The Next Recession and Government Policy Options

1. The Next Recession and Government Policy Options Mark S. LeClair Professor of Economics Fairfield University

2. To obtain slides: • Go to www.faculty.Fairfield.edu/mleclair • Look for link at top of webpage

3. Layout of Six Weeks…… Week 1 – History of Recessions and Policy Responses Week 2 – The Great Recession Week 3 – Policy Responses Week 4 – The Great Recession Abroad and Alternative Policy Options Week 5 – Policy Options in the Aftermath of the Great Recession Week 6 – Policy Revisions

4. A Quick Walk-Through of Policy – Both Fiscal and Monetary • As we look at each recession, what did the government do or not do • Sometimes had to do with the brevity of the recession • Sometimes it was philosophical • Each recession provides both a lesson how recessions start (and play out) and how government responds

5. Fundamentals of Fiscal Policy • Spending and taxation policy of the federal government • As recession develops (and is identified), can either raise spending or cut taxes • In some recessions (2001 and 2009) response has been significant • Major tax cuts in 2001 • American Reinvestment and Recovery Act in 2009 – $800 billion in new spending and tax cuts

6. Total spending in an economy is made up of: • Consumption + Investment + Government Spending + (Exports – Imports) • Raising government spending raises GDP directly • Cutting taxes raises consumption spending • Changes in Government Spending and Consumption produce a “multiplier effect” • Money moving through the economy has bigger impact than initial expenditure

7. For most recessions (1948, 1982, 1991) fiscal policy not implemented • Either philosophical difference (Reagan) or recession viewed as “shallow” and policy not needed (1991) • When implemented, two significant issues have arisen: • Crowding Out – Rise in government borrowing pushing out private investment • Lags – Probably the key issue

8. Types of Lags • Recognition – takes the Bureau of Economic Analysis 3-6 months to determine we are in a recession • Policy – takes a period of time to design policies to address recession (in the 1961 case, years) • Implementation – If policy conducted on the spending side, government compliance delays spending by months (Fair Wage rules, EEOC guidelines, competitive bidding)

9. Issue is not easily resolved • Can put “automatic stabilizers” in place (unemployment compensation, social security, even the progressive tax schedule) • These will either raise spending or cut taxes automatically • But, the magnitude of dollars involved is not large enough when a serious downturn hits • Side note – gasoline prices role in 2009 downturn

10. Fundamentals of Monetary Policy • Federal Reserve buys bonds when economy is weak • Increase in money in circulation increases amount of loanable funds available. • Borrowing and spending increase as interest rates drop • Not as direct as fiscal policy • Money is not a “good” – cannot eat it, wear it, or drive it • Federal Reserve policy takes time to get the real side of the economy • Once again, can express this in terms of “lags”

11. Monetary Policy Lags….. • Recognition (as before) • Policy – Essentially no lag • Federal Reserve policy originates with Federal Open Market Committee (FOMC) • Can make a decision at 9:00 AM and implement ten minutes later • Hence, no Implementation Lag either • But, Effectiveness Lag (as above) – Has to get from money side of economy to real side

12. Origination of Interventionist Policy • Birth of Policy Begins with 1907 Recession and the Advent of the Federal Reserve • Only possible policy was monetary policy • Fiscal Side of government small • Ability to tax income originated in 1913 • Hard to imagine any intervention with sources of revenue confined to tariffs and excise taxes • Fiscal policy has to wait for FDR and Keynes

13. The 1907 Recession and the Creation of the Federal Reserve • Generalized panic in 1907 that led to bank runs and a shutting down of the banking system • Large New York banks (clearinghouse banks) managed crisis by closing (temporarily) banks during bank runs • Financial crisis led to significant economic downturn • Public was incensed that access to their money was denied • Led to Federal Reserve Act of 1913 and the birth of Central Banking in the U.S.

