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Policy Responses to Recession, Financial Crisis and Anemic Recovery

Michael J. Boskin

Senior Fellow, Hoover InstitutionTully M. Friedman Professor of Economics

Stanford University

The Uneven Recovery:

Emerging Markets vs. Developed Economies

Hoover Institution, Stanford University

October 14, 2011

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Two Big Questions1. What happened and why?

Severe recession Financial crisis Anemic recovery

2. 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

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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

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Government Social Engineering of Housing Market

1. Community Re-Investment Act (CRA), 1977; Expanded, 1990’s.

2. President Clinton announces goal to raise homeownership to over 70%, 1990’s;

3. Fannie Mae and Freddie Mac expand, increase leverage, 1990’s – 2000’s, required quota on low income loan support.

4. President Bush “Ownership Society” agenda, 2000’s

HUD announces innovative “low down payment” mortgages

5. Rescue attempts 2008-10

Foreclosure relief, 5 iterations; principal reduction?

Homebuyers’ tax credit

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

Originally Committed

Currently Provided

Ultimate Cost

Treasury Fed supplementary financing account 560 200 0Fannie Mae and Freddie Mac Unlimited 145 305FDIC Guarantee of U.S. banks’ debt* 1,400 305 4 Guarantee of Citigroup debt 10 0 Guarantee of Bank of America debt 3 0 Transaction deposit accounts 500 0 0Public-Private Investment Fund Guarantee 1,000 0 0Bank Resolutions Unlimited 23 71Federal Housing Administration

Refinancing of mortgages, Hope for Homeowners 100 0 0Expanded Mortgage Lending Unlimited 150 26Congress TARP 700 277 101Economic Stimulus Act of 2008 170 170 170American Recovery and Reinvestment Act of 2009 821 200 821Cash for Clunkers 3 3 3Additional Emergency UI benefits 90 39 90Other Stimulus 21 12 21Dec 2010 stimulus 200 100

NOTES: *Includes foreign denominated debt; **Net portfolio holdings; *** Excludes AMT patch

Originally Committed

Currently Provided

Ultimate Cost

Total $13 ,000 + $4,000 +up to

$2,000Federal Reserve Term auction credit 900 0 0Other loans Unlimited 68 3Primary credit Unlimited 0 0Secondary credit Unlimited 0 0Seasonal credit Unlimited 0 0

Primary Dealer Credit Facility (expired 2/1/2010) Unlimited 0 0Asset-Backed Commercial Paper Money Market Mutual Fund Unlimited 0 0AIG 26 25 2AIG (for SPVs) 9 0 0AIG (for ALICO, AIA) 26 0 1Rescue of Bear Stearns (Maiden Lane)** 27 28 4

AIG-RMBS purchase program (Maiden Lane II)** 23 16 1AIG-CDO purchase program (Maiden Lane III)** 30 23 4

Term Securities Lending Facility (expired 2/1/2010) 200 0 0

Commercial Paper Funding Facility** (expired 2/1/2010) 1,800 0 0TALF 1,000 43 0Money Market Investor Funding Facility (expired 10/30/2009) 540 0 0Currency swap lines (expired 2/1/2010) Unlimited 0 0

Purchase of GSE debt and MBS (expired 3/31/2010) 1,425 1,295 0

Guarantee of Citigroup assets (terminated 12/23/2009) 286 0 0

Guarantee of Bank of America assets (terminated) 108 0 0

Purchase of long-term Treasuries (under QE-I & QE-II) 900 600 0Operation Twist 2 400

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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

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

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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)

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Evaluating Efficacy of Counter Cyclical Fiscal Policy

Methods used:1. Stylized analytical models2. Macroeconometric models3. Direct estimation of key relationships 4. Vector autoregressions (VARs)5. 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

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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

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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)

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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

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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

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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) ? ?

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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

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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

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Sensible Policy Responses to Severe Recessions(plus sensible financial reform)

1. 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

2. 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?3. 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