It May Be Slow, But at

Least It’s An
Economic Recovery
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth

Senior Executive Fellows

October 25, 2010
 Topics
• The trough of
the 2007-09 recession
• Root causes of the crisis

• Policy response:
• How did we avoid a Great Depression?

• Intellectual implications
• Appendix
• US budget deficits
2
 BUSINESS CYCLE REFERENCE DATES  Source: NBER

Peak Trough Contraction

Quarterly dates are in parentheses Peak to Trough

August 1929 (III) March 1933 (I) 43 months

May 1937 (II) June 1938 (II) 13
February 1945 (I) October 1945 (IV) 8
November 1948 (IV) October 1949 (IV) 11
July 1953 (II) May 1954 (II) 10
August 1957 (III) April 1958 (II) 8
April 1960 (II) February 1961 (I) 10
December 1969 (IV) November 1970 (IV) 11
November 1973 (IV) March 1975 (I) 16
January 1980 (I) July 1980 (III) 6
July 1981 (III) November 1982 (IV) 16
July 1990 (III) March 1991 (I) 8
March 2001 (I) November 2001 (IV) 8
December 2007 (IV) 18
June 2009 (II)
Average, all cycles:
1854-2001 (32 cycles) 17
1945-2001 (10 cycles) 10 3
The economic roller coaster went into free-fall
in 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
 In September 2010, the NBER
Business Cycle Committee
announced that the trough of
the recession came in June
2009
 which marked the end of the longest
& most severe recession since the 1930s.

 As usual, we were attacked

 both for not having declared the obvious trough earlier,
 based on the rule of 2 consecutive quarters of positive growth,

 and also for not waiting until the economy was better
 which showed we were “out of touch with reality.”
 Much of the confusion can be
easily explained by a few
points:
 The definition of recession is declining economic activity,
 not a low level.
 The definition of recovery is rising economic recovery,
 not a high level.

 GDP & other economic statistics tend to

 point in different directions,
 have measurement error,
 and be revised.

 We can’t declare the end of a recession until we are

reasonably sure that a hypothetical new downturn (“double
dip”) would count as a separate new recession.
 National output gives a pretty
clear answer
though GDP & Gross Domestic Income look
slightly different.
Figure 1. Monthly Output, Jan. 2006 - J
Indexed to Dec. 2007 = 100
Peak
102
101 Trough
Index Value

100
99
98
97
96
95
 Some other indicators such as
industrial production so
similar dating
Figure 6. Index of Industrial Production vs. Av
Mar. 2006 - Aug. 2010
Peak
108
Trough
103
Index Value

98

93

88
The labor market lags behind,
as usual
Figure 5. Average Employment vs. Ave
Mar. 2006 - Aug. 2010,
Indexed to Dec. 2007 = 10
Peak

102 Trough
Index Value

100

98

96

94
In the labor market, hours
responds first.
Firms delay hiring until they are
confident of the need.
Figure 4. Employment vs. Aggregate Hours, Ma
Indexed to Dec. 2007 = 10
Peak
102
Trough
100
Index Value

98
96
94
92
90
 Interbank lending spreads are the best
OECD Econ.Outlook, April
2010
measure
of the extraordinary financial crisis that led to
global recession
The banking sector “normalized” in Q3 20

Lehman
Start of US failure
sub-prime
mortgage
crisis

11 April
OECD Economic Outlook,
2010
 Danger of a double-
dip?
 Demand growth in the 1st year of recovery
came in large part from:
 fiscal stimulus, &
 ending of firms’ inventory disinvestment.
 Both sources of demand have run down in 2010
 The withdrawal of fiscal stimulus is now slowing growth.

 There could always be new shocks:

 Sovereign debt contagion, spreading from Greece
 Hard landing for the $
 Geopolitical/oil shock…

 I put the odds of a double dip recession as

 rather small, but
 big enough to have persuaded the NBER to wait until
September.
12
 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.
 Tax revenue
 Let President Bush’s tax cuts expire for the rich in 2011.
 Introduce a VAT or phase in auctioning of tradable emission
permits
 Curtail expensive and distorting tax expenditures
 E.g., Tax-deductibility of mortgage interest

 All politically very difficult, needless to say.

