The Impact of Economic & Regulatory Policy on US Economic Recovery: Where Does the Financial Crisis Leave the US Economy

1. Global Macroeconomic Address:The Impact of Current Economic & Regulatory Policy on Economic Recovery --Where Does the Financial Crisis Leave the U.S. Economy in Global Terms? Jeffrey FrankelJames W. Harpel Professor of Capital Formation & Growth, Harvard University Westin Boston Waterfront, Harbor Ball Room, June 3, 2010

2. Recession • Recovery • Outlook • The Impact of Policy • Where Does The Financial Crisis Leave the U.S. Economy in Global Terms?

3. The US Recession The US recession started in Dec. 2007 according to the NBER Business Cycle Dating Committee. The earliest we might date the trough is June 2009. Even then, at 18 months, the recession’s length passed thepostwar records: 16 months -- 1973-75 & 1981-82. One has to go back to 1929-33 for a longer downturn. Also the most severe, by most measures: rise in unemployment rate, job loss, output loss….

4. June 2009 (II) or later> 18 months [not yet declared]

5. US employment peaked in Dec. 2007,which is one reason why the NBER BCDC dated the peak from that month. 8 million jobs were lost over the next two years. Jobs trough Jobs peak Payroll employment series Source: Bureau of Labor Statistics, April 2010 Payroll employment series Source: Bureau of Labor Statistics

6. The U.S. recession of 2007-09 differed from the usual, not just in its length and severity, but also in the extent of the loss of liquidity… Source: WEO, IMF, April 2010

7. …and in the extent of the loss of jobs. Source: WEO, IMF, April 2010

8. Most indicators began to improve by mid or late 2009 • Interbank spreads • GDP • Stock market • Consumer confidence & spending • The labor market has been terrible. • But even it has responded, with lags no worse than usual.

9. Interbank spreads came back down sharply in 2009 Source: OECD Economic Outlook May 2010

10. 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

11. Growth has been positive for the last 3 quarters Source: OECD Economic Outlook May 2010

12. Total hours worked in the US economy(an indicator that does not lag as far behind as unemployment)began to turn upward in October 2009 Source: New series from BLS covering the entire private economy.May 2010

13. Source: OECD Economic Outlook May 2010 US performance a bit better than other rich countries, worse than rest of world (emerging markets).

14. Danger of a W-shaped recession? • Demand growth in the 2nd half of 2009came in large part from: • fiscal stimulus, & • end of firms’ inventory disinvestment. • Both stimulus sources are running down in 2010. • Fortunately consumption & investment seem to be catching fire in their place: • GDP reported by BEA(5/27/10). • QIII: +2.2% QIV: +5.6% QI: +3.0 % , now led by consumption & business equipment.

15. Danger of a W-shaped recession? • There could always be new shocks: • Contagion from Greece • Hard landing for the $ • Geopolitical/oil shock… • I now put the odds of a double dip recession as • << 50%, but • big enough to have persuaded the NBER BCDC in our April 8 meeting to wait longer before declaring the 2009 trough.

16. Policy Response of 2007-09 -- How did we avoid another Great Depression? • We learned important lessons from the 1930s and, for the most part, didn’t repeat the mistakes made then. 16

17. We learnt from the mistakes of the 1930s. Trade policy: Some slippage, e.g., Chinese tires. But we did not repeat 1981 auto quotas or 2001 steel tariffs let alone Smoot-Hawley ! Monetary response: good this time. Fiscal response: relatively good, but : constrained by inherited debt and congressional politics. Financial regulation? Clearly inadequate, going in. But now…? 17

18. U.S. Policy Responses Monetaryeasing was unprecedented, appropriately avoiding the mistake of 1930s. (graph) Policy interest rates ≈ 0. Then we had aggressive quantitative easing: the Fed purchased assets not previously dreamt of. 18

19. The Fed certainly did not repeated the mistake of 1930s: letting the money supply fall. 2008-09 1930s Source: IMF, WEO, April 2009Box 3.1 19

20. Federal Reserve Assetshave more-than-doubled, through new facilities, rather than conventional T bill purchases 20 Source: Federal Reserve H.4.1 report

21. 30 years of monetary theory • say that if you double the monetary base, • you will soon double the price level. • So, should we fear that inflation will soon soar? • In a word, “No.” • So long as unemployment is high, & output below potential, inflation is not an immediate threat. • This will hold (unfortunately) through 2011-2012. • Of course the Fed must plan ahead a year or two.

