1. Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth, Harvard University 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? Westin Boston Waterfront, Harbor Ball Room, June 3, 2010

2. RecessionRecession RecoveryRecovery OutlookOutlook The Impact of PolicyThe Impact of Policy Where Does The Financial Crisis Leave the U.S. Economy in Global Terms?Where Does The Financial Crisis Leave the U.S. Economy in Global Terms?

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

4. 4 BUSINESS CYCLE REFERENCE DATES Source: NBER Source: NBER PeakTroughContraction Quarterly dates are in parentheses Peak to Trough 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) 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 20011 (IV) 43 months 13 8 11 10 8 10 11 16 6 16 8 8 Average, all cycles: 1854-2001 (32 cycles) 1945-2001 (10 cycles) 17 10 June 2009 (II) or later > 18 months [not yet declared]

5. 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. Payroll employment series Source: Bureau of Labor Statistics Jobs peak Jobs trough Payroll employment series Source: Bureau of Labor Statistics, April 2010

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. 8 Most indicators began to improve by mid or late 2009 Interbank spreads Interbank spreads GDP GDP Stock market Stock market Consumer confidence & spending Consumer confidence & spending The labor market has been terrible. The labor market has been terrible. But even it has responded, with lags no worse than usual. 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. Source: Jeff Frankel’s blog, Nov. 2009 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. The economic roller coaster went into free-fall in the 3 rd quarter of 2008.

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

12. 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. 14 Demand growth in the 2 nd half of 2009 came in large part from: Demand growth in the 2 nd half of 2009 came in large part from: fiscal stimulus, & fiscal stimulus, & end of firms’ inventory disinvestment. end of firms’ inventory disinvestment. Both stimulus sources are running down in 2010. Both stimulus sources are running down in 2010. Fortunately consumption & investment seem to be catching fire in their place: Fortunately consumption & investment seem to be catching fire in their place: GDP reported by BEA (5/27/10). GDP reported by BEA (5/27/10). QIII: +2.2% QIV: +5.6% QI: +3.0 %, now led by consumption & business equipment. QIII: +2.2% QIV: +5.6% QI: +3.0 %, now led by consumption & business equipment. Danger of a W-shaped recession?

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

16. 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. We learned important lessons from the 1930s and, for the most part, didn’t repeat the mistakes made then.

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

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

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

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

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. 22 Policy Responses, continued succeeded in getting the financial system going again, succeeded in getting the financial system going again, thereby precluding a new Great Depression, thereby precluding a new Great Depression, yet without “nationalization” of the banks. yet without “nationalization” of the banks. Contrary to almost all commentary at the time of TARP: 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 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. The banks have since paid back the taxpayer at a profit. Geithner’s stress tests fulfilled their function of telling strong banks from weak. Geithner’s stress tests fulfilled their function of telling strong banks from weak. The policy of “financial repair”

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

24. 24 Financial reform, continued Lending Lending Banks: Banks: Regulators shouldn’t let banks use their own risk models ; Regulators shouldn’t let banks use their own risk models ; should make capital requirements higher & less pro-cyclical. should make capital requirements higher & less pro-cyclical. Is “too big to fail” inevitable? Is “too big to fail” inevitable? The worst is to say “no” and then do “yes.” The worst is to say “no” and then do “yes.” Tax banks, so that they pay for rescues in long run. Tax banks, so that they pay for rescues in long run. Internationally coordinated Internationally coordinated But I wouldn’t earmark the revenues for a bailout fund. But I wouldn’t earmark the revenues for a bailout fund. Extend bank-like regulation to “near banks.” Extend bank-like regulation to “near banks.” Regulators need resolution authority. Regulators need resolution authority. Segmentation of function: Segmentation of function: Volcker rule ? or all the way back to Glass-Steagall ? (I don’t think so.) Volcker rule ? or all the way back to Glass-Steagall ? (I don’t think so.)

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

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

27. 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. The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. A solution requires, first: A solution requires, first: Honest budgeting (e.g., Iraq war goes on-budget…) Honest budgeting (e.g., Iraq war goes on-budget…) PAYGO 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. 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.

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

29. 29 Spending Spending Cuts in farm subsidies for agribusiness & farmers Cuts in farm subsidies for agribusiness & farmers Cut unwanted weapons systems (a rare success: the F22 fighter) Cut unwanted weapons systems (a rare success: the F22 fighter) Cut manned space program… Cut manned space program… Social security Social security Raise retirement age – just a little Raise retirement age – just a little Progressively index future benefit growth to inflation (vs. wages) Progressively index future benefit growth to inflation (vs. wages) If necessary, raise the cap on social security taxes. If necessary, raise the cap on social security taxes. Health care Health care Encourage hospitals to standardize around best-practice medicine Encourage hospitals to standardize around best-practice medicine to pursue the checklist that minimizes patient infections and to pursue the checklist that minimizes patient infections and to avoid unnecessary medical tests & procedures. to avoid unnecessary medical tests & procedures. Lever: making Medicare payments conditional on these best practices. Lever: making Medicare payments conditional on these best practices. Curtail corporate tax-deductibility of health insurance, Curtail corporate tax-deductibility of health insurance, especially gold-plated health plans. especially gold-plated health plans.

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. 31 Bottom line of macroeconomic policy response: The monetary and fiscal response was sufficient to halt the economic free-fall. The monetary and fiscal response was sufficient to halt the economic free-fall. It wasn’t be enough to return us rapidly to full employment & potential output. 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. 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 ! Chinese officials are already questioning US creditworthiness !

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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