One of the things we do poorly is to look at the past and project erroneously to the future. People looked at the past, and housing prices had gone up 25%. They said it was going to keep going that way.

The economics in the book held up pretty well--namely, that the incentives are just horribly misaligned at so many different levels. Why is your bank loaning you this money? Well, it probably wasn't your bank; it was a mortgage broker paid on commission with someone else's cash. Why is the bank allowing the mortgage broker to do it? Because they can securitize it and sell it to Goldman Sachs. Why is Goldman Sachs doing that? Because they're taking a cut and selling it off. Why is somebody buying that bad debt? Well, because they've got bad ratings, because the rating agencies were being paid by the issuers.

What's amazing is that you can just go up this chain, and at every rung, the incentives are misaligned. You know, economics is really about incentives, and I was struck how it hews so closely to what happened. In my revision, I just used new examples, but I think that that part of the book held up pretty well.

Then, I added a chapter on international economics that addresses China, currencies, and so on. We are lacking a Bretton Woods II. The whole currency system is in a state of flux. You have these growing imbalances between China and the United States, which are working beautifully in the short run, but they can't go on forever. The question is, how do they unravel? Is it in a peaceful, orderly way, or might there be something that disrupts this that could actually have quite pernicious consequences?

Peng Chen is president of Ibbotson Associates, a Morningstar company.

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