22. 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 in early 2009 were strong enough to make them balk at keeping the funds. The banks have since paid back the taxpayer at a profit. Geithner’s stress tests fulfilled their function of telling strong banks from weak. The policy of “financial repair” 22

23. Financial reform, for next time. My own views on what is needed Lending Mortgages Consumer protection agency, including standards for mortgage brokers I would not have let the Fed have this one. Fix “originate to distribute” model, so lenders stay on the hook. Remove policy bias toward housing debt. (Sadly, politicians won’t hear of it.) 23

24. Financial reform,continued Lending 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.” Tax banks, so that they pay for rescues in long run. Internationally coordinated But I wouldn’t earmark the revenues for a bailout fund. 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.) 24

25. Financial reformcontinued Executive compensation Compensation committee not under CEO. Maybe need Chairman of Board. Discourage golden parachutes & options, unless truly tied to performance. Securities Derivatives: Create a central clearing house for CDSs . Don’t ban short sales, as the Germans are doing. Credit ratings: Reduce ratings agencies’ conflicts of interest. Reduce reliance on ratings: AAA does not mean no risk. MSN Money & Forbes 25

26. Policy Response,continuedFiscal Policy $787 b fiscal stimulus passed Feb.2009. Good old-fashioned Keynesian stimulus Even the principle that spending provides more stimulus than tax cuts has returned; not just from Larry Summers, e.g., but also from Martin Feldstein. Was $787 billion too small? Too large? Yes: Too small to knock out recession ; too large to reassure global investors re US debt. Also Congress was not willing to vote for more, especially on the spending side. 26

27. The fiscal stimulus of 2008-09 helped. But 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. A solution requires, first: Honest budgeting (e.g., Iraq war goes on-budget…) PAYGO Wise up to politicians who claim they will eliminate budget deficits entirely on the spending side (and even with lower taxes), but who raise spending when they get the chance. 27

28. On the tax side… • Tax revenue • Let President Bush’s tax cuts expire in 2011. • Introduce a Value Added Tax • Or phase in carbon tax or auctioned tradable emission permits • And curtail expensive and distorting tax expenditures • E.g., Tax-deductibility of mortgage interest • All politically very difficult, needless to say.

29. Spending Cuts in farm subsidies for agribusiness & farmers 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 (vs. wages) 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 and to avoid unnecessary medical tests & procedures. Lever: making Medicare payments conditional on these best practices . Curtail corporate tax-deductibility of health insurance, especially gold-plated health plans. 29

30. 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 by 2012 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 !

31. Bottom line of macroeconomic policy response: The monetary and fiscal response wassufficient to halt the economic free-fall. It wasn’t be enough to return us rapidly to full employment & potential output. Given the debt path that was inherited in 2009, it is unlikely that much more could be done. Chinese officials are already questioning US creditworthiness ! 31

32. 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 $. • Nor in 2010 in response to Greek crisis • Chinese warnings 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 $ (Nov 09) . • PBoC Gov. Zhou proposed replacing $ as international currency, with the SDR(March 09).

33. Where Does The Financial Crisis Leave the U.S. Economy in Global Terms? • Europe has made as many policy mistakes over the last decade as the US has. • Lack of structural reform to match expansion of € • Poor handling of fiscal deficits & the Greek debt crisis • A long-run debt profile that is still as bad as ours. • The future belongs to China and other major emerging market countries (represented in G-20). • They now have lower debt, and in some cases better ratings, than the advanced countries, • which helped them respond well to the 2008 global crisis.

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