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Global Macroeconomic Address:
The Impact of Current Economic &
Regulatory Policy on Economic Recovery -Where Does the Financial Crisis Leave the U.S.
Economy in Global Terms?
Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth,
Harvard University
Westin Boston Waterfront, Harbor Ball Room, June 3, 2010
• Recession
• Recovery
• Outlook
• The Impact of Policy
• Where Does The Financial
Crisis Leave the U.S. Economy
in Global Terms?
The US Recession

The US recession started in Dec. 2007 according
to the NBER Business Cycle Dating Committee.

The earliest we might date the trough is June 2009.

Even then, at 18 months,
the recession’s length passed the postwar records:
16 months -- 1973-75 & 1981-82.
 One has to go back to 1929-33 for a longer downturn.


Also the most severe, by most measures:

rise in unemployment rate, job loss, output loss….
3
BUSINESS CYCLE REFERENCE DATES
Peak
Trough
Quarterly dates are in parentheses
August 1929 (III)
May 1937 (II)
February 1945 (I)
November 1948 (IV)
July 1953 (II)
August 1957 (III)
April 1960 (II)
December 1969 (IV)
November 1973 (IV)
January 1980 (I)
July 1981 (III)
July 1990 (III)
March 2001 (I)
December 2007 (IV)
Average, all cycles:
1854-2001
Source: NBER
Contraction
Peak to Trough
March 1933 (I)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
March 1991 (I)
November 20011 (IV)
43 months
13
8
11
10
8
10
11
16
6
16
8
8
June 2009 (II) or later
> 18 months
[not yet declared]
(32 cycles)
1945-2001 (10 cycles)
17
10
4
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.
Jobs
trough
Jobs peak
Payroll employment series Source: Bureau of Labor Statistics, April 2010
Payroll employment series
Source: Bureau of Labor Statistics
5
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
Most indicators began to improve
by mid or late 2009

Interbank spreads

GDP

Stock market

Consumer confidence & spending

The labor market has been terrible.

But even it has responded, with lags no worse than usual.
8
Interbank spreads came back down sharply in 2009
Source: OECD Economic Outlook May 2010
The economic roller coaster went into free-fall
in the 3rd quarter of 2008.
But the usual cyclical pattern of recovery
began in 2009, Q II:
1. Leading indicators come first.
2. Output indicators come next.
3. Labor market indicators come last.
Source:
Jeff Frankel’s blog,
Nov. 2009
Growth has been positive for the last 3 quarters
Source: OECD Economic Outlook May 2010
Total hours worked in the US economy
(an indicator that does not lag as far behind as unemployment)
began to turn upward in October 2009
Source: New series from BLS covering the entire private economy. May 2010
12
Source: OECD
Economic Outlook
May 2010
Danger of a W-shaped recession?

Demand growth in the 2nd half of 2009
came in large part from:
fiscal stimulus, &
 end of firms’ inventory disinvestment.


Both stimulus sources are running down in 2010.
Fortunately consumption & investment
seem to be catching fire in their place:
 GDP reported by BEA (5/27/10).
 QIII: +2.2%
QIV: +5.6%
QI: +3.0 % ,
now led by consumption & business equipment.

14
Danger of a W-shaped recession?

There could always be new shocks:
 Contagion from Greece
 Hard landing for the $
 Geopolitical/oil shock…

I now put the odds of a double dip recession as
<< 50%, but
 big enough to have persuaded the NBER BCDC
in our April 8 meeting to wait longer
before declaring the 2009 trough.

Policy Response of 2007-09 -How did we avoid another
Great Depression?
 We
learned important
lessons from the 1930s
and, for the most part,
didn’t repeat the
mistakes made then.
16
We learnt from the mistakes of the 1930s.
 Trade policy:
 Some slippage, e.g., Chinese tires.
 But we did not repeat 1981 auto quotas or 2001 steel tariffs
 let alone Smoot-Hawley !
 Monetary

response:
good this time.
 Fiscal
response:
relatively good, but :
 constrained by inherited debt
 and congressional politics.

 Financial
 Clearly
regulation?
inadequate, going in. But now…?
17
U.S. Policy Responses

Monetary easing was unprecedented,
appropriately avoiding the mistake of 1930s.
 Policy

(graph)
interest rates ≈ 0.
Then we had aggressive quantitative easing:

the Fed purchased assets not previously dreamt of.
18
The Fed certainly did not repeated the
mistake of 1930s: letting the money supply fall.
2008-09
1930s
Source:
IMF,
WEO,
April 2009
Box 3.1
19
Federal Reserve Assets ($ billions)
have more-than-doubled, through new
facilities, rather than conventional T bill purchases
Source: Federal Reserve H.4.1 report
20
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.

