Jeffrey Frankel Harpel Professor of Capital Formation & Growth

It May Be Slow, But at Least It’s An Economic Recovery Jeffrey FrankelHarpel Professor of Capital Formation & Growth Senior Executive Fellows October 25, 2010

Topics • The trough of the 2007-09 recession • Root causes of the crisis • Policy response: • How did we avoid a Great Depression? • Intellectual implications • Appendix • US budget deficits

June 2009 (II)

The economic roller coaster went into free-fallin the 3rd quarter of 2008. But the usual cyclical pattern of recovery began in 2009, Q II: 1. Leading indicators come first. 2. Output indicators come next. 3. Labor market indicators come last. Source: Jeff Frankel’s blog, Nov. 2009

In September 2010, the NBER Business Cycle Committee announced that the trough of the recession came in June 2009 • which marked the end of the longest & most severe recession since the 1930s. • As usual, we were attacked • both for not having declared the obvious trough earlier, • based on the rule of 2 consecutive quarters of positive growth, • and also for not waiting until the economy was better • which showed we were “out of touch with reality.”

Much of the confusion can be easily explained by a few points: • The definition of recession is declining economic activity, • not a low level. • The definition of recovery is rising economic recovery, • not a high level. • GDP & other economic statistics tend to • point in different directions, • have measurement error, • and be revised. • We can’t declare the end of a recession until we are reasonably sure that a hypothetical new downturn (“double dip”) would count as a separate new recession.

National output gives a pretty clear answerthough GDP & Gross Domestic Income look slightly different. Peak Trough

Some other indicators such as industrial production so similar dating Peak Trough

The labor market lags behind, as usual Peak Trough

In the labor market, hours responds first.Firms delay hiring until they are confident of the need. Peak Trough

Interbanklending spreads are the best measure of the extraordinary financial crisis that led to globalrecession OECD Econ.Outlook, April 2010 The banking sector “normalized” in Q3 2009. Lehman failure Start of US sub-prime mortgage crisis OECD Economic Outlook, April 2010

Danger of a double-dip? • Demand growth in the 1st year of recoverycame in large part from: • fiscal stimulus, & • ending of firms’ inventory disinvestment. • Both sources of demand have run down in 2010 • The withdrawal of fiscal stimulus is now slowing growth. • There could always be new shocks: • Sovereign debt contagion, spreading from Greece • Hard landing for the $ • Geopolitical/oil shock… • I put the odds of a double dip recession as • rather small, but • big enough to have persuaded the NBER to wait until September.

Soon we must return toward fiscal discipline. • The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. • Tax revenue • Let President Bush’s tax cuts expire for the rich in 2011. • Introduce a VAT or phase in auctioning of tradable emission permits • Curtail expensive and distorting tax expenditures • E.g., Tax-deductibility of mortgage interest • All politically very difficult, needless to say. • Any solution requires: • Honest budgeting (e.g., Iraq war on-budget, etc…) • PAYGO • Wise up to politicians who claim they want to do it entirely on the spending side & but who raise spending when they get the chance.

Spending • Cuts in farm subsidies for agribusiness & farmers, incl. ethanol • Cut unwanted weapons systems (a rare success: the F22 fighter) • Cut manned space program… • Social security • Raise retirement age – just a little • Progressively index future benefit growth to inflation • If necessary, raise the cap on social security taxes. • Health care • Encourage hospitals to standardize around best-practice medicine • to pursue the checklist that minimizes patient infections, • avoid unnecessary medical tests & procedures, • & standardize around best-practice treatment. • Lever: making Medicare payments conditional on these best practices . • Curtail corporate tax-deductibility of health insurance, • especially gold-plated.

When will US adopt the tough measures to get back to fiscal sustainability? • Ideally, we would now adopt measures that would begin to go into effect in 2011-12 and over the coming decades – repeating the 1990s success. • That is unlikely politically, due to partisan gridlock. • Hopefully, then, after the 2012 presidential elections. • Otherwise, in response to future crises, when it will be much more painful !

When will the day of reckoning come? • It didn’t come in 2008: The financial crisis caused a flight to quality which evidently still means a flight to US $. • Chinese warnings in 2009 may have augured a turning point: • Premier Wen worried US T bills will lose value.He urged the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $ . • PBoC Gov. Zhou proposed replacing $ as international currency, with the SDR.

