Economic Policy Institute: Generating a Robust Recovery

September 30, 2009: 2:00 PM - 4:30 PM

Officially, the Great Recession may be coming to an end, but it will leave in its wake historically high unemployment and a host of other serious economic problems. How will policy-makers promote a robust, employment-led recovery that will lay the foundation for strong, long-term growth?  Meeting this challenge requires both the will to continue investing in families hard hit by the recession despite growing budget deficits and the skill in crafting the right mix of policies to ensure that this recovery - unlike the last one - will bring significant numbers of new jobs and rising living standards along with it.

  Please join the Economic Policy Institute for a discussion of these issues with noted experts in this exciting forum.

Registration begins at 1:30 p.m. Coffee and snacks will be provided.

Location: Economic Policy Institute, 1333 H Street NW, Suite 300 East Tower, Washington DC (Near McPherson Square Metro (Orange/Blue lines) and Metro Center (Red line))

Keynote speakers:

• Rep. Rosa DeLauro, Congresswoman, 3rd District of Connecticut
• Geoffrey Garin, President, Hart Reasearch Associates

Panelists:

• J. Bradford DeLong, Professor, UC Berkeley; Research Associate, National Bureau of Economic Research
• John Irons, Research and Policy Director, Economic Policy Institute
• Paul Krugman, Columnist, New York Times; Professor, Princeton University and Nobel Laureate

Moderator:

• Steven Pearlstein, Business Columnist, The Washington Post

Register for this event: This event is at capacity and will not accept additional guests.

Macroeconomic Policy for a Stronger Recovery

J. Bradford DeLong
Professor of Economics, U.C. Berkeley
Research Associate, NBER

September 30, 2009

A Little Background

About a year and a half ago—in the days after the forced merger of Bear Stearns into J.P. MorganChase, say—there was a near consensus of economists that an additional dose of expansionary fiscal policy was unlikely to be necessary. The Congress had passed a first round of tax cut-based stimulus, the impact of which in the summer of 2008 is clearly visible in disposable personal income and perhaps visible in the tracks of estimated monthly real GDP. The near-consensus belief back then, however, was that that was the only expansionary discretionary fiscal policy move that was appropriate.

With the Bear Stearns forced merger it appeared that the Federal Reserve and the Treasury had settled on a policy: they would punish as severely as they could the shareholders of and the managers at institutions too-big-to-fail that required rescue, but that they would insulate bondholders and counterparties. The incentives to avoid bankruptcy would thus be concentrated on those who actually had power to do something to manage organizational risk. As for the rest—well, the markets interpreted the forced merger as the Federal Reserve guaranteeing and making riskless essentially all the unsecured debt of all the large commercial and investment banks in the country.

Figure 1: (Nominal) Disposable Personal Income

Figure 2: Monthly Real GDP Estimates from Macroeconomic Advisors

The resulting "approaching liquidity tsunami," as more than one senior policymaker described it to me, meant that the risk of a deep recession was very low—or so the situation looked in the spring of 2008.

Late 2008's Need for Expansionary Fiscal Policy

By the late summer of 2008 things looked significantly different. The tax-based expansionary fiscal policy of early 2008 had had less than the desired effect—perhaps it had prevented a decline in the economy and kept things marching in place, but it effect was not overwhelming and not entirely obvious. It was clear that the formal announcement that the economy had fallen into recession was only a matter of time.

By August 2008 Lawrence Summers was writing of a gap between actual and sustainable production of $300 billion at an annual rate, forecasting that that gap was likely to more than double over the following year, and predicting sustained weakness thereafter—"unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances…" in a time when "the remaining scope for monetary policy to stimulate the US economy is surely very limited…"(1) Take an initial output gap growing from $300 to $600 billion over the first year and then declining to zero over the next three and you have a cumulative output gap of $1,350 billion in a situation in which monetary policy on it own can do little to correct it. Suppose that a prudent use of fiscal policy would be to enlarge the government's budget deficits by a third of the forecast output gap, and you have an estimate of the appropriate size of expansionary fiscal policy as the situation looked in August 2008: $450 billion in cumulative deficit spending spread out over the next four years.

Then came the nationalization of Fannie Mae (FNM)and Freddie Mac (FRE) on September 7, 2008; the bankruptcy of Lehman Brothers on September 15, 2008; and the nationalization of AIG on September 22, 2008. In the aftermath it was immediately clear that the recession problem was at least twice as bad as it had looked in August, and over the next four and a half months until the February 17, 2009 signing of the ARRA the magnitude of the likely cumulative output gap doubled again as the magnitude of the financial crisis's impact on the real economy became clear. If $450 billion was the appropriate size of a short-term deficit-spending program for the $1,350 billion cumulative output gap that Lawrence Summers had anticipated as of August 2008, then the appropriate size of the boost to short-term deficit spending as of February 2009 was $1.8 trillion (over three to four years).

What we got was a cumulative number of $600 billion—roughly 1/3 aid to states, 1/3 tax cuts (in a good-faith effort by the Obama administration to propose a bipartisan plan that legislators of both parties could sign on to), and 1/3 infrastructure and other direct government purchases intended not so much to slow the decline as rather to boost the recovery. We also got an extension of the AMT and other measures that no economist I have talked to believes are properly counted as part of an effective fiscal boost under any currently-live theory of how the economy works. Figure an increase in deficits of $200 billion per year spread out over the next three years. At the technocratic level, the disproportion between the size of the response and the magnitude of the need is obvious.

Today's Arguments Against More Fiscal Expansion

Now if you go a little bit south to Lafayette Park and, addressing the air, ask why it is that we did not pass a larger short-term deficit-spending fiscal boost program of $1.2 or $1.8 trillion last January and February and why we are not acting to boost it now, I hear four answers back on the wind:

1. This was the most that we could get sixty senators to vote for—and with a Senate that, in Majority Leader Harry Reid's words, takes forty-eight hours to flush the toilet we need to spend our time on legislative initiatives that might pass, rather than on those that certainly will not.

2. Further expansionary fiscal policy would be counterproductive in this current situation because of the long-run U.S. budgetary and global balance-of-payments imbalances. More short-run deficit spending would require the U.S. to issue more debt which would cause a sharp spike in U.S. long-term interest and a flight from the dollar that would generate a much bigger crisis and deeper depression—as Austria's issuance of huge amounts of additional debt in 1931 set off the wave of crises that turned the recession of 1929-1931 in Europe into the European half of the Great Depression.