Soon we must return toward fiscal discipline.

The only way to do this is both reduce spending
& raise tax revenue, as we did in the 1990s.

Any solution requires:
Honest budgeting (e.g., Iraq war goes on-budget…)
 PAYGO
 Wise up to politicians who claim they will eliminate budget
deficits entirely on the spending side (and even with lower
taxes), but who raise spending when they get the chance.

22
On the tax side…

Tax revenue
Let President Bush’s tax cuts expire in 2011.
 Introduce a Value Added Tax
 Or phase in carbon tax or
auctioned tradable emission permits
 And curtail expensive and distorting tax expenditures



E.g., Tax-deductibility of mortgage interest
All politically very difficult, needless to say.
 Spending




Social security




Cuts in farm subsidies for agribusiness & farmers
Cut unwanted weapons systems (a rare success: the F22 fighter)
Cut manned space program…
Raise retirement age – just a little
Progressively index future benefit growth to inflation (vs. wages)
If necessary, raise the cap on social security taxes.
Health care

Encourage hospitals to standardize around best-practice medicine




to pursue the checklist that minimizes patient infections and
to avoid unnecessary medical tests & procedures.
Lever: making Medicare payments conditional on these best practices .
Curtail corporate tax-deductibility of health insurance,

especially gold-plated health plans.
24
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 !
Policy Responses, continued
The policy of “financial repair”

succeeded in getting the financial system going again,
 thereby
precluding a new Great Depression,
 yet without “nationalization” of the banks.

Contrary to almost all commentary at the time of TARP:
 The
conditions imposed on banks in early 2009 were
strong enough to make them balk at keeping the funds.
 The banks have since paid back the taxpayer at a profit.
 Geithner’s stress tests fulfilled their function
of telling strong banks from weak.
26
Financial reform. My own views on what is needed

Lending

Mortgages

Consumer protection agency, including standards for mortgage brokers




Fix “originate to distribute” model, so lenders stay on the hook.
Remove policy bias toward housing debt.
(Sadly, politicians won’t hear of it.)
Banks:





I would not have let the Fed have this one.
Regulators shouldn’t let banks use their own risk models;
should make capital requirements higher & less pro-cyclical .
Is “too big to fail” inevitable?
The worst is to say “no” and then do “yes.”
Tax banks. But I wouldn’t earmark the revenues for a bailout fund.
Extend bank-like regulation to “near banks.”
Regulators need resolution authority.
 Segmentation of function:


Volcker rule ?
or all the way back to Glass-Steagall ? (I don’t think so.)
27
Financial reform continued

Executive compensation

Compensation committee not under CEO.


Discourage golden parachutes & options,


Maybe need Chairman of Board.
unless truly tied to performance.
MSN Money & Forbes
Securities

Derivatives:
Create a central clearing house for CDSs .
 Don’t ban short sales, as the Germans are doing.


Credit ratings:
Reduce ratings agencies’ conflicts of interest.
 Reduce reliance on ratings: AAA does not mean no risk.

28
Policy Responses,
continued
 $787 b fiscal stimulus passed Feb. 2009.
 Good old-fashioned Keynesian stimulus

Even the principle that spending provides more stimulus
than tax cuts has returned;
not just from Larry Summers, e.g.,
 but also from Martin Feldstein.

 Is
$800 billion too small? Too large?
 Yes:
Too small to knock out recession ;
 too large to reassure global investors re US debt.

Also Congress was not willing to vote for more,
especially on the spending side.
29
Bottom line of macroeconomic
policy response:



The monetary and fiscal response was
sufficient to halt the economic free-fall.
It won’t be enough to return us rapidly
to full employment and potential output.
Given the debt path that was inherited in 2009,
it is unlikely that much more could be done.

Chinese officials already questioning our creditworthiness
30
The return of Keynes

Keynesian truths abound today:
 Origins
of the crisis
 The Liquidity Trap
 Fiscal response, including spending vs. tax cuts
 Motivation for macroeconomic intervention:
to save market microeconomics
 International transmission
 Need for coordinated expansion (now the G20)
31
Motivation for macroeconomic intervention

The view that Keynes stood for
big government is not really right.



He wanted to save market microeconomics from
central planning, which had allure in the 30s & 40s,
by using macroeconomic demand to return to equilibrium.
Some on the Left reacted to the 2008 crisis & election by
hoping for fundamental overhaul of the economic system.