More on the crisis of 2007-2009 • Six root causes of the financial crisis • Policy response: How did we avoid a Great Depression? • Intellectual implications

1. Six root causes of the financial crisis 1. UScorporate governance falls short E.g., rating agencies; executive compensation … options; golden parachutes… 2. US households save too little,borrow too much. 3. Politicians slant excessively toward homeowner debt Tax-deductible mortgage interest; FannieMae & Freddie Mac; Allowing teasers, NINJA loans, liar loans… MSN Money & Forbes 18

Six root causes of financial crisis,cont. 4. The federal budgethas been on a reckless path since 2001, reminiscent of 1981-1990 5. Monetary policy was too loose during 2004-05, accommodating fiscal expansion,reminiscent of the Vietnam era. 6. Financial market participants grossly underpriced risk 2005-07. Ignoring possible shocks such as: housing crash, $ crash, oil prices, geopolitics…. 19

US real interest rate < 0, 2003-04 Source: Benn Steil, CFR, March 2009 Real interest rates <0 20

Source: “The EMBI in the Global Village,” Javier GomezMay 18, 2008 juanpablofernandez.wordpress.com/2008/05/ In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted. So did spreads on US junk & emerging market bonds. In 2008, it all reversed. 21

Origins of the financial/economic crises Underestimated riskin financial mkts Failures of corporate governance Households saving too little, borrowing too much Federal budget deficits Monetary policy easy 2004-05 Excessive leverage in financial institutions Housing bubble Low national saving Stock market bubble Stock market crash Housing crash China’s growth Financial crisis 2007-08 Lower long-term econ.growth Eventual loss of US hegemony Homeownershipbias Predatory lending Excessive complexity MBSs Foreigndebt CDSs CDOs Gulf insta-bility Oil price spike 2007-08 Recession 2008-09 22

They did. Indices peaked in late 2006, and fell 1/3. The “black swan”: investors thought housing prices could never go down. 23

Financial meltdown:bank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD Economic Outlook (Nov. 2008). 24

Monthly GDP Peak Trough

National income has been more reliable than GDP, even though they are supposed to measure the same thing. Recession of July1990 – March91 Recession ofMar. 2001 – Nov. 2001 Recession of Dec. 2007 – June 09 26

2. Policy Response -- How did we avoid another Great Depression? • We learned important lessons from the 1930s and, for the most part, didn’t repeat the mistakes we made then. 27

We learnt from the mistakes of the 1930s. Monetary response: good this time Fiscal response: relatively good, but : constrained by inherited debt and congressional politics. Trade policy: Some slippage, e.g., Chinese tires. But we did not repeat 1981 auto quotas or 2001 steel tariffs let alone Smoot-Hawley ! Financial regulation? 28

U.S. Policy Responses Monetaryeasing was unprecedented, appropriately avoiding the mistake of 1930s. (graph) Policy interest rates ≈ 0. The liquidity trip is not mythical after all. Then we had aggressive quantitative easing: the Fed purchased assets not previously dreamt of. 29

The Fed certainly did not repeated the mistake of 1930s: letting the money supply fall. 2008-09 Source: IMF, WEO, April 2009Box 3.1 1930s 30

Federal Reserve Assets($ billions)more-than-doubled in 2008, through new facilities, rather than conventional T bill purchases 31 Source: Federal Reserve H.4.1 report

Policy Responses,continued succeeded in getting the financial system going again, thereby precluding a new Great Depression, yet without “nationalization” of the banks. Contrary to almost all commentary at the time of TARP: The conditions imposed on banks were enough to make them balk at keeping the funds. The banks have now paid back the taxpayer at a profit. Geithner’s stress tests fulfilled their function of distinguishing strong banks from weak. The policy of “financial repair” 32

Financial reform. Lending Mortgages Consumer protection, including standards for mortgage brokers Fix “originate to distribute” model, so lenders stay on the hook. Remove pro-housing bias in policy. (But politicians remain in favor.) Banks: Regulators shouldn’t let banks use their own risk models; should make capital requirements higher & less pro-cyclical . Is “too big to fail” inevitable? (The worst is to say “no” and then do “yes.”) Extend bank-like regulation to “near banks.” Regulators need resolution authority. Segmentation of function: Volcker rule ? or all the way back to Glass-Steagall ?(I don’t think so.) 33

Financial reformscontinued Executive compensation Compensation committee not under CEO. Maybe need Chairman of Board. Discourage golden parachutes & options, unless truly tied to performance. Securities Regulate derivatives: Create a central clearing house for CDSs . Credit ratings: Reduce reliance on ratings: AAA does not mean no risk. Reduce ratings agencies’ conflicts of interest. 34

Policy Responses,continued $787 b fiscal stimulus passed Feb. 2009. Good old-fashioned Keynesian stimulus Even the principle that spending provides more stimulus than tax cuts returned; not just from Larry Summers, e.g., but also from Martin Feldstein. Was $800 billion too small? Too large? Yes: Too small to knock out recession ; But Congress was not willing to vote for more, especially on the spending side. Perhaps also too big to reassure global investors re US debt. 35

