Jeffrey FrankelJeffrey FrankelJames W. Harpel Professor of Capital Formation & James W. Harpel Professor of Capital Formation &

Growth, Harvard UniversityGrowth, Harvard University

Global Macroeconomic Global Macroeconomic Address:Address:

The Impact of Current Economic & The Impact of Current Economic & Regulatory Policy on Economic Regulatory Policy on Economic

Recovery --Where Does the Recovery --Where Does the Financial Crisis Leave the U.S. Financial Crisis Leave the U.S.

Economy in Global Terms?Economy in Global Terms?

Westin Boston Waterfront, Harbor Ball Room, June Westin Boston Waterfront, Harbor Ball Room, June 3, 20103, 2010

• Recession Recession • RecoveryRecovery• OutlookOutlook

• The Impact of PolicyThe Impact of Policy

• Where Does The Financial Where Does The Financial Crisis Leave the U.S. Crisis Leave the U.S. Economy in Global Terms?Economy in Global Terms?

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The US RecessionThe US Recession

The US recession started in Dec. 2007 according The US recession started in Dec. 2007 according to the NBER Business Cycle Dating Committee.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, Even then, at 18 months, the recession’s length passed thethe recession’s length passed the postwar records: 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….

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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 20011 (IV)November 20011 (IV)

43 months43 months13138811111010881010111116166616168888

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) or later > 18 months[not yet declared]

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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

Jobstrough

Payroll employment series Source: Bureau of Labor Statistics, April 2010

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

…and in the extent of the loss of jobs.

Source: WEO, IMF, April 2010

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Most indicators began to Most indicators began to improve improve

by mid or late 2009by mid or late 2009 Interbank spreadsInterbank spreads

GDP GDP

Stock marketStock market

Consumer confidence & spendingConsumer confidence & spending

The labor market has been terrible.The labor market has been terrible. But even it has responded, with lags no worse But even it has responded, with lags no worse

than usual.than usual.

Interbank spreads came back down sharply in 2009

Source: OECD Economic Outlook May 2010

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.

Source: OECD Economic Outlook May 2010

Growth has been positive for the last 3 quarters

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Total hours worked in the US Total hours worked in the US economyeconomy

(an indicator that does not lag as far behind as (an indicator that does not lag as far behind as unemployment)unemployment)

began to turn upward in began to turn upward in October 2009October 2009

Source: New series from BLS covering the entire private economy. May 2010

Source: OECD Economic Outlook May 2010

US performance a bit better than other rich countries, worse than rest of world (emerging markets).

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Demand growth in the 2Demand growth in the 2ndnd half of 2009 half of 2009came in large part from: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 Both stimulus sources are running down in 2010.in 2010. Fortunately consumption & investmentFortunately consumption & investment

seem to be catching fire in their place: seem to be catching fire in their place: GDP GDP reported by BEAreported by BEA (5/27/10).(5/27/10).

QIII: +2.2% QIV: +5.6% QI: +3.0QIII: +2.2% QIV: +5.6% QI: +3.0 % , % , now led by consumption & business equipment.now led by consumption & business equipment.

Danger of a W-shaped Danger of a W-shaped recession?recession?

There could always be new shocks:There could always be new shocks: Contagion from GreeceContagion from Greece Hard landing for the $Hard landing for the $ Geopolitical/oil shock…Geopolitical/oil shock…

I now put the I now put the odds of a double dip odds of a double dip recessionrecession as as << 50%,<< 50%, but but big enoughbig enough to have persuaded the NBER BCDC to have persuaded the NBER BCDC

in our April 8 meeting to wait longer in our April 8 meeting to wait longer before declaring the 2009 trough.before declaring the 2009 trough.

Danger of a W-shaped Danger of a W-shaped recession?recession?

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Policy Response of 2007-09 --

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 the mistakes made then.made then.

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We learnt from the mistakes of the We learnt from the mistakes of the 1930s.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 But we did not repeat 1981 auto quotas or 2001 steel

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

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.

