Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

It May Be Slow, But at It May Be Slow, But at Least It’s An Least It’s An

Economic RecoveryEconomic Recovery

Senior Executive FellowsSenior Executive FellowsOctober 25, 2010October 25, 2010

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• 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

Topics

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BUSINESS CYCLE REFERENCE DATESBUSINESS CYCLE REFERENCE DATES   Source: NBERSource: NBER

PeakPeak TroughTrough ContractioContractionn

Quarterly dates are in parenthesesQuarterly dates are in parentheses Peak to TroughPeak to Trough

August 1929 (III)August 1929 (III)May 1937 (II)May 1937 (II)February 1945 (I)February 1945 (I)November 1948 (IV)November 1948 (IV)July 1953 (II)July 1953 (II)August 1957 (III)August 1957 (III)April 1960 (II)April 1960 (II)December 1969 (IV)December 1969 (IV)November 1973 (IV)November 1973 (IV)January 1980 (I)January 1980 (I)July 1981 (III)July 1981 (III)July 1990 (III)July 1990 (III)March 2001 (I)March 2001 (I)December 2007 (IV) December 2007 (IV)

March 1933 (I)March 1933 (I)June 1938 (II)June 1938 (II)October 1945 (IV)October 1945 (IV)October 1949 (IV)October 1949 (IV)May 1954 (II)May 1954 (II)April 1958 (II)April 1958 (II)February 1961 (I)February 1961 (I)November 1970 (IV)November 1970 (IV)March 1975 (I)March 1975 (I)July 1980 (III)July 1980 (III)November 1982 (IV)November 1982 (IV)March 1991 (I)March 1991 (I)November 2001 (IV)November 2001 (IV)

43 months43 months13138811111010881010111116166616168888

1818

Average, all cycles:Average, all cycles: 1854-2001 (32 cycles) 1854-2001 (32 cycles)

1945-2001 (10 cycles)1945-2001 (10 cycles)

  

1717

1010

June 2009 (II)

Source:Jeff Frankel’s blog,

Nov. 2009

But the usual cyclical pattern of recoverybegan 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-fallin the 3rd quarter of 2008.

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 - June 2010,Indexed to Dec. 2007 = 100

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100

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102

Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Year

Index

Val

ue

S-W GDP

S-W GDI

Average S-WGDP&GDI

Peak

Trough

Some other indicators such as industrial production so

similar datingFigure 6. Index of Industrial Production vs. Average Output,

Mar. 2006 - Aug. 2010

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93

98

103

108

Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Year

Index

Valu

e

Index of IndustrialProductionAverage S-WGDP&GDI

Peak

Trough

Figure 5. Average Employment vs. Average Output, Mar. 2006 - Aug. 2010,

Indexed to Dec. 2007 = 100

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100

102

Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Year

Index

Val

ue

AverageEmployment

Average S-WGDP&GDI

Peak

Trough

The labor market lags behind, as usual

In the labor market, hours responds first.

Firms delay hiring until they are confident of the need.

Figure 4. Employment vs. Aggregate Hours, Mar. 2006 - Aug. 2010,Indexed to Dec. 2007 = 100

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102

Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10

Year

Index

Val

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HouseholdEmploymentPayrollEmploymentAggregate Hours

Peak

Trough

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OECD Econ.Outlook, April 2010

The banking sector “normalized” in Q3 2009.

Start of US sub-prime mortgage

crisis

Lehmanfailure

Interbank lending spreads are the best measure

of the extraordinary financial crisis that led to global recession

OECD Economic Outlook, April 2010

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Danger of a double-Danger of a double-dip?dip?

Demand growth in the 1Demand growth in the 1stst year of recovery year of recoverycame in large part from:came in large part from: fiscal stimulus, &fiscal stimulus, & ending of firms’ inventory disinvestment.ending of firms’ inventory disinvestment.

Both sources of demand have run down in 2010Both sources of demand have run down in 2010 The withdrawal of fiscal stimulus is now slowing The withdrawal of fiscal stimulus is now slowing

growth.growth.

There could always be new shocks:There could always be new shocks: Sovereign debt contagion, spreading from GreeceSovereign debt contagion, spreading from Greece Hard landing for the $Hard landing for the $ Geopolitical/oil shock…Geopolitical/oil shock…

I put the I put the odds of a double dip recessionodds of a double dip recession as as rather small,rather small, but but big enoughbig enough to have persuaded the NBER to wait until to have persuaded the NBER to wait until

September.September.

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Soon we must return toward fiscal Soon we must return toward fiscal discipline.discipline.

The only way to do this is The only way to do this is both both reduce spending reduce spending & raise tax revenue, as we did in the 1990s.& raise tax revenue, as we did in the 1990s.

