Transcript www.ksg.harvard.edu

It May Be Slow, But at Least
It’s An Economic Recovery
Jeffrey Frankel
Harpel 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
2
BUSINESS CYCLE REFERENCE DATES
Peak
Trough
Quarterly dates are in parentheses
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)
Average, all cycles:
1854-2001
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)
June 2009 (II)
(32 cycles)
1945-2001 (10 cycles)
Source: NBER
Contraction
Peak to Trough
43 months
13
8
11
10
8
10
11
16
6
16
8
8
18
17
10
3
The economic roller coaster went into free-fall
in 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,


The definition of recovery is rising economic recovery,


not a high level.
GDP & other economic statistics tend to




not a low level.
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 answer
though GDP & Gross Domestic Income look slightly different.
Figure 1. Monthly Output, Jan. 2006 - June 2010,
Indexed to Dec. 2007 = 100
S-W GDI
Peak
102
Average S-W
GDP&GDI
101
Index Value
S-W GDP
100
Trough
99
98
97
96
95
94
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08 Jul-08
Year
Jan-09
Jul-09
Jan-10
Some other indicators such as industrial
production so similar dating
Figure 6. Index of Industrial Production vs. Average Output,
Mar. 2006 - Aug. 2010
108
Index Value
Index of Industrial
Production
Average S-W
GDP&GDI
Peak
103
Trough
98
93
88
83
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Year
Jan-09
Jul-09
Jan-10
Jul-10
The labor market lags behind, as usual
Figure 5. Average Employment vs. Average Output,
Mar. 2006 - Aug. 2010,
Indexed to Dec. 2007 = 100
Peak
Average S-W
GDP&GDI
102
Index Value
Average
Employment
Trough
100
98
96
94
92
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
Year
In the labor market, hours responds first.
Firms delay hiring until they are confident of the need.
Figure 4. Employment vs. Aggregate Hours, Mar. 2006 - Aug. 2010,
Indexed to Dec. 2007 = 100
Index Value
102
Household
Employment
Payroll
Employment
Aggregate Hours
Peak
100
Trough
98
96
94
92
90
88
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10
Year
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.
Start of US
sub-prime
mortgage crisis
Lehman
failure
OECD Economic Outlook, April
112010
Danger of a double-dip?

Demand growth in the 1st year of recovery
came in large part from:



Both sources of demand have run down in 2010


The withdrawal of fiscal stimulus is now slowing growth.
There could always be new shocks:




fiscal stimulus, &
ending of firms’ inventory disinvestment.
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
12
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.
13

Spending




Social security




Cuts in farm subsidies for agribusiness & farmers, incl. ethanol
Cut unwanted weapons systems (a rare success: the F22 fighter)
Cut manned space program…
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.
14
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
1. Six root causes of the financial crisis
2. Policy response:
How did we avoid a Great Depression?
3. Intellectual implications
1. Six root causes of the financial crisis

1. US corporate governance falls short


E.g., rating agencies;
executive compensation …


options;
golden parachutes…
MSN Money & Forbes
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…
18
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
reminiscent of the Vietnam era.
expansion,
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 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.
21
Origins of the financial/economic crises
Monetary
policy easy
2004-05
Stock
market
bubble
Underestimated
risk in
financial mkts
Failures of
corporate
governance
saving too little,
borrowing too
much
Homeownership bias
Excessive leverage in
financial institutions
Predatory
lending
Stock
market
crash
Gulf
instability
MBS
s
CDO
s
Financial
crisis
2007-08
Oil
price
spike
2007-08
Federal
budget
deficits
Low
national
saving
Housin
g
bubble
Excessive
complexity
CDSs
China’s
growth
Households
Recession
2008-09
Foreig
n debt
Housin
g
crash
Lower longterm
econ.growth
Eventual loss
of US hegemony
22
The “black swan”:
investors thought housing prices could never go down.
They did. Indices peaked in late 2006, and fell 1/3.
23
Financial meltdown: bank spreads rose sharply
when 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
Figure 7. Macro Advisers Real GDP vs. Average S-W Output,
Jan. 2006 - June 2010,
Indexed to Dec. 2007 = 100
MA GDP
Peak
Index Value
104
Average S-W GDP&GDI
102
Trough
100
98
96
94
92
90
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Year
Jan-09
Jul-09
Jan-10
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 of
Mar. 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
 Fiscal


response: good this time
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

Monetary easing was unprecedented,
appropriately avoiding the mistake of 1930s.
 Policy


(graph)
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
1930s
Source:
IMF,
WEO,
April
2009
Box 3.1
30
Federal Reserve Assets ($ billions)
more-than-doubled in 2008, through new
facilities, rather than conventional T bill purchases
Source: Federal Reserve H.4.1 report
31
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.
 Geithner’s stress tests fulfilled their function
of distinguishing strong banks from weak.

32
Financial reform.

Lending

Mortgages




Banks:




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.)
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 reforms

Executive compensation

Compensation committee not under CEO.


Maybe need Chairman of Board.
Discourage golden parachutes & options,


continued
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,
 $787

b fiscal stimulus passed Feb. 2009.
Good old-fashioned Keynesian stimulus


continued
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 was
sufficient 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
37
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)
38
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.
39

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,
Kindleberger ’s “manias & panics”
the “Minsky moment,”
& Fisher’s “debt deflation.”
78
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.
40
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.
41
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.
Spending and Budget Balance(inverse) as % of GDP (Current US$)
15
24
13
22
11
20
9
18
7
ρ = 0.86
5
16
G.W. Bush
R. Reagan
G.H.W. Bush
10
1
-1
-3
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 Est
2009 Est
2010 Est
12
J. Carter
14
W.J. Clinton
3
Spending/GDP
Budget Balance/GDP
Source:
OMB
(iii) States ranked by federal spending received
per tax dollar paid in 2005
versus party vote ratio in preceding election
“red”
states
“blue”
states
big inflow of US $
Republican states take home
significantly more federal $
(relative to taxes paid)
than Democratic 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.

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


and slowing the growth of benefits for future retirees


just a little (in proportion to lengthening life spans)
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.