Policy Responses to Recession, Financial Crisis
and Anemic Recovery
The Uneven Recovery:
Emerging Markets vs. Developed Economies
Hoover Institution, Stanford University
October 14, 2011
Michael J. Boskin
Senior Fellow, Hoover Institution
Tully M. Friedman Professor of Economics
Stanford University
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Two Big Questions
1. 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)
Total
Federal Reserve
Term auction credit
Other loans
Primary credit
Secondary credit
Seasonal credit
Primary Dealer Credit Facility (expired 2/1/2010)
Asset-Backed Commercial Paper Money Market Mutual
Fund
AIG
AIG (for SPVs)
AIG (for ALICO, AIA)
Rescue of Bear Stearns (Maiden Lane)**
Originally Currently Ultimate
Committed Provided
Cost
up to
$13 ,000 + $4,000 + $2,000 Treasury
Fed supplementary financing account
900
Unlimited
Unlimited
Unlimited
Unlimited
0
68
0
0
0
Unlimited
0
Unlimited
26
9
26
27
0
25
0
0
28
23
30
16
23
200
0
0 Fannie Mae and Freddie Mac
3 FDIC
0 Guarantee of U.S. banks’ debt*
0 Guarantee of Citigroup debt
0 Guarantee of Bank of America debt
Transaction deposit accounts
Public-Private Investment Fund Guarantee
Bank Resolutions
0
Federal Housing Administration
0
2
0
1 Refinancing of mortgages, Hope for Homeowners
4 Expanded Mortgage Lending
Originally Currently Ultimate
Committed Provided
Cost
560
Unlimited
200
145
0
305
1,400
10
3
500
1,000
Unlimited
305
0
0
0
0
23
4
0
0
71
100
Unlimited
0
150
0
26
700
170
277
170
101
170
821
3
90
21
200
200
3
39
12
100
821
3
90
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Congress
AIG-RMBS purchase program (Maiden Lane II)**
AIG-CDO purchase program (Maiden Lane III)**
1 TARP
4 Economic Stimulus Act of 2008
American Recovery and Reinvestment Act of
Term Securities Lending Facility (expired 2/1/2010)
Commercial Paper Funding Facility** (expired 2/1/2010)
TALF
Money Market Investor Funding Facility (expired
10/30/2009)
Currency swap lines (expired 2/1/2010)
0 2009
Cash for Clunkers
0 Additional Emergency UI benefits
0
Other Stimulus
Dec 2010 stimulus
1,800
1,000
0
43
540
Unlimited
0
0
1,425
1,295
Guarantee of Citigroup assets (terminated 12/23/2009)
286
0
0
Guarantee of Bank of America assets (terminated)
108
0
0
900
400
600
0
Purchase of GSE debt and MBS (expired 3/31/2010)
Purchase of long-term Treasuries (under QE-I & QE-II)
Operation Twist 2
0
0
NOTES: *Includes foreign denominated debt;
0 **Net portfolio holdings; *** Excludes AMT patch
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Net Effects of U.S. Stimulus
($13+ trillion commitment)

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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
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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



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Methods used:
1.
Stylized analytical models
2.
Macroeconometric models
3.
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
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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.
2.
3.
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
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?
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
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