Tax revenueTax revenue Let President Bush’s tax cuts expire for the rich in 2011.Let President Bush’s tax cuts expire for the rich in 2011. Introduce a VAT or phase in auctioning of tradable emission Introduce a VAT or phase in auctioning of tradable emission

permitspermits Curtail expensive and distorting tax expendituresCurtail expensive and distorting tax expenditures

E.g., Tax-deductibility of mortgage interestE.g., Tax-deductibility of mortgage interest

All politically All politically veryvery difficult, needless to say. difficult, needless to say.

Any solution requires:Any solution requires: Honest budgeting Honest budgeting (e.g., Iraq war on-budget, etc…)(e.g., Iraq war on-budget, etc…) PAYGOPAYGO Wise up to politicians who claim they want to do it Wise up to politicians who claim they want to do it

entirely on the spending side & but who raise spending entirely on the spending side & but who raise spending when they get the chance.when they get the chance.

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SpendingSpending Cuts in farm subsidies for agribusiness & farmers, incl. Cuts in farm subsidies for agribusiness & farmers, incl.

ethanol ethanol Cut unwanted weapons systems Cut unwanted weapons systems (a rare success: the F22 fighter)(a rare success: the F22 fighter) Cut manned space program…Cut manned space program…

Social securitySocial security Raise retirement age – just a littleRaise retirement age – just a little Progressively index future benefit growth to inflationProgressively index future benefit growth to inflation If necessary, raise the cap on social security taxes.If necessary, raise the cap on social security taxes.

Health careHealth care Encourage hospitals to standardize around best-practice Encourage hospitals to standardize around best-practice

medicine medicine to pursue the checklist that minimizes patient infections, to pursue the checklist that minimizes patient infections, avoid unnecessary medical tests & procedures,avoid unnecessary medical tests & procedures, & standardize around best-practice treatment.& standardize around best-practice treatment. 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.especially gold-plated.

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 currency, with the SDR.

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

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1. Six root causes 1. Six root causes of theof the financial crisisfinancial crisis

1. US1. US corporate governance falls corporate governance falls shortshort E.g., rating agencies; E.g., rating agencies; executive compensationexecutive compensation … …

options; options; golden parachutes…golden parachutes…

2. US households save too little,2. US households save too little, borrow too much.borrow too much.

3.3. Politicians slant excessively Politicians slant excessively toward toward homeowner debthomeowner debt

Tax-deductible mortgage interest; Tax-deductible mortgage interest; FFannieannieMMae & Freddie Macae & Freddie Mac; ; Allowing teasers, Allowing teasers, NINJANINJA loans, liar loans… loans, liar loans…

MSN Money & Forbes

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Six root causes of financial crisis,Six root causes of financial crisis, cont.cont.

4. The 4. The federal budgetfederal budget has been on a reckless path since 2001,has been on a reckless path since 2001,

reminiscent of 1981-1990reminiscent of 1981-1990

5. Monetary policy 5. Monetary policy was too loose during was too loose during 2004-05,2004-05,

accommodating fiscal expansion,accommodating fiscal expansion, reminiscent of the Vietnam era.reminiscent of the Vietnam era.

6. Financial market participants 6. Financial market participants grossly grossly underpriced risk underpriced risk 2005-07.2005-07. Ignoring possible shocks such as: Ignoring possible shocks such as:

housing crash, housing crash, $ crash, $ crash, oil prices, oil prices, geopolitics….geopolitics….

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US real interest rate < 0, US real interest rate < 0, 2003-04 2003-04

Real interest Real interest rates <0 rates <0

Source: Benn Steil, CFR, March 2009

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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.

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

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Monetary policy easy

2004-05

Federal budget deficits

Underestimated

risk in financial mkts

Failures of corporate

governance

Households saving too little, borrowing too

much

Excessive leverage in financial institutions

Stockmarketbubble

Housing

bubble

Stock marketcrash

HousingcrashFinancial

crisis2007-08

China’s growth

Low national saving

Lower long-term

econ.growth

Eventual loss of US hegemony

Recession2008-09

Oil price spike2007-08

Gulfinsta-bility

Foreign debt

Origins of the financial/economic Origins of the financial/economic crisescrises

Excessive complexity

CDSsMBSs

CDOs

Predatory lending

Homeownership bias

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They did. Indices peaked in late 2006, They did. Indices peaked in late 2006, and fell 1/3.and fell 1/3.

The “black swan”: The “black swan”: investors thought housing prices could investors thought housing prices could

never go down. never go down.