 Any solution requires:
 Honest budgeting (e.g., Iraq war on-budget, etc…)
 PAYGO
 Wise up to politicians who claim they want to do it 13
 Spending
 Cuts in farm subsidies for agribusiness & farmers, incl. ethanol
 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
 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,
 avoid unnecessary medical tests & procedures,
 & standardize around best-practice treatment.
 Lever: making Medicare payments conditional on these best practices .
 Curtail corporate tax-deductibility of health insurance,
 especially gold-plated.

14
 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 in 2011-12 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 !
 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 $.

 Chinese warnings in 2009

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 $ .
 PBoC Gov. Zhou proposed
replacing $ as international
 More on the crisis of
2007-2009
1. Six root causes of the
financial crisis

2. Policy response:
How did we avoid a Great
Depression?

3. Intellectual implications
 1. Six root causes of the

financial crisis
1. US corporate governance falls short
 E.g., rating agencies;
 executive compensation …
 options;
 golden parachutes…
MSN Money & Forbes

2. US households save too little,

borrow too much.

3. Politicians slant excessively

toward homeowner debt
 Tax-deductible mortgage interest;
 FannieMae & Freddie Mac;
 Allowing teasers, NINJA loans, liar loans…

18
 Six root causes of financial crisis,



cont.

4. The federal budget

has been on a reckless path since 2001,
 reminiscent of 1981-1990

5. Monetary policy was too loose during

2004-05,
 accommodating fiscal expansion,
reminiscent of the Vietnam era.

6. Financial market participants

grossly underpriced risk 2005-07.
 Ignoring possible shocks such as:
 housing crash,
 $ crash,
 oil prices,
 geopolitics….
19
 US real interest rate < 0,
2003-04
Source: Benn Steil, CFR, March 2009

Real interest
rates <0

20
  
Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008   juanpablofernandez.wordpress.com/2008/05/

In 2003-07, market-
perceived volatility, as
measured by options
(VIX), plummeted.
So did spreads on US
junk
& emerging market
bonds.
In 2008, it all reversed.

21
 Origins of the financial/economic
crises
Underestimated Failures of
Monetary Households Federal
risk in corporate saving too little,
policy easy
financial mkts
budget
2004-05
governance borrowing too
much deficits
Homeownership
bias Predatory 
Excessive leverage in lending Low
financial institutions Housin national
Stock saving
g
market Excessive
complexity bubble
bubble MBS
CDSs Foreig
s
China’s n debt
CDO
growth
Stock s Housing
market Financial crash
Gulf
insta- crash crisis
bility 2007-08
Lower long-
term
Oil econ.growth
price
spike
2007-08
Recession Eventual loss
2008-09 of US hegemony
22
 The “black swan”:
investors thought housing prices could
never go
They did. Indices down.in late 2006,
peaked
and fell 1/3.

23
Financial meltdown: bank spreads
rose sharply
when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).

Source:
OECD Economic Outlook
(Nov. 2008).

24
 Monthly GDP
Figure 7. Macro Advisers Real GDP vs. Averag
Jan. 2006 - June 2010,
Indexed to Dec. 2007 = 100
Peak

104
Trough
102
Index Value

100
98
96
94
92
 National income has been more
reliable than GDP,
even though they are supposed to measure
the same thing.

Recession of Recession of Recession of

July 1990 – Mar. 2001 – Nov. Dec. 2007 –
March 91 2001 June 09

26
 2. Policy Response --
How did we avoid
another
Great Depression?
 We learned
important lessons
from the 1930s
and, for the most
part, didn’t repeat
the mistakes we
made then.
27
We learnt from the mistakes of the
1930s.
 Monetary response: good this time

 Fiscal response: relatively good, but :

 constrained by inherited debt
 and congressional politics.

 Trade policy:
 Some slippage, e.g., Chinese tires.
 But we did not repeat 1981 auto quotas or 2001 steel
tariffs
 let alone Smoot-Hawley !

 Financial regulation? 28
 U.S. Policy
Responses
 Monetary easing was
unprecedented,
appropriately avoiding the mistake of
1930s. (graph)

 Policy interest rates ≈ 0.

 The liquidity trip is not mythical after all.

