Mission Concluding Statement 

United States of America -- Concluding Statement of the 2010 Article IV Mission

July 8, 2010

Thanks to a powerful and effective policy response, the recovery from the Great Recession has become increasingly well established. Since mid-2009, massive macroeconomic stimulus and the turn in the inventory cycle have overcome prevailing balance sheet strains, and—aided by steadily improving financial conditions—autonomous private demand has also started to gain ground. While still modest by historical standards, the recovery has proved stronger than we had earlier expected, owing much to the authorities’ strong and effective macroeconomic response, as well as the substantial progress made in stabilizing the financial system. Important steps have also been taken to sustain growth and stability over the medium term, including through landmark health-care legislation and, as noted in the FSAP assessment (see attached box), significant progress toward reform of financial regulation.

The outlook has improved in tandem with the recovery, but remaining household and financial balance sheet weaknesses—along with elevated unemployment—are likely to continue to restrain private spending. We forecast GDP growth of 3¼ percent in 2010 and about 3 percent in 2011, with inflation very low, and unemployment remaining above 9 percent. On the upside, consumption could outperform expectations, if confidence and employment improve faster than expected; more generally, the level of activity in a number of sectors is extraordinarily subdued and could return to normal levels faster than expected. On the downside, the backlog of foreclosures and high levels of negative equity, combined with elevated unemployment, pose risks of a double dip in housing; the continued deterioration in commercial real estate poses risks for smaller banks; and financing conditions remain tight, especially for smaller firms reliant on bank finance. Most recently, and tipping the balance of risks to the downside, sovereign strains in Europe have become an increasing concern, potentially impacting the United States through financial market and, in a tail risk scenario, trade links.

On the macroeconomic side, the central challenge is to develop a credible fiscal strategy to ensure that public debt is put—and is seen to be put—on a sustainable path without putting the recovery in jeopardy. Since 2007, the debt held by the public has almost doubled to 64 percent of GDP—the highest level since 1950—and under current policies could reach 95 percent of GDP by 2020. Thereafter, as the impact of the aging population and rising health care costs is increasingly felt, debt will rise further to over 135 percent of GDP by 2030 and continue to increase thereafter. In this connection, the health-care reform provides a welcome basis for cost control, but initial savings will be modest and will hinge on the implementation of many measures. Given the uncertainty whether new policy measures will mitigate health care costs, the Independent Payments Advisory Board will play a key role in monitoring and remediating excess cost growth. If excess cost growth persists, consideration should be given to other measures such as reducing tax exemptions for employer health insurance contributions.

The authorities’ commitment to halve the budget deficit by 2013, and intention to stabilize public debt at just over 70 percent of GDP by 2015 are welcome, although much remains to be done to achieve these aims. Given that we use less optimistic economic assumptions than the Administration, we see the need for a more ambitious adjustment to stabilize debt than that envisioned by the authorities—in particular, a federal primary surplus of about ¾ percent of GDP by 2015, larger than the primary balance target given to the Fiscal Commission. This in turn will require an underlying fiscal adjustment (excluding the normal cyclical rebound) of about 8 percent of GDP during that period, some 2¾ percent of GDP more than in the Administration’s plans. Part of this adjustment could be achieved through expenditure reductions—and the Administration’s intention to freeze non-security discretionary spending is welcome. However, measures to increase revenues will also be needed, which the mission believes could include further base broadening via cuts in deductions, particularly for mortgage interest; higher taxes on energy; a national consumption tax; or a financial activities tax (which could also mitigate systemic risks). Looking beyond 2015, the aim should be to put public debt firmly on a downward path to rebuild the room for fiscal maneuver (especially given the risks from large funding shortfalls in state and local government pension and health schemes).

The timing and composition of the adjustment will need to be carefully designed to minimize the impact on demand while ensuring credibility. In this connection, a credible fiscal plan could have three basic elements. First, an upfront adjustment beginning in FY2011; in current circumstances, we believe that the 2 percent reduction in the structural deficit proposed in the FY2011 budget is broadly appropriate. This should be accompanied by, second, a clear commitment to the further measures needed over coming years, for instance through enshrining targets and/or measures in legislation; and third, further measures to address entitlement pressures, notably imbalances in Social Security, where the needed policies are well known. Immediate measures should be designed to have the smallest impact on demand (for example, reduction of exemptions for high-income households). There could also be scope for tradeoffs among the three elements if necessary, for example, in the event downside risks were to materialize: for instance, if there were to be a consensus for substantive entitlement reform—which would likely have little impact on demand—immediate actions could be more backloaded.

In the interim, additional measures being considered in the Congress to support activity should be carefully targeted within the framework laid out in the FY2011 budget, and to the maximum extent possible, offset in future years. In this connection, the risk of rising structural unemployment, in light of persistent skills and geographic mismatches (the latter aggravated by underwater mortgages) and high unemployment spells, could merit support for job search and employment. As unemployment declines, a gradual shift from expanded support for the unemployed to targeted measures such as credits for hiring could encourage job creation and job search, while mitigating the risks that protracted unemployment support erodes job skills and boosts structural unemployment (as with existing unemployment insurance extensions, support could be calibrated to regional labor-market conditions). In addition, further support for foreclosure mitigation under the existing framework may be needed if the housing market were to weaken. In a worse-case scenario, there may be a case for reconsidering introducing cramdown procedures. To maintain consistency with long-term fiscal stability, any such targeted measures should be self-liquidating as housing and labor market strains improve, and offset with future tightening under binding pay-as-you-go provisions.