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Financial meltdown:Financial meltdown: bank spreads bank spreads rose sharplyrose sharply

when sub-prime mortgage crisis hit (Aug. 2007) when sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008).and up again when Lehman crisis hit (Sept. 2008).

Source: OECD Economic Outlook

(Nov. 2008).

Monthly GDP

Figure 7. Macro Advisers Real GDP vs. Average S-W Output, Jan. 2006 - June 2010,

Indexed to Dec. 2007 = 100

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Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10Year

Index

Val

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MA GDP

Average S-W GDP&GDI

Peak

Trough

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National income has been more National income has been more reliable than GDP, reliable than GDP,

even though they are supposed to measure even though they are supposed to measure the same thingthe same thing..

Recession of July 1990 –

March 91

Recession ofMar. 2001 – Nov.

2001

Recession of Dec. 2007 –

June 09

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2. Policy Response -- How did we avoid

another Great Depression?

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

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We learnt from the mistakes of the We learnt from the mistakes of the 1930s.1930s.

Monetary response:Monetary response: good this time good this time

Fiscal response:Fiscal response: relatively good, relatively good, but but : : constrained by inherited debtconstrained by inherited debt and congressional politics. and congressional politics.

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 But we did not repeat 1981 auto quotas or 2001 steel

tariffstariffs let alone Smoot-Hawley !let alone Smoot-Hawley !

Financial regulation?Financial regulation?

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U.S. Policy U.S. Policy ResponsesResponses

MonetaryMonetary easingeasing was was unprecedented, unprecedented, appropriately avoiding the mistake of appropriately avoiding the mistake of 1930s. 1930s. (graph)(graph)

Policy interest rates ≈ 0.Policy interest rates ≈ 0.

The liquidity trip is not mythical after all.The liquidity trip is not mythical after all.

Then we had aggressive quantitative Then we had aggressive quantitative easing: easing: the Fed purchased assets not previously the Fed purchased assets not previously

dreamt of.dreamt of.

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The Fed certainly did The Fed certainly did not not repeated repeated the mistake of 1930s: letting the the mistake of 1930s: letting the

money supply fall.money supply fall.

SourcSource: e:

IMF, IMF, WEOWEO, , April April 20092009Box Box 3.13.1

1930s

2008-09

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Federal Reserve AssetsFederal Reserve Assets ($ billions)($ billions)

more-than-doubled in 2008more-than-doubled in 2008, , through new facilities, rather than through new facilities, rather than

conventional T bill purchasesconventional T bill purchases

Source: Federal Reserve H.4.1 report

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Policy Responses,Policy Responses, continuedcontinued

succeeded in getting the financial system succeeded in getting the financial system going again,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 Contrary to almost all commentary at the time of TARP:time of TARP: The conditions imposed on banks The conditions imposed on banks

were enough to make them balk at keeping the were enough to make them balk at keeping the funds.funds.

The banks have now paid back the taxpayer at a The banks have now paid back the taxpayer at a profit.profit.

Geithner’s stress tests fulfilled their function Geithner’s stress tests fulfilled their function of distinguishing strong banks from weak.of distinguishing strong banks from weak.

The policy of The policy of “financial repair”“financial repair”

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Financial reform. Financial reform.

LendingLending MortgagesMortgages

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

favor.)favor.)

Banks: Banks: Regulators shouldn’t let banks use their own risk modelsRegulators 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 (The worst is to say “no” and

then do “yes.”)then do “yes.”)

Extend bank-like regulation to “Extend bank-like regulation to “near banksnear banks.”.” Regulators need resolution authority.Regulators need resolution authority. Segmentation of function: Segmentation of function:

Volcker rule ?Volcker rule ? or all the way back to Glass-Steagall ?or all the way back to Glass-Steagall ? (I don’t (I don’t

think so.)think so.)

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Financial reformsFinancial reforms continuedcontinued

Executive compensationExecutive 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.

SecuritiesSecurities Regulate Regulate derivativesderivatives: :

Create a central clearing house for Create a central clearing house for CDSsCDSs . . Credit ratings: Credit ratings:

Reduce reliance on ratings: AAA does not mean Reduce reliance on ratings: AAA does not mean no risk.no risk.

Reduce ratings agencies’ conflicts of interest.Reduce ratings agencies’ conflicts of interest.

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Policy Responses,Policy Responses, continuedcontinued

$787 b $787 b fiscal stimulus fiscal stimulus passed passed Feb. Feb. 2009.2009. Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the principle that spending provides more stimulus Even the principle that spending provides more stimulus than tax cuts returned;than tax cuts 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 $800 billion too small? Too large?Was $800 billion too small? Too large? Yes: Too small to knock out recession ;Yes: Too small to knock out recession ; But Congress was not willing to vote for more, But Congress was not willing to vote for more,

especially on the spending side.especially on the spending side. Perhaps also too big to reassure global investors re Perhaps also too big to reassure global investors re

US debt.US debt.

