Policy Responses to Recession, Financial Crisis and Anemic Recovery

1. Policy Responses to Recession, Financial Crisis and Anemic Recovery • The Uneven Recovery: • Emerging Markets vs. Developed Economies • Hoover Institution, Stanford University • October 14, 2011 • Michael J. Boskin • Senior Fellow, Hoover Institution • Tully M. Friedman Professor of Economics • Stanford University 1

2. Two Big Questions • What happened and why? • Severe recession • Financial crisis • Anemic recovery • Where do we go from here? • short/medium term: • How strongly will the economy recover? • Long-term growth: • Some scenarios: • Normal • New normal • Japanese style stagnation • Policy issues: • Round off rough edges of Reagan revolution/capitalism • Permanent expansion of temporary programs • European style social welfare state • FED and inflation from failure to exit soon enough 2

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11. Role of Government • The economic and financial crisis has sparkled renewed debate over the size, scope, and role of government in many countries • Two interrelated fiscal debates • General long term size and role of government • Taxes, spending, regulation • Short-run fiscal stimulus vs. fiscal consolidation • Did stimulus work? Is more desirable? • At what cost ? • Are better alternatives available? • Would fiscal consolidation help or hurt short-term? • Long run cost of delay? • How to consolidate: taxes vs. spending? • Fiscal policy and monetary policy 11

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13. Government Social Engineering of Housing Market • Community Re-Investment Act (CRA), 1977; Expanded, 1990’s. • President Clinton announces goal to raise homeownership to over 70%, 1990’s; • Fannie Mae and Freddie Mac expand, increase leverage, 1990’s – 2000’s, required quota on low income loan support. • President Bush “Ownership Society” agenda, 2000’s • HUD announces innovative “low down payment” mortgages • Rescue attempts 2008-10 • Foreclosure relief, 5 iterations; principal reduction? • Homebuyers’ tax credit 13

14. Federal Government Response to the Financial Crisis ($bln)(note: not updated) 14

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18. Net Effects of U.S. Stimulus($13+ trillion commitment) • Bailouts (Bear Sterns, AIG, TARP, Fannie and Freddie, GM, Chrysler, HAMP, bank debt, MMF, commercial paper, etc.): mixed record • Fiscal stimulus • Tax cuts/transfers initially barely budged consumption or investment • State and local grants delayed some layoffs and pay cuts, but mostly reduced borrowing • Supposed biggest “bang for the buck” infrastructure spending, only 7% of total, spent slowly and poorly (LA example) • Temporary special programs (cash for clunkers, home buyers credit) briefly borrowed sales from future, then collapsed • Lame duck tax deal • Automatic stabilizers large • A new stimulus? • Effects of monetary policy • Lowering FED funds to “almost zero” • QE1 + special facilities, bailouts • QE2 • Operation Twist 18

19. Evaluation of U.S. Policy Responses to Economic and Financial Crisis • Effective • Traditional monetary policy • Automatic fiscal stabilizers • Ineffective • Discretionary fiscal policy (ARRA): small, late impact at high cost, lots of social engineering and pork • Debatable • Bailouts, mixed record • QE-II • Operation Twist 19

20. Economics Debate • New classical vs. new Keynesian vs. old Keynesian macroeconomics imply differing conclusions on efficacy of fiscal policy to combat recession, speed recovery • Theories of Consumption • Keynesian consumption out of disposable income • Modern Consumption Theory • longer time horizons, consumption smoothing (Friedman, Modigliani, Hall and Mishkin) • Expectations (Lucas, Sargent, Barro, others) • Incentives (Feldstein, Boskin, many others) • “Sticky” wages or prices • Wage rigidity (Taylor) • Price rigidity (Bils and Klenow) 20

21. Evaluating Efficacy of Counter Cyclical Fiscal Policy • Methods used: • Stylized analytical models • Macroeconometric models • Direct estimation of key relationships • Vector autoregressions (VARs) • Historical case studies • Strengths and weaknesses: • model assumptions, data limitations, difficulties of identification • Conclusions differ, heavily depending upon: • Model assumptions • Nature, timing, and assumed duration of fiscal actions • Assumed path of monetary policy • Large impact (CEA, CBO, Zandi) • Models downplay private and state and local and monetary policy offsets • Assumes fiscal policy is correctly timed, and effective • Smaller impact (Cogan and Taylor, Mulligan) • Larger offsets 21

22. When are Fiscal Deficits Desirable and When are They Harmful? Desirable • Recession: allow automatic stabilizers to work, discretionary policy debatable • Funding net productive public investment • Funding temporary swings in spending (matched by surpluses) Harmful: • Well into expansion • If crowd out private investment rather than increase private saving or foreign capital imports • If debt/GDP ratio is high or rapidly rising • If finance consumption rather than investment • If ineffective in constraining future spending and hence require higher taxes • If they lead to inflationary monetary policy (or default) • External vs. internal debt 22

