Jeffrey Frankel Harpel Professor of Capital Formation

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

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BUSINESS CYCLE REFERENCE DATES BUSINESS CYCLE REFERENCE DATES  Source NBER
Peak Trough Contraction
Quarterly dates are in parentheses Quarterly dates are in parentheses Peak to Trough
August 1929 (III)May 1937 (II)February 1945 (I)November 1948 (IV)July 1953 (II)August 1957 (III)April 1960 (II)December 1969 (IV)November 1973 (IV)January 1980 (I)July 1981 (III)July 1990 (III)March 2001 (I)December 2007 (IV) March 1933 (I)June 1938 (II)October 1945 (IV)October 1949 (IV)May 1954 (II)April 1958 (II)February 1961 (I)November 1970 (IV)March 1975 (I)July 1980 (III)November 1982 (IV)March 1991 (I)November 2001 (IV) 43 months1381110810111661688 18
Average, all cycles 1854-2001 (32 cycles) 1945-2001 (10 cycles) Average, all cycles 1854-2001 (32 cycles) 1945-2001 (10 cycles)   1710
June 2009 (II)
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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 Frankels blog, Nov. 2009
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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.

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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 cant 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.

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National output gives a pretty clear
answerthough GDP Gross Domestic Income look
slightly different.
Peak
Trough
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Some other indicators such as industrial
production so similar dating
Peak
Trough
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The labor market lags behind, as usual
Peak
Trough
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In the labor market, hours responds first.Firms
delay hiring until they are confident of the need.
Peak
Trough
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Interbank lending spreads are the best measure
of the extraordinary financial crisis that led
to global recession
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
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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.

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• 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 Bushs 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.

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• 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.

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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 !

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When will the day of reckoning come?

• It didnt 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.

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More on the crisis of 2007-2009

1. Six root causes of the financial crisis
2. Policy response How did we avoid a Great
   Depression?
3. Intellectual implications

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1. Six root causes of the financial crisis

• 1. US corporate 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
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Six root causes of financial crisis, cont.

• 4. The federal budget has 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.

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US real interest rate lt 0, 2003-04
Source Benn Steil, CFR, March 2009
Real interest rates lt0
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Source The EMBI in the Global Village, Javier
Gomez May 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.
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Origins of the financial/economic crises
Homeownership bias
Predatory lending
Excessive complexity
MBSs
Foreign debt
CDSs
CDOs
Gulf insta-bility
Oil price spike 2007-08
Recession 2008-09
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They did. Indices peaked in late 2006, and
fell 1/3.
The black swan investors thought housing
prices could never go down.
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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).
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Monthly GDP
Peak
Trough
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National income has been more reliable than GDP,
even though they are supposed to measure the
same thing.
Recession of July 1990 March 91
Recession ofMar. 2001 Nov. 2001
Recession of Dec. 2007 June 09
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2. Policy Response -- How did we avoid another
Great Depression?

• We learned important lessons from the 1930s and,
  for the most part, didnt repeat the mistakes we
  made then.

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• 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?

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U.S. Policy Responses

• Monetary easing 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.

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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
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Federal Reserve Assets ( billions)more-than-doub
led in 2008, through new facilities, rather than
conventional T bill purchases
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Source Federal Reserve H.4.1 report
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Policy Responses, continued
The policy of financial repair

• 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.
• Geithners stress tests fulfilled their function
  of distinguishing strong banks from weak.

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• 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 shouldnt 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 dont think so.)

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• Financial reforms continued
• 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.

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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.

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Bottom line of macroeconomic policy response

• The monetary fiscal response wassufficient to
  halt the economic free-fall.
• It wont 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

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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

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The return of Keynes

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

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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.

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• 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 Hayeks credit cycle,
• Kindleberger78 s manias panics
• the Minsky moment,
• Fishers debt deflation.
• The origin this time was not a monetary
  contraction in response to inflation as were
  1980-82 or 1991.
• But, rather, a credit cycle 2003-04 monetary
  expansion showed up only in asset prices.

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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 cant repay.
• Rogoff This Time Is Not Different.
• Roubini The recession will be severe.

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Appendix

• US fiscal policy

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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 lt 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.

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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.

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Vs. the 1990s The Shared Sacrifice approach
succeeded in eliminating budget deficits,
importantly by slowing spending.
(ii) Spending deficts both rose sharply when
Presidents Reagan, Bush I, Bush II took office.
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(iii) States ranked by federal spending
receivedper tax dollar paid in 2005
versus party vote ratio in preceding election
redstates
Republican states take home significantly more
federal (relative to taxes paid) than
Democratic states
big inflow of US
bluestates
low inflow of US
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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. cant 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.

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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 gt 250,000.
• If the stimulus has to take the form of tax cuts,
  then the best options are
• extending President Obamas Make Work Pay tax
  cuts,
• fixing the Alternative Minimum Tax, and
• extending the Bush tax cuts for those households
  lt 250,000.
• Some business tax cuts could also give high bang
  for the buck.
• such as temporary credits for investment or
  hiring.

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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 dont have to lay off teachers,
  policemen, firemen, subway drivers
  construction workers.

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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.

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U.S. fiscal policy in 2010-2011, continued

• One big reform might work best pass
  legislation today to put Social Security on a
  sound financial footing in the long term.
• It would consist of a combination
• of raising the retirement age
• just a little (in proportion to lengthening life
  spans)
• and slowing the growth of benefits for future
  retirees
• just a little (perhaps by progressive
  indexation).
• If Washington could fix Social Security,
• it would address the long-term fiscal outlook,
• yet would create no drag for the current fragile
  recovery.