Turning to monetary policy, the Federal Reserve has deftly managed the tradeoff between near-term support and medium-term credibility. It has appropriately maintained an extraordinarily low level of policy rates and signaled its intention to maintain them for an extended period, supporting economic and financial stability. And at the same time, it has wound down almost all of its emergency facilities and ended a very substantive asset purchase program, with very little adverse impact on markets, aided by careful and effective communication. For the near term, with inflation very low, we believe that maintaining the present high level of accommodation is appropriate to hedge deflation risks and help to counteract the forthcoming fiscal drag on economic activity, while also supporting financial conditions.

Looking further ahead, the Fed is well placed to manage the uncertainty of the monetary exit. These include the heightened uncertainties surrounding the effects of monetary operations on the fed funds rate, the desirable level of reserves consistent with a more normal operating mode, and the efficacy of tools recently adopted. Its well-diversified toolkit—including interest on reserves, reverse repos, and term deposits—seem well-suited to managing the monetary exit while navigating smoothly these remaining uncertainties. In addition, it has credibly communicated its commitment to sustaining appropriately accommodative monetary conditions even as it has introduced tools to prepare for the later exit. Continued clear communication about its strategy and operations will be essential as the exit evolves, particularly if it needs to sell assets at some later stage.

Considerable progress has been made in restoring financial stability, as emphasized in the recent FSAP assessment, but important risks remain. While risk-based capital ratios have rebounded to around historical averages, this partly reflects a shift into less risky assets (which will reverse when lending expands). Looking forward, more capital will be needed to support additional bank lending if securitization does not pick up as expected, and to accommodate the higher expected capital standards. More generally, as shown in FSAP stress tests, important parts of the banking system remain vulnerable to shocks. A recent Fed survey shows increased use of loan extensions to commercial real estate borrowers, amid widespread concerns about weaknesses in the sector, as well as concerns about whether banks have adequately addressed the risks in underwater mortgages. Against this background, it will be important that banks adequately recognize the risks on their balance sheets, and have sufficient capital to support the ongoing recovery.

As highlighted in the FSAP exercise, much needs to be done to reform supervision and regulation to address the gaps exposed by the crisis. The legislation under consideration in Congress would make major steps in this direction, including creating an interagency council (the “FSOC”) to identify and act upon emerging risks to financial stability, strengthening the resolution framework for systemic institutions, imposing tougher capital and liquidity requirements (especially for systemic firms), and containing systemic risks in derivatives markets while improving transparency. That said, existing legislative proposals miss the opportunity to significantly reduce the number of supervisory agencies, which leaves a heavy burden on relevant agencies to cooperate effectively and avoid supervisory gaps and duplication.

Strong implementation of all these steps will be key. The FSOC will need to quickly develop a common macro prudential focus, and a culture of transparency and cutting-edge thinking on financial stability issues. To this end, regular broad based stress test exercises—along the lines of the SCAP—and publication of periodic financial stability reports that include stress tests and identify financial stability risks in a forward looking fashion would be helpful. Regulation of systemic institutions should be tight enough to disincentivize systemic size and complexity, so as to offset moral hazard and the externality of systemic risk. Accordingly, we see strong roles for both the Treasury and the Fed in the FSOC, with the Fed building on its work in the SCAP exercise to integrate macroeconomic and financial analysis. “Living wills” should be rigorously vetted and updated frequently, and an institution should be streamlined if its will cannot be implemented in a crisis. Finally, we support the aim to improve transparency and contain counterparty risks in OTC derivatives.

A key challenge will be to revitalize private securitization, to supplement bank credit. Draft legislation appropriately emphasizes a return to “safe securitization” via greater oversight and accountability for ratings agencies, increased transparency, emphasis on investor due diligence, and “skin in the game” for originators to strengthen incentives for prudent asset vetting and structuring. Given the large role that securitization played in the past, and the potential limits to bank balance sheets for creating credit, speedy implementation of these measures would be essential to avoid limits on credit supply that could crimp the recovery. It will also be important to coordinate reforms domestically and internationally to ensure safe securitization and promote a level playing field.

A key area of unfinished business is the reform of the housing system. The current system is costly, inefficient and complex, with numerous subsidies that do not seem to translate into a sustainably higher homeownership rate. In this connection, we welcome the ongoing review of the housing finance system, and we attach particular importance to the review of tax expenditures (which are both sizeable and largely benefit the better-off). In addition, the ambiguous precrisis public/private status of the GSEs proved unsustainable. The GSE’s mandates should be streamlined and their retained portfolios should be privatized, as they have been the source of past losses and are unrelated to their core bundling and guarantee business lines. Those lines, which arguably provide public goods, should be made explicitly public.

A multilateral approach to economic policy management will be as important in the recovery as it was in the crisis. We welcome the authorities’ leading role in multilateral fora, as well as their efforts to promote international stability (most recently through the Fed’s redeployment of its swap lines). For the medium term, the key contribution that the United States can make to global growth and stability, consistent with the G-20 Mutual Assessment Process, is through raising domestic savings—particularly through fiscal consolidation—to ensure that the current account deficit remains within bounds; and restoring and strengthening its financial sector. It follows, as also emphasized in last year’s Article IV, that the United States can no longer play the role of global consumer of last resort, underscoring the importance of measures to boost growth and demand in current account surplus countries. With the U.S. dollar now moderately overvalued from a medium term perspective, this will need to be accompanied by greater exchange rate flexibility/appreciation elsewhere.

Finally, we welcome the limited recourse to protectionist measures. Indeed, the President’s goal of doubling exports over five years—while ambitious in quantitative terms—sends an important and appropriate signal of the need to increase, rather than reduce, openness. In this connection, we encourage the authorities, in conjunction with other countries, to redouble their efforts to conclude the Doha Round, which will bring increased and more secure market access, promoting U.S. and global exports.