23. Multipliers • Keynes: large for spending, smaller for taxes/transfers • Full employment: zero, full crowding out of private spending by government spending • New Keynesians: initially large, but decline rapidly, at ZLB (Christiano, Eichenbaum, Rebelo; Woodford and Hall); but if taxes and spending expected beyond ZLB, can be negative – a “destroyer” (Woodford) • With high unemployment, depends on extent spending draws on unemployed resources vs. displacing other uses • Most likely between zero and one, partial crowding out (Barro:”dampener”) • Empirical estimates: 0.3-1.4, clustering at 0.5-0.7 and differ in time pattern, before turning negative • Smaller still in new classical macro models • Estimates for ARRA proved very small (Cogan and Taylor, Mulligan) • Longer term, output falls unless new spending is enough more productive than private spending to offset distortions from higher taxes • Feb. 2009 ARRA: $821 billion; estimates zero to small impact to 2-3 million jobs; even at 2m jobs, that’s more than $400k/job (8-10 times median pay) 23

24. Spending multipliers in VARs: • Mountford and Uhlig, 2009, (U.S. data) • Multiplier starts small (0.6) turns negative by the start of the second year • Mendoza and Vegh, 2010 (international data) • No significant output gains in open economies with flexible exchange rates • Negative with debt/GDP ratio over 60% (current U.S.) • Auerbach and Gorodnichenko (U.S.) - may be large in recessions, especially for military spending 24

25. Infrastructure • Virtually all countries have important infrastructure needs • ARRA initially sold as “shovel-ready” projects that would quickly create jobs • But (Harvard's Ed Glaeser): • Infrastructure spending poorly designed for short run anti-recession policy • ARRA infrastructure spending NOT directed to areas with highest unemployment or biggest housing busts • “Impossible to create infrastructure quickly and wisely. Good planning takes years.” Total ARRA federal transportation spending only $4 billion in first year (2009) • Public infrastructure jobs less labor intensive than home building • Japanese experience with repeated 15-20 trillion yen stimulus programs heavy on infrastructure 25

26. Tax Cuts vs. Spending Increases • Keynesian theory predicts tax cuts less effective than spending increases, but • Last two major U.S. tax cuts – Reagan and Bush ‘43 – seemed to help engineer takeoff of economy • Focused on lower marginal rates and expected to last long time • In contrast, 2008 (Bush ‘43) and 2009 (Obama) tax cuts barely budged private spending • Empirical studies of tax cut multipliers • Romer and Romer: tax cut multiplier 3.0 • Mountford and Uhlig : PV multiplier 5.0, much larger than spending • Alesina and Ardagna: large fiscal changes in OECD: tax cuts more likely to increase growth than spending increases • Barro and Redlick: higher marginal tax rates have large negative effects on GDP • Why seem to work? • relative productivity of private and government spending ? • Tax cuts favorably alter future expectations (more spending control) relative to spending increases (more future tax hikes) ? • ? 26

27. Fiscal Consolidation • Alesina and Ardagna: • Successful consolidation had 5 or 6 times the spending cuts vs. tax hikes • Spending cuts less likely to cause recession than tax increases • IMF: different definition of fiscal adjustments • Cautions against sharp fiscal consolidation in weak economy • Spending cuts less worrisome than tax increases • Is fiscal consolidation expansionary? • Trichet: yes • Giavazzi and Pagano: Ireland and Denmark in 1980s • But: U.S. not Ireland or Denmark • 1/5 global economy • Dollar global reserve currency • Interest rates are low • Many countries consolidating simultaneousely 27

28. Tax Structure • Broad-based consumption taxes more conducive to growth than high rate personal and corporate income taxes • OECD • Ahltig, Auerbach, Kotlikoff, Smetters and Walliser • Jorgenson and Yun • Europe reliance on consumption taxes offsets perhaps 1/6 of per capita income difference (i.e. it would be even larger) • U.S. has most progressive income tax in OECD, and second highest corporate tax (although effective rate less than usually quoted statutory rate) – with broad based consumption tax instead, 30% higher per capita GDP gap over large Western European countries would be larger still • Prescott attributes all of the gap to higher taxes, but large labor supply elasticity • McGrattan, higher European labor income tax rates account for 80% of the large decline in hours worked 28

29. Sensible Policy Responses to Severe Recessions(plus sensible financial reform) • Monetary policy: • Lower fed funds rate to combat recession, but raise more quickly during expansion • Quantitative easing as last resort, but do not buy long-run treasuries • Predictably withdraw liquidity to prevent inflation • Fiscal policy • Speedup spending that would be done anyway, eg. replenish military equipment • Credible commitment to fiscal consolidation before temporary programs develop powerful constituencies and become permanent, control long-term budget and keep tax rates as low as possible • Possibly: • Cut or suspend payroll tax • U.I. reform, shelf of projects? • Financial regulation • Regulators that regulate • Reform too big to fail (TBTF) (enhanced bankruptcy; capital requirements vary with size) • Clearing, exchanges for derivatives, if done properly 29