14. One of the primary goal of the Federal Reserve was to prevent bank holidays from ever occurring again • Policies that prevent bank runs not adopted by Congress until much later • e.g. Deposit insurance (FDIC is from 1933) • Federal Reserve continued policy of letting “bad banks fail” • 5000 banks ceased operations in 1931

15. The Great Depression • Causes: • Stock market crash of 1929, Dust Bowl, Bank runs and lack of Federal Reserve action, Smoot-Hawley, etc. • Demonstrated need for increased bank regulation and dropping policy of letting banks fail • On fiscal side, illustrated the mechanisms of fiscal policy • Did not seem to have much effect • Interventions by Roosevelt Administration too small for such a deep downturn

16. Spending by FDR’s administration under Works Progress Administration mirrored what would be suggested by Keynes in General Theory • Keynes would have argued for a larger intervention in a shorter time period • Equivalent to wartime spending that eventually did end the depression

17. The Recession of 1948 • A relatively deep downturn that created fear that the Great Depression was returning • Drawdown from war reduced government spending dramatically • Keynsians predicted a steep recession that would require (once again) major intervention • Economy recovered, however, and the 1948 downturn is now regarded as largely a “vanilla” recession

18. What about Recession in 1961? • The first recession in which Keynsians were dominant in Washington • Immediately began discussing tax cuts and other fiscal responses • In end, nothing actually done until 1964 with Kennedy Tax Cuts • Illustrates a key problem noted above with Keynsian policy • Lags – timely implementation of policy difficult

19. Kennedy Tax Cut took years to negotiate, pass and implement • Missed the recession by 3 years • By the time it was passed in 1964, focus on recession was long since gone • Likewise, in 1982, gasoline taxes were raised and money was earmarked for infrastructure • Problem – money was collected first, pooled, and then spent • Actually a drag on GDP

20. 1974 Recession and the Challenge to Keynsianism • 1974 recession a result of dramatic increase in the price of oil in 1973 • Approximately a quadrupling of the price per barrel • From $3.00 to $12.00 in round numbers • A so-called “supply-side shock” • Keynsian policy poorly equipped to deal with this • Had both excess unemployment and excess inflation • Policy cannot address both at same time

21. Decade of the 1970s characterized by numerous recessions • Since inflation also high, no appropriate policy • Increase in spending would lower unemployment but raise inflation • Crisis of confidence for Keynsians • If policy could not address downturns, Keynsianism of little use

22. Inflation Peaks in 1979 • Is wrung out of the economy through a deliberate downturn in 1982 (orchestrated by Federal Reserve) • With elimination of high inflation, Keynsian policy is possible again • Bush Tax Cuts were a Keynsian stimulus • 2009 Recovery and Reinvestment Act purposeful use of fiscal policy

24. Note that Recessions used to be More Common • Government policies – automatic and deliberate – have reduced the number of downturns • Automatic stabilizers: Unemployment compensation, social security, progressive tax code • Recession in 2009 was a wake up call • Most believed a downturn of this magnitude could not occur • But, recessions that begin on the financial side tend to be much more severe

25. Next Week……. • Begin discussing the Great Recession • Deepest downturn since the Great Depression • Although 1982 was almost as severe, recovery much quicker • Focus on a key question – What are the consequences (long-term) of how the Great Recession was addressed?

26. Week #2 – The Great Recession and its Aftermath • Uniqueness of Great Recession • High unemployment rate was matched by 1982 recession • Differences: • Began on financial side with lock up of financial markets in October 2008 • When growth recovered it was anemic – well below what had happened in previous recoveries • Sense that something had gone fundamentally wrong with economy

27. Details of the 2009 Recession • Description • Began with “poisoning” of financial assets • Partly attributable to the Community Reinvestment Act and the creation of unpayable mortgages • Bonds issued that were backed by these mortgages • Bonds then became part of derivatives • At peak, banks would not lend to banks • TARP used $800 billion in loans to unfreeze markets

28. TED Spread as an indicator of Risk • Short-term lending rate between banks (such as LIBOR) – short-term government bond yield • The second rate is considered risk-free • First should be largely risk-free, but not when the banking system itself is in trouble • Huge increase in spread an indicator of how serious the problems with the banking system were

