--- US Federal Government Fiscal Deficits began to grow in 2002

--- During 2000s C and G increased, now it must be I and NX increasing

--- Need to Rebalance

--- When Obama took over in 2009 fiscal situation was grim

Fiscal Deficits Projected to Grow out to 2040 under Bush budgets

Debt to GDP Ratio Rising at an Alarming Rate projected under Bush budgets

Why the bad fiscal situation?

--- Spending on prescription drug benefits, war expenditures

--- Revenues down due to Bush tax cuts in 2001 and 2003

Federal government revenues lowest since 1950s

Policy decisions 2001- 2008 caused ½ of the increase in deficits and debt

---Tremendous fiscal challenge of Medicare, Medicaid, and Social Security Retirement

(next 20 years) the problem is aging of the population

(after 20 years) the problem is rising health care costs

Note: health costs grew 2.3% faster than per capita GDP growth 1975-2007

--- % of disability recipients doubled since 1985

Obama team places blame of fiscal crisis on the Bush Administration

Bush Administration added Billions and Worsened the Forecast

Effect of ARRA on the Deficit only a Short Run Phenomenon 2-3% of GDP

Economic Effect of Deficits Depend on Two Things

--- State of the Economy (Weak Economy Strong Output Effects, Strong Economy Crowding Out Effects, Interest Rates only slightly impacted)

--- Magnitude and Persistence of Deficits (Moderate Deficits in Weak Economy poses no problem, Continued Deficits Drive up Interest Rates)

US is close to average and therefore will be able to continue borrowing

Discussion of Deficit/GDP and Debt/GDP Dynamics (page 148 of ERP 2010)

During this time of recession, sharp fiscal contraction in not desirable.

Need is for long run steady correction of the drivers of fiscal imbalance

Immediate reduction in spending or increase in taxes could cause a double dip recession as in 1937-1938

Gradual deficit reduction is better as a policy

Three areas to improve the long run deficit picture

--- comprehensive health care reform --- eliminate tax cuts for the wealthy --- eliminate wasteful spending

Health Care (This week a Federal judge ruled parts of Obama Care unconstitutional – on to

the Supreme Court for a final judgment)

Taxes (Note that Obama has changed his mind on this one – all

Bush tax cuts extended for 2 years)

Obama’s New Tax Policy Initiative (December 2010)

Liberal Base is Angry about the New Deal

Wasteful Government Spending (This one is popular and useless)

After the Great Depression, the US created a good system of financial regulation.

----- In the period 60 years before the Great Depression there were 7 banking panics

----- In the period 80 years after the Great Depression there were none of the level of the Great Depression

Problems came with

----- Savings and Loan Crisis in the 1980s----- 1998 collapse of Long Term Capital Management----- 2001 collapse of Enron

System of regulation was becoming outdated

----- Fall of Lehman Brothers September 2008----- Freezing of short term credit markets

Short Term Actions by Fed and Administration (Chapter 2)

Need for Long Term Planning for Financial Reform (Chapter 6)

Financial Intermediation – Getting Funds from Lenders to Borrowers

Adverse selection (asymmetric Information) and Moral Hazard (Too Much Protection)

Financial Intermediation One Means of Solving These

Types of Financial Intermediaries

----- Banks, Securities Firms, and Insurance Companies

----- Mutual Funds and Pension Funds (Money Market Mutual Funds)

----- GSEs and Federally Related and Private Mortgage Pools

----- Federal Reserve

----- Hedge Funds

Financial Crisis results from a sudden and widespread increase in asymmetric

information

--- Central Bank cannot act quickly across all institutions

--- Bank runs are rational meaning bank panics are rational

--- Central banks used to solve liquidity problems not solvency problems, but both become mixed together in a crisis

--- Deposit insurance helps reduce the problem of asymmetric information (US deposit insurance up to $250,000)

Four Major Gaps in Current Financial Regulatory System

----- Many new financial institutions (hedge funds, mortgage pools, etc.)

----- Overlapping jurisdictions and competitive regulation

----- Regulators specialized, regulated multi-markets

----- Regulators focused on micro-environment

Of the four gaps, the last gap is most important and reforms are needed

Three Types of Financial Contagion

----- Confidence Contagion

----- Counterparty Contagion

----- Coordination Contagion

5 Basic Financial Regulatory Reforms