Financial regulation?Financial regulation? Clearly inadequate, going in. But now…?Clearly inadequate, going in. But now…?

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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.

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 20092009

Box 3.1Box 3.1

1930s

2008-09

20Source: Federal Reserve H.4.1 report

Federal Reserve AssetsFederal Reserve Assets have more-than-doubledhave more-than-doubled, through , through

new facilities, new facilities, rather than conventional T bill purchasesrather than conventional T bill purchases

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.

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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 in early 2009 were The conditions imposed on banks in early 2009 were strong enough to make them balk at keeping the funds.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 Geithner’s stress tests fulfilled their function

of telling strong banks from weak.of telling strong banks from weak.

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

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Financial reform, for next Financial reform, for next time.time.

My own views on what is neededMy own views on what is needed

LendingLending MortgagesMortgages

Consumer protection agency, including Consumer protection agency, including standards for mortgage brokersstandards 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.)

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Financial reform,Financial reform, continuedcontinued

LendingLending 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-should make capital requirements higher & less pro-cyclical .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 coordinatedInternationally 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 “Extend bank-like regulation to “near banksnear 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 ?Volcker rule ? or all the way back to Glass-Steagall ? (I don’t (I don’t think so.)think so.)

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Financial reformFinancial reform 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 DerDerivativesivatives: :

Create a central clearing house for Create a central clearing house for CDSsCDSs . . 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 Reduce reliance on ratings: AAA does not mean

no risk.no risk.

MSN Money & Forbes

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Policy Response,Policy Response, continuedcontinued

Fiscal PolicyFiscal Policy$787 b $787 b fiscal stimulus fiscal stimulus passed passed

Feb.2009.Feb.2009. Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the principle that spending provides more Even the principle that spending provides more stimulus than tax cuts has returned;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 too large to reassure global investors re US

debt.debt. Also Congress was not willing to vote for more, Also Congress was not willing to vote for more,

especially on the spending side.especially on the spending side.

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The fiscal stimulus of 2008-09 helped.The fiscal stimulus of 2008-09 helped.But soon we must return toward fiscal But 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 reduce spending spending & raise tax revenue, as we did in the & raise tax revenue, as we did in the 1990s.1990s.

A solution requires, first:A solution requires, first: Honest budgeting Honest budgeting (e.g., Iraq war goes on-budget…)(e.g., Iraq war goes on-budget…) PAYGOPAYGO Wise up to politicians who claim they will Wise up to politicians who claim they will

eliminate budget deficits entirely on the eliminate budget deficits entirely on the spending side (and even with lower taxes), but spending side (and even with lower taxes), but who raise spending when they get the chance.who raise spending when they get the chance.

On the tax side…

Tax revenueTax revenue Let President Bush’s tax cuts expire in 2011.Let President Bush’s tax cuts expire in 2011. Introduce a Value Added TaxIntroduce a Value Added Tax Or phase in carbon tax or Or phase in carbon tax or

auctioned tradable emission permitsauctioned tradable emission permits And curtail expensive and distorting tax And curtail expensive and distorting tax

expendituresexpenditures 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.

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SpendingSpending Cuts in farm subsidies for agribusiness & farmers Cuts in farm subsidies for agribusiness & farmers Cut unwanted weapons systems Cut unwanted weapons systems (a rare success: the F22 (a rare success: the F22

fighter)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 inflation (vs. Progressively index future benefit growth to inflation (vs.

wages)wages) 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 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 Lever: making Medicare payments conditional on these best

practices .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.

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 !

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Bottom line of Bottom line of macroeconomic policy macroeconomic policy

response:response: The monetary and fiscal response wasThe monetary and fiscal response was

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

to full employment & potential output.to full employment & potential output. Given the debt path that was inherited in Given the debt path that was inherited in

2009, 2009, it is unlikely that much more could be it is unlikely that much more could be done.done. Chinese officials are already questioning US Chinese officials are already questioning US

creditworthiness !creditworthiness !

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).

Where Does The Financial Where Does The Financial Crisis Leave the U.S. Crisis Leave the U.S.

Economy in Global Terms?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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