30. Indicators of how bad the 2009 Downturn was……Unemployment Rate

31. Rapidly rose to 10% range – much higher than most recessions • Most importantly – very slow to fall • In 2012, still in the 8% range • Also had a fall off in the Labor Force Participation Rate – so the number was actually worse • Did not reach 6% range (normality) until 2014 • This was in the presence of trillion-dollar deficits at the federal level

32. Labor Force Participation Rate

33. Natural influences: • Aging population • Economics of childcare costs • Dramatic Change due partly (however) to the discouraged worker affect • Those that hunted for jobs for a period of time, and then gave up

34. Difficult to Reverse this Change • No established government policy that affects decision to participate in the labor force • Except cutting benefits for those that don’t • Job training is one alternative • Government does not have a good record in that respect • CETA of the 1970s • Current emphasis on STEM training might help

35. Growth Rate of Gross Domestic Product

36. See fall off in 2009 and then recovery by second half of the year • Return to growth is very uneven • In 2011, actually have a decline in GDP again • Growth in 2013 is anemic • Did not return to normal growth until 2016, nearly 7 years out • Once again, this is in presence of trillion-dollar deficits

37. Other Indicators of the Depth of the Recession • Impact on housing markets and automobile sector • Both are particularly vulnerable to falling demand during a recession • Certain business sectors – travel, financial services, etc. badly damaged • Also, demographic indicator • Birth rate plummeted and, in some ways, never fully recovered • Economics of having children has fundamentally changed

38. Housing Market

39. Once again, recovery very slow in comparison to prior downturns • Not until 2012 does market start to rebound • This with low single-digit mortgage rates • Job uncertainty made buying a home a big risk • Market recovered in 2015, 6 years out from the downturn

40. Automobile Sales

41. Long-term rate about 15 million units per year • It is 2012 before we return to that rate of sales • Once again, even with low interest rates and heavy government intervention (Cash for Clunkers) • Employment in industry a small fraction of what it used to be • Spillovers to rest of economy small • But, still an indicator of continued weakness well after recovery would normally have occurred

42. Note one significant Rise in Demand in 2009 • Cash for Clunkers program • Produced a two-month jump in demand • Weakness in automobile market promptly returned • Fundamental problems at General Motors led to it declaring bankruptcy anyways in June of 2009 • Just postponed the inevitable • On positive side, allowed company to reorganize a truly horrible balance sheet (Liabilities exceeded assets by $90 billion)

43. Comparisons to 1982 – A similarly Deep Recession • Drop in GDP significant (worse since Great Depression) • Rise in unemployment dramatic

44. Gross Domestic Product • Fell for 5 quarters • Recovery (robust) occurred in late 1983 • GDP growth rate went to nearly six percent • Unemployment rapidly fell • Policy response consisted of tax reform, which didn’t impact economy until post-recession

45. Comparisons to 1982 – A similarly Deep Recession (Unemployment Rate)

46. Note difference in how unemployment falls off • Dramatic after 1982 • Very slow after 2009 • Sustained economic growth continued until the 1991 recession

47. Overall – 2009 Recession….. • Recovery was slow and not very robust (about 1.6% annual rise in GDP from 2009-16) • Unemployment persistent, leading to problems with housing and automobile markets • Debt hangover a significant problem (U.S. now owes $21 trillion) • Balance sheet of Federal Reserve also a problem

48. Question was Raised about Whether the U.S. Economy had been Fundamentally Altered • Long-term growth of 3-3.5% enabled U.S. to achieve the highest standard of living in the developed world • Currently only surpassed by Luxembourg and Norway • Drop in long-term rate has dramatic effects • At 3%, economy doubles in size every 24 years (using the “rule of 72”) • At 2%, takes 36 years • All economic decisions (e.g. redistribution) are more difficult with lower growth

49. Next Time – Policy Responses….. • Given depth and persistence of downturn, what policies were used to bring about recovery • Both fiscal and monetary • Why was recovery so weak? • What lessons have we learned about policy for the next time?

50. Week 3 - Policy Responses to the Downturn • Cover: • What was done on both Fiscal and Monetary side? • What seemed to work and not work? • What has it left us with? • In long-run, what is the future of policy?