But the policy that prevails today is the same.
32

The origin of the crisis was an asset bubble
collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contest .






Add in von Hayek’s credit cycle,
Kindleberger ’s “manias & panics”
the “Minsky moment,”
& Fisher’s “debt deflation.”
78
The origin this time was not a monetary contraction
in response to inflation as were 1980-82 or 1991.
But, rather, a credit cycle:
2003-04 monetary expansion showed up only in asset prices.
33
34
Appendix:

Origins of the 2007-09 financial crisis

The U.S. Economy compared to others

The Global Economy

The Problem of Global Current Account
Imbalances
Who got pieces of it right, beforehand?







Krugman: If a Depression can happen in Japan,
it can happen in any modern economy.
Rajan: Failures of corporate governance.
BIS (Borio & White): Too-easy credit, via asset prices,
leads to crises -- with no inflation in between.
Shiller: US housing price bubble.
Gramlich: Homeowners are being
sold mortgages that they can’t repay.
Rogoff: “This Time Is Not Different.”
Roubini: The recession will be severe.
36
Six root causes of the financial crisis

1. US corporate governance falls short


E.g., rating agencies;
executive compensation …


options;
golden parachutes…
MSN Money & Forbes
2. US households save too little,
borrow too much.
3. Politicians slant excessively
toward homeowner debt
 Tax-deductible
mortgage interest;
 FannieMae & Freddie Mac;
 Allowing teasers, NINJA loans, liar loans…
37
Six root causes of financial crisis,
cont.


4. The federal budget
has been on a reckless path since 2001,

reminiscent of 1981-1990
5. Monetary policy was too loose during 2004-05,
 accommodating fiscal
reminiscent of the Vietnam era.
expansion,
6. Financial market participants
grossly underpriced risk 2005-07.

Ignoring possible shocks such as:
housing crash,
 $ crash,
 oil prices,
 geopolitics….

38
US real interest rate < 0, 2003-04
Source: Benn Steil, CFR, March 2009
Real interest rates <0
39
Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008 juanpablofernandez.wordpress.com/2008/05/
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.
40
Origins of the financial/economic crises
Monetary
policy easy
2004-05
Stock
market
bubble
Underestimated
risk in
financial mkts
Failures of
corporate
governance
saving too little,
borrowing too
much
Homeownership bias
Excessive leverage in
financial institutions
Predatory
lending
Stock
market
crash
Gulf
instability
MBS
s
CDO
s
Financial
crisis
2007-08
Oil
price
spike
2007-08
Federal
budget
deficits
Low
national
saving
Housin
g
bubble
Excessive
complexity
CDSs
China’s
growth
Households
Recession
2008-09
Foreig
n debt
Housin
g
crash
Lower longterm
econ.growth
Eventual loss
of US hegemony
41
The “black swan”:
investors thought housing prices could never go down.
They did. Indices peaked in late 2006, and fell 1/3.
42
Financial meltdown: bank spreads rose sharply
when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).
Source:
OECD Economic Outlook
(Nov. 2008).
43
My favorite monthly indicator:
total hours worked in the economy
It confirms: US recession began Dec. 07, turned severe in Sept. 08,
when the worst of the financial crisis hit (Lehman bankruptcy…)
44
National income has been more reliable than GDP,
even though they are supposed to measure the same thing.
Recession of
July 1990 – March 91
Recession of
Mar. 2001 – Nov. 2001
Recession
of
Dec. 2007 – ?
45
OECD Econ.Outlook, April 2010
Evidence that the banking sector
returned to normal by late 2009.
Start of US
sub-prime
mortgage crisis
Lehman
failure
46
OECD Economic Outlook,
April 2010
Evidence that the banking sector
returned to normal in late 2009.
47
Corporate bond rates have come back down too.
%
%
OECD Economic
April 2010
Now < interest rates in the (mild)
2001Outlook,
recession.
US employment fell fully in proportion to GDP,
unlike the “labor hoarding” pattern of the past.
In Germany, by contrast,
the recession has shown up only in GDP,
not at all in employment.
The global economy quickly
followed
the back
US into
and now
out recession,
again (starting 2009, QIII)
Source:
OECD Economic Outlook, April 2010
51
Unemployment is forecast to come
down only slowly (typical of financial crashes)
Source:
OECD Economic Outlook, April 2010
52
The countries with the big housing bubbles
suffered the most severe recessions
measured by unemployment
Source: IMF World Economic Outlook, April 2010
Unlike the U.S. & Spain, where job loss > GDP loss,
other countries like Germany & Japan had it the other way around.
IMF World Economic Outlook, April 2010
Unlike the
U.S. & Spain,
where job
loss > GDP
loss,
other countries
like Germany
& Japan had it
the other way
around.
Unemployment in the US has risen above Europe
for the first time in decades
Source: OECD Economic Outlook, April 2010
Employment Lags Behind GDP
Although U.S. job loss has been especially bad
in this recession, the recovery lag behind GDP has not been unusual.
Recession of
Mar. 2001 – Nov. 2001
Recession
of
Dec. 2007 – ?
57
De-coupling turned out to be real after all