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Bottom line of Bottom line of macroeconomic policy macroeconomic policy

response:response: The monetary & fiscal response wasThe monetary & fiscal response was

sufficient to halt the economic free-fall.sufficient to halt the economic free-fall. It won’t be enough to return us rapidly It won’t be enough to return us rapidly

to full employment and potential output.to full employment and potential output. Given the path of debt that was inherited Given the path of debt that was inherited

in 2009, perhaps not much more could in 2009, perhaps not much more could be done.be done. Chinese officials already questioning our Chinese officials already questioning our

creditworthinesscreditworthiness Risk of hard landing for the $Risk of hard landing for the $

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3: Intellectual 3: Intellectual implications of the implications of the crisis for economicscrisis for economics

The return of KeynesThe return of Keynes And 4 others who mainstream theory had And 4 others who mainstream theory had

forgotten.forgotten.

8 economists who got parts right8 economists who got parts right

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The return of KeynesThe return of Keynes

Keynesian truths abound todayKeynesian truths abound today:: Origins of the crisisOrigins of the crisis The Liquidity TrapThe Liquidity Trap Fiscal response; spending vs. tax cutsFiscal response; spending vs. tax cuts Motivation for macroeconomic Motivation for macroeconomic

intervention:intervention:to save market microeconomicsto save market microeconomics

International transmissionInternational transmission Need for coordinated expansion (now the Need for coordinated expansion (now the

G20)G20)

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Motivation for macroeconomic Motivation for macroeconomic interventionintervention

The view that Keynes stood for The view that Keynes stood for big government is not really right.big government is not really right. He wanted to save market microeconomics from He wanted to save market microeconomics from

central planning, which had allure in the 30s & central planning, which had allure in the 30s & 40s,40s,

by using macroeconomic demand to return to by using macroeconomic demand to return to equilibrium.equilibrium.

Some on the Left reacted to the 2008 crisis Some on the Left reacted to the 2008 crisis & election by hoping for fundamental & election by hoping for fundamental overhaul of the economic system.overhaul of the economic system. But the policy that prevails today is the same.But the policy that prevails today is the same.

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The origin of the crisis was an asset bubble The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch….collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contestlike Keynes’ animal spirits or beauty contest . . Add in von Hayek’s credit cycle, Add in von Hayek’s credit cycle, KindlebergerKindleberger78 78 ’s “manias & panics”’s “manias & panics” the “Minsky moment,” the “Minsky moment,” & Fisher’s “debt deflation.”& Fisher’s “debt deflation.”

The origin this time was The origin this time was notnot a monetary a monetary contraction contraction in response to inflationin response to inflation as were 1980-82 or 1991.as were 1980-82 or 1991.

But, rather, a credit cycle: But, rather, a credit cycle: 2003-04 monetary expansion showed up only in 2003-04 monetary expansion showed up only in asset prices. asset prices.

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Who got pieces of it right, Who got pieces of it right, beforehand?beforehand?

Krugman: If a Depression can happen in Japan, Krugman: If a Depression can happen in Japan, it can happen in any modern economy. it can happen in any modern economy.

Rajan: Failures of corporate governance.Rajan: Failures of corporate governance. BIS (Borio & White): Too-easy credit, via asset BIS (Borio & White): Too-easy credit, via asset

prices, prices, leads to crises -- with no inflation in between.leads to crises -- with no inflation in between.

Shiller: US housing price bubble.Shiller: US housing price bubble. Gramlich: Homeowners are being Gramlich: Homeowners are being

sold mortgages that they can’t repay.sold mortgages that they can’t repay. Rogoff: “This Time Is Rogoff: “This Time Is NotNot Different.” Different.” Roubini: The recession will be severe.Roubini: The recession will be severe.

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.

Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending.

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Est

Spending and Budget Balance(inverse) as % of GDP (Current US$)

Spending/GDP Budget Balance/GDP

R. R

ea

ga

n

J. C

art

er

G.H

.W.

Bu

sh

W.J

. C

lin

ton

G.W

.Bu

sh

Source: OMB

ρ = 0.86

(ii) Spending & deficts both rose sharply when Presidents Reagan, Bush I, & Bush II took office.

(iii) States ranked by federal spending received

per tax dollar paid in 2005versus party vote ratio in preceding election

Republican states take home Republican states take home significantly more federal $ significantly more federal $ (relative to taxes paid)(relative to taxes paid) than Democratic statesthan Democratic states

“red”states

“blue”states low inflow of US $

big 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.