10/23/10 5:50 PMHoisted from the Archives: The U.S. Macroeconomic Situation as of June 18, 2009 - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchAugust 27, 2010

Hoisted from the Archives: The U.S. Macroeconomic Situation

as of June 18, 2009

Comment for the Economist on Christina Romer (2009), "The Lessons of 1937": Five

Lessons from 1937 and Otherwhen:

Let me make five points to eliminate or refute or at least to fight against or lay down amarker that there is--well, call it "confusion" about what the right state of policy forthe American macroeconomy should be.

My first point is that over the past six months the economy has been a severedisappointment. Output and employment have fallen much faster than people wereprojecting last December. Romer and Bernstein (2009) projected at the very start ofthis year that unemployment in the U.S. would reach a peak of 7.9% in the summer of2009. But unemployment now in mid-June is about 9.7%, with 10% baked in the cakeand the possibility existing that it might go much higher. The signs that the cliff-dive ofemployment has come to an end are very few. The level of new unemployment claimsis still consistent with a rapidly-collapsing labor market nationwide.

Six months ago a net federal fiscal stimulus of about $1 trillion--$400 billion each yearfor about 2.5 years--seemed appropriate: that seemed to balance the benefits of filling-in the hole in aggregate demand without running too great a risk of triggeringworrisome inflationary fever further down the road. Now the hole in aggregate demandis greater than was thought likely last December--about twice as great--and thelikelihood of heightened future inflation is less. Thus if it was appropriate to set a $1trillion federal fiscal stimulus in motion last December given what we knew then, if wehad known then what we know now it would have been appropriate to set a roughly$2.4 trillion fiscal stimulus--$800 billion for 3 years--in motion back then.

My first point is thus that the Obama administration's federal fiscal stimulus programs

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are on the low side of what is appropriate by a substantial margin: this is the largesteconomic downturn since the Great Depression and the standard tools of expansionarymonetary policy are tapped out and broken right now.

My second--related--point is that the need for federal-level fiscal expansion isreinforced by what state governments are doing right now. The federal government'sdiscretionary actions are expanding aggregate demand by about $400 billion over fiscalyear 2010, but state governments are right now cutting their spending and raising theirtaxes in order to offset this federal fiscal expansion more or less completely. On net,the government sector will be on autopilot as far as discretionary policy moves tostimulate the economy are concerned: federal-level expansion is offset and neutralizedby state-level fiscal contraction. This is not an appropriate macroeconomic policystance: this is the largest economic downturn since the Great Depression.

My third--unrelated--point is that the policy innovations of the past year have createda potentially dangerous weakness in the Federal Reserve system. The Federal Reserve'sbalance sheet has more than doubled over the past year, as it has acquired anenormous and bizarre menagerie of assets. On the liability side, it has funded thisacquisition by expanding the monetary base, and has increased private-sectorwillingness to hold this monetary base by paying interest on reserves. This has added afourth motive--profit--to the three traditional motives for holding reserve deposits atthe Fed: the transactions demand, the emergency liquidity demand, and the speculativedemand.

As long as the dollar remains the safest currency in the world, as long as the dollarremains the linchpin of the global financial system, there is no problem in the FederalReserve's funding by what is essentially overnight borrowing the expansion of itsbalance sheet and the purchase of private securities that will vary up or down inmarket price with an eye toward holding them to maturity.

However, at some future time the dollar will cease to be the linchpin of the worldfinancial system, in which case the Federal Reserve's financing its balance sheet viaovernight borrowing will leave it vulnerable to the mother of all bank runs. It would bevery good to fix this now: to give the Federal Reserve now the option to borrow not inwhat are essentially demand but rather in time deposits--to grant the Federal Reservethe power to issue its own bonds. This diminishes the chance of a great financial crisisin 2050 or so, with no downside that I can see.

My fourth point is the obvious one that health care is the only thing that matters forthe long run budget. The other points that the Hon. Dr Christina Romer raises, are--asis almost always the case--accurate and important. America's long-run fiscal problemsare caused by health care, and will not be appreciably made worse by this half-decade'sfederal fiscal stimulus. If restructuring the health care system can bend the curve onthe rise in overall (and hence public as well as private) health care costs, then Americahas ample debt capacity to borrow whatever we wish in this crisis--and to borrow it atextraordinarily favorable rates as well. If the curve of rising health-care costs is notbent, then the government's long-term finances are in trouble and so is the growth ofprivate-sector non-health living standards: health care costs that rise as fast as CBO isprojecting in the baseline cause lots of long-run economic problems, of whichgovernment fiscal bankruptcy is not the worst. Health care reform to bend the long-runcurve of costs is now just what it was back in 1993: the most important issue for theAmerican political system to deal with.

Fifth, I have the sense that the Obama administration's economic policymakers have

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forgotten one of the most basic lessons taught by Robert Rubin during his stewardshipof economic policy during the 1990s. The lesson is to think probabilistically: to projectyourself forward into the possible futures, to ask in each one what would be the actionsthat you would then wish you hd undertaken today, and then to actually take theappropriate action today. Looking forward into the future, (a) I see a 10% chance thatsomething happens to create renewed cliff diving--a recession that bottoms out notwith an unemployment rate in the 10-12% range that we currently anticipate but anunemployment rate that blows through 12% and keeps on rising. (b) I see a 30%chance of a rapid recovery as confidence and asset prices recover, and firms takeadvantage of high unemployment to hire new workers in droves at wage levels thatmake increasing production very profitable. But (c) I see a 60% chance of the end ofthe current cliff-dive in employment being followed by what happened in Japan in the1990s, in the U.S. after 1991, in the U.S. after 2001, and to some extent in the U.S.after 1933--a recovery that does not see the market exert sufficient upward pressure onemployment to return the unemployment rate to normal levels in two or three years,but that instead sees a jobless or low-job recovery during which the unemploymentrate continues to drift upward for years, or falls only then to rise again.