at least with respect to East Asia,
which has rebounded very strongly over the last year,

after a sharp loss of exports over the preceding year,


from 2008 QI to 2009 Q I.
China’s growth
has not only returned to its blistering pace of > 10%
 but by now is a source of global growth



because China is now a much larger share
of the world economy than in the 1980s or 90s.
India, Indonesia, & other Asian countries also weathered
the global recession well, and are growing strongly.
59
The worst post-war decline in global
trade (2008-09) has now reversed
Source:
IMF WEO,
April 2010
Source:
IMF WEO,
April 2010
Source:
IMF WEO,
April 2010
Source:
IMF WEO,
April 2010
So far, it doesn’t look like one of those recessions where
“the deeper they fall, The faster they bounce back.”
Source:
IMF WEO,
April 2010
Forecasts
International Monetary Fund
April 14,
World Economic Outlook
Year over Year
2010
(%)
Q4 over Q4
(2010-2011 are projections)
2008 2009 2010 2011
2009 2010 2011
World
Output
3.0 –0.6 4.2 4.3
1.7 3.9 4.5
Advanced
Economies
0.5 –3.2 2.3 2.4
–0.5 2.2 2.5
Japan
United States
–1.2 –5.2 1.9 2.0
0.4 –2.4 3.1 2.6
Euro Area
0.6 –4.1 1.0 1.5
Newly Industrialized
Asian Economies 1.8 –0.9 5.2 4.9
–1.4 1.6 2.3
0.1 2.8 2.4
–2.2 1.2 1.8
6.1 3.4 5.9
Year over Year
Q4 over Q4
(2010-2011 are projections)
2008 2009 2010 2011
2009 2010 2011
Emerging & Developing Economies
6.1 2.4 6.3 6.5
5.2 6.3 7.3
Central & E.Europe
Russia
3.0 –3.7 2.8 3.4
5.6 –7.9 4.0 3.3
1.9 1.3 4.1
–3.8 1.7 4.2
Developing Asia
7.9 6.6 8.7 8.7
8.6 8.9 9.1
China
India
ASEAN-5
9.6
7.3
4.7
Middle East & N.Africa
Sub-Saharan Africa
Western Hemisphere
5.1 2.4 4.5 4.8
5.5 2.1 4.7 5.9
4.3 –1.8 4.0 4.0
.........
.........
.........
Brazil
Mexico
5.1 –0.2 5.5 4.1
1.5 –6.5 4.2 4.5
4.3 4.2 4.2
–2.4 2.3 5.5
8.7 10.0 9.9
5.7 8.8 8.4
1.7 5.4 5.6
10.7 9.4 10.1
6.0 10.9 8.2
5.0 4.2 6.2
Global Growth Forecasts
RGE Global Economic Outlook Q2 2010
Roubini Global Economics
Country
USA
Japan
Eurozone
UK
G7
Advanced Economies 1
Asia 2
Asia ex-Japan
Latin America 3
EMEA 4
BRICs
BICs 5
World
Draft, for release April 20
Real GDP (% chg, y/y)
2009
-2.4
-5.2
-4.1
-5
-3.4
-3.4
3.6
5.8
-2.1
-3.5
4.9
7
-0.8
2010
2.8
2
0.9
1.1
2.2
2
6.9
8.2
4.3
3.1
8.3
9
3.7
1 Includes USA, Canada,
Japan, UK, Eurozone, Sweden,
Denmark, Australia & NZ.
2 Includes Japan, China, India,
Hong Kong, Indonesia, Malaysia,
Philippines, Singapore, Vietnam,
Korea, Taiwan & Thailand.
3 Brazil, Argentina, Mexico, Chile,
Peru, Colombia & Venezuela.
4 Turkey, Russia, Kazakhstan,
Ukraine, Czech Rep., Hungary,
Slovakia, Poland, Romania,
Bulgaria, Egypt, Saudi Arabia,
UAE, Israel, Nigeria, S. Africa
5 Brazil, India & China;
or BRICs excl. Russia.
The