 Then we had aggressive quantitative easing:

 the Fed purchased assets not previously dreamt
29
The Fed certainly did not repeated
the mistake of 1930s: letting the
money supply fall.

2008-09
Sourc
e:
1930s IMF,
WEO,
April
2009
Box
3.1

30
Federal Reserve Assets ($ billions)
more-than-doubled in 2008,
through new facilities, rather than
conventional T bill purchases

31
Source: Federal Reserve H.4.1 report
 Policy Responses,
continued
The policy of “financial repair”

 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
were enough to make them balk at keeping the
funds.
 The banks have now paid back the taxpayer at a
32
profit.
 Financial reform.

 Lending
 Mortgages
 Consumer protection, including standards for mortgage brokers
 Fix “originate to distribute” model, so lenders stay on the hook.
 Remove pro-housing bias in policy. (But politicians remain in favor.)
 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.”)
 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.)

33
 Financial reforms continued
 Executive compensation
 Compensation committee not under CEO.
 Maybe need Chairman of Board.
 Discourage golden parachutes & options,
 unless truly tied to performance.

 Securities
 Regulate derivatives:
 Create a central clearing house for CDSs .
 Credit ratings:
 Reduce reliance on ratings: AAA does not mean
no risk.
 Reduce ratings agencies’ conflicts of interest. 34
 Policy Responses, continued

 $787 b fiscal stimulus passed Feb. 2009.

 Good old-fashioned Keynesian stimulus
 Even the principle that spending provides more stimulus than tax
cuts returned;
 not just from Larry Summers, e.g.,

 but also from Martin Feldstein.

 Was $800 billion too small? Too large?

 Yes: Too small to knock out recession ;
 But Congress was not willing to vote for more,
 especially on the spending side.

 Perhaps also too big to reassure global investors re US

debt.

35
 Bottom line of
macroeconomic policy
response:
 The monetary & fiscal response was
sufficient to halt the economic free-fall.
 It won’t be enough to return us rapidly
to full employment and potential output.
 Given the path of debt that was inherited in
2009, perhaps not much more could be done.
 Chinese officials already questioning our
creditworthiness
 Risk of hard landing for the $

36
3: Intellectual
implications of the
crisis for economics
 The return of Keynes
 And 4 others who mainstream theory had
forgotten.

 8 economists who got parts right

37
 The return of Keynes

 Keynesian truths abound today:

 Origins of the crisis
 The Liquidity Trap

 Fiscal response; spending vs. tax cuts

 Motivation for macroeconomic intervention:

to save market microeconomics
 International transmission

 Need for coordinated expansion (now the

G20)
38
 Motivation for macroeconomic
intervention
 The view that Keynes stood for
big government is not really right.
 He wanted to save market microeconomics from
central planning, which had allure in the 30s & 40s,
 by using macroeconomic demand to return to
equilibrium.
 Some on the Left reacted to the 2008 crisis
& election by hoping for fundamental
overhaul of the economic system.
 But the policy that prevails today is the same.
39
 The origin of the crisis was an asset bubble
collapse, loss of confidence, credit crunch….

 like Keynes’ animal spirits or beauty contest .

 Add in von Hayek’s credit cycle,
 Kindleberger ’s “manias & panics”
78
78

 the “Minsky moment,”

 & Fisher’s “debt deflation.”

 The origin this time was not a monetary contraction

in response to inflation as were 1980-82 or 1991.
 But, rather, a credit cycle:
2003-04 monetary expansion showed up only in asset
prices.
40
 Who got pieces of it right,
beforehand?
 Krugman: If a Depression can happen in Japan,
it can happen in any modern economy.
 Rajan: Failures of corporate governance.
 BIS (Borio & White): Too-easy credit, via asset
prices,
leads to crises -- with no inflation in between.
 Shiller: US housing price bubble.
 Gramlich: Homeowners are being
sold mortgages that they can’t repay.
 Rogoff: “This Time Is Not Different.”
 Roubini: The recession will be severe.
41
Appendix:

US fiscal
policy
 The US public discussion is framed like a battle between
conservatives who philosophically believe in strong
budgets & small government, and liberals who do not.
Not the right way to characterize the debate. [1]

 (1) The right goal should be budgets that allow 
surpluses in booms and deficits in recession.
    