Bottom line of macroeconomic policy response: The monetary & fiscal response wassufficient to halt the economic free-fall. It won’t be enough to return us rapidly to full employment and potential output. Given the path of debt that was inherited in 2009, perhaps not much more could be done. Chinese officials already questioning our creditworthiness Risk of hard landing for the $ 36

3: Intellectual implications of the crisis for economics • The return of Keynes • And 4 others who mainstream theory had forgotten. • 8 economists who got parts right

The return of Keynes • Keynesian truths abound today: • Origins of the crisis • The Liquidity Trap • Fiscal response; spending vs. tax cuts • Motivation for macroeconomic intervention:to save market microeconomics • International transmission • Need for coordinated expansion (now the G20)

Motivation for macroeconomic intervention • The view that Keynes stood for big government is not really right. • He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s, • by using macroeconomic demand to return to equilibrium. • Some on the Left reacted to the 2008 crisis & election by hoping for fundamental overhaul of the economic system. • But the policy that prevails today is the same.

The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch…. • like Keynes’ animal spirits or beauty contest . • Add in von Hayek’s credit cycle, • Kindleberger78 ’s “manias & panics” • the “Minsky moment,” • & Fisher’s “debt deflation.” • The origin this time was not a monetary contraction in response to inflationas were 1980-82 or 1991. • But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices.

Who got pieces of it right, beforehand? • Krugman: If a Depression can happen in Japan, it can happen in any modern economy. • Rajan: Failures of corporate governance. • BIS (Borio & White): Too-easy credit, via asset prices, leads to crises -- with no inflation in between. • Shiller: US housing price bubble. • Gramlich: Homeowners are being sold mortgages that they can’t repay. • Rogoff: “This Time Is Not Different.” • Roubini: The recession will be severe.

Appendix: US fiscal policy

The US public discussion is framed like a battle between conservatives who philosophically believe in strong budgets & small government, and liberals who do not. Not the right way to characterize the debate. [1] • (1) The right goal should be budgets that allow surpluses in booms and deficits in recession. • (2) The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take corresponding policy steps < 0. [1] Forget that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.”My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.”“Republican & Democratic Presidents Have Switched Economic Policies”Milken Inst.Rev.2003.

Three pieces of evidence to support the claim that “fiscal conservatives” are not: • (i) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes: • As of 2004, they had voted for more spending than those who did not sign the pledge. [2] • (ii) The pattern of spending under different presidents.[3] • (iii) The pattern of states whose Senators win pork & other federal spending.[4] • [2]William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,”Tax Notes, July. • [3] JF “Snake-Oil Tax Cuts,”EPI, Briefing Paper 221.2008. • [4]JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.

(ii) Spending & deficts both rose sharply when Presidents Reagan, Bush I, & Bush II took office. Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending.

(iii) States ranked by federal spending receivedper tax dollar paid in 2005 versus party vote ratio in preceding election “red”states Republican states take home significantly more federal $ (relative to taxes paid)than Democratic states big inflow of US $ “blue”states low inflow of US $

U.S. fiscal policy in 2010-2011? • What changes in American fiscal policy would be desirable at the current juncture, • if politics were not an obstacle? • On the one hand, the economy is still weak. • On the other hand, the U.S. can’t wait until the recovery is complete to tackle the long run fiscal problem. • A two-part strategy: • Current steps to extend the fiscal stimulus, • designed to maximize bang for the buck. • Current steps to lock in future progress back toward fiscal discipline in the long run.

U.S. fiscal policy in 2010-2011, continued • Maximizing bang for the buck ≡ fiscal stimulus that gives the most demand per $ added to long-term debt. • Example that would minimize bang for the buck: • proposal to make permanent the 2010 estate tax abolition . • Almost as poorly targeted: proposal to prevent the Bush tax cuts from expiring in 2011 for those households > $250,000. • If the stimulus has to take the form of tax cuts, then the best options are: • extending President Obama’s “Make Work Pay” tax cuts, • fixing the Alternative Minimum Tax, and • extending the Bush tax cuts for those households < $250,000. • Some business tax cuts could also give high bang for the buck. • such as temporary credits for investment or hiring.

U.S. fiscal policy in 2010-2011, continued • But spending boosts demand more than tax cuts do, • because the latter are partly saved. • Extend elements of the Obama stimulus • such as infrastructure investment and • giving money to the states • so that they don’t have to lay off teachers, policemen, firemen, subway drivers & construction workers.

U.S. fiscal policy in 2010-2011, continued • How does one take steps today to lock in future fiscal consolidation? • Not by raising taxes or cutting spending today (see above); • nor by promising to do so in a year or two (not credible). • There are lots of economically sensible proposals • for spending to eliminate, • more efficient taxes to switch to, • and “tax expenditures” to cut.

Jeffrey Frankel Harpel Professor of Capital Formation & Growth