The Obama administration's policies appear to me to be the ones that would beadopted if we believed that there was a 75% chance of scenario (b) and a 25% chanceof scenario (a). But I don't think those are the probabilities. And I wonder what theHon. Dr. Christina Romer thinks the probabilities are. For she is the one who warns ofhow:

[t]he 1937 episode provides a cautionary tale. The urge to declare victory and getback to normal policy following an economic crisis is strong. That urge needs to beresisted until the economy is again approaching full employment. Financial crises,in particular, tend to leave scars that make financial institutions, households andfirms behave differently [than in normal times]. If the government withdrawssupport too early, a return to economic decline or even panic could follow...

The blunt fact is that the economic recoveries that have been rapid and seen fastgrowth in employment are those that ended when a Federal Reserve following stronglyrestrictionary policies to fight inflation eased off and significantly lowered interestrates. No such lowering of interest rates is possible this time--interest rates are alreadyas low as they can possibly go at the short end. So I can see no reason to anticipate arapid recovery and employment when the cliff-diving stops. And I do not understandwhy the Obama administration is following policies that presume such a rapidrecovery--a V rather than an L for the shape of the recession--is not just possible butprobable.

Brad DeLong on August 27, 2010 at 09:43 PM in Economics, Economics: FederalReserve, Economics: Finance, Economics: Fiscal Policy, Economics: Macro, ObamaAdministration | Permalink

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Comments

Tax Lawyer said...The current debate, especially the populist uprising somehow made me think of HueyLong, the quintessential populist. I realized that I really didn't know what he stood for.Who was he, and what did he say that was so sensational at the time to get himassassinated? So I looked it up on Wiki: http://en.wikipedia.org/wiki/Huey_Long

What I found was he was exactly the opposite of the Tea Baggers. Where are the HueyLong supporters today. The man made some remarkable achievements, despite hisreputation today. He really did help Louisiana and especially those who weredisheartened during the first GD.

If a similar candidate arose today, I bet he would be assassinated just like Huey was,eventually.

Reply August 27, 2010 at 10:31 PMbakho said...Pretty good prediction.

Reply August 28, 2010 at 05:47 AMsave_the_rustbelt said...For two decades the federal government and academic economists focused oneconomic growth and job creation --- in China.

Well, that part worked really well. Now about the US......

Reply August 28, 2010 at 06:35 AMNeal said...Re: waiting for the calvary (Krugman, previous post) and this post....

The real failure was the failure to recognize that the economy in the form of the USconsumer had already been rescued twice, once by the dotcom boom and the secondtime by the real estate boom. By the end of the real estate boom we had climbed to aneven higher cliff to run off of, ala' Wiley Coyote. The fall was naturally going to be moredisastrous and recovery would be far more uncertain.

What was and what is supposed to be the third rescuer?

Can resumption of "normal" earning, spending, taxation and asset appreciation restorethe apparent wealth of 2006?

Should we be looking back to a different decade?

I don't see that probability expressed anywhere.

Reply August 28, 2010 at 06:39 AMNeal said..."Normal" in the sense as mediated by the everchanging global economy.

Reply August 28, 2010 at 06:41 AM

10/23/10 5:50 PMHoisted from the Archives: The U.S. Macroeconomic Situation as of June 18, 2009 - Grasping Reality with Both Hands

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Me: Economists:Juicebox Moral

Peter K. said...The Clinton experience was to a) reappoint Greenspan who was the man mostresponsible for the Great Panic. He even admitted it.

b) deregulate the financial industryhttp://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act

c) end welfare as we knew ithttp://en.wikipedia.org/wiki/Personal_Responsibility_and_Work_Opportunity_Act

What do you do when the only social safety net is low unemployment andunemployment is at 10 percent thanks to the financial crisis of Clinton-Bush?

At least Clinton balanced the budget thanks in part to the bubble in tech stocks (thebursting of which combined with 9/11 Greenspan had to fight with exceptionally lowrates).

Besides the unemployment chart, Romer were was very prescient, even about the"structural unemployment" and "new normal" nonsense. Hopefully she'll be nominatedto be President of the San Fran Fed. (It would have been very very impressive to haveforeseen the European sovereign debt crisis).

Reply August 28, 2010 at 09:24 AMdilbert dogbert said...I read this early in the morning then had to take the wife and horse to a ride to eatevent.My comment then was: Anne and Rusty should sit down and have a chat in some neutral but very nicecomfortable place. They should talk about data and their personal experiences in lifeand what they see happening in their areas. They might have a lot more in commonthan their comments here. They might even become friends. Who knows?

Reply August 28, 2010 at 01:26 PMComments on this post are closed.

Economists Debate The Philosophy Behind British Budget CutsNPR (blog) - Oct 21, 2010Brad de Long, an economist at UC Berkeley, and a prolific blogger, is quoted in theTimes as mourning the dismissal of Keynes. ...Related Articles » « Previous Next »

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