 (2) The correlation between how loudly an American 
politician proclaims a belief in fiscal conservatism 
and how likely he is to take corresponding policy steps < 0.   
[1]  Forget that small government is classically supposed to be 
the aim of “liberals,” in the 19th century definition, not “conservatives.”   
My point is different:  those who call themselves conservatives in practice tend to 
adopt policies that are the opposite of fiscal conservatism.  I call them “illiberal.” 
“Republican & Democratic Presidents Have Switched Economic Policies”  Milken Inst.Rev.
2003.
Three pieces of evidence to support the claim
that “fiscal conservatives” are not:
 (i) The voting pattern among the 258 Congressmen 
who signed an unconditional pledge not to raise taxes:
 As of 2004, they had voted for more spending 
than those who did not sign the pledge. [2]  
 
 (ii) The pattern of spending 
under different presidents.[3]  
 (iii) The pattern of states whose Senators win pork 
& other federal spending. [4]

 [2] William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July.

 [3] JF “Snake-Oil Tax Cuts,”  EPI, Briefing Paper 221. 2008. 
 [4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.
 (ii) Spending & deficts both rose sharply when
Presidents Reagan, Bush I, & Bush II took office.
Vs. the 1990s: The Shared Sacrifice approach succeeded in
eliminating budget deficits, importantly by slowing spending.
Spending and Budget Balance(inverse) as % of GDP (Current US$)

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 (iii) States ranked by federal
spending received
per taxparty
versus dollar
votepaid
ratio in 2005
in preceding
election
“red”
states Republican states take hom
big inflow of US $
significantly more federal $
(relative to taxes paid)
than Democratic states

“blue”
states
low inflow of US $
 U.S. fiscal policy in 2010-2011?
 What changes in American fiscal policy
would be desirable at the current juncture, 
 if politics were not an obstacle?  
   

 On the one hand, the economy is still weak.  
 On the other hand, the U.S. can’t wait until the recovery 
is complete to tackle the long run fiscal problem. 
 

 A two-part strategy:
 Current steps to extend the fiscal stimulus, 
 designed to maximize bang for the buck.
 Current steps to lock in future progress 
back toward fiscal discipline in the long run.
 U.S. fiscal policy in 2010-2011, continued

 Maximizing bang for the buck ≡ fiscal stimulus that 
gives the most demand per $ added to long-term debt.
     

 Example that would minimize bang for the buck: 
 proposal to make permanent the 2010 estate tax abolition .   
 Almost as poorly targeted:  proposal to prevent the Bush tax 
cuts from expiring in 2011 for those households > $250,000.  
 If the stimulus has to take the form of tax cuts, 
then the best options are:
 extending President Obama’s “Make Work Pay” tax cuts, 
 fixing the Alternative Minimum Tax, and 
 extending the Bush tax cuts for those households <  $250,000.    
 Some business tax cuts could also give high bang for the buck. 
 such as temporary credits for investment or hiring.
 U.S. fiscal policy in 2010-2011, continued

 But spending boosts demand more than tax cuts do, 
 because the latter are partly saved.

 Extend elements of the Obama stimulus 
 such as infrastructure investment and 
 giving money to the states 
 so that they don’t have to lay off teachers, policemen, 
firemen, subway drivers & construction workers.
 U.S. fiscal policy in 2010-2011, continued

 How does one take steps today 
to lock in future fiscal consolidation?   
 

 Not by raising taxes or cutting spending today (see above); 
 nor by promising to do so in a year or two (not credible).
     
 There are lots of economically sensible proposals
 for spending to eliminate, 
 more efficient taxes to switch to, 

 and “tax expenditures” to cut.   
 U.S. fiscal policy in 2010-2011, continued

 One big reform might work best:   
pass legislation today to put Social Security 
on a sound financial footing in the long term. 
   

 It would consist of a combination 
 of raising the retirement age 
 just a little (in proportion to lengthening life spans) 
 and slowing the growth of benefits for future retirees 
 just a little (perhaps by “progressive indexation). 
   

 If Washington could fix Social Security, 
 it would address the long-term fiscal outlook,
 yet would create no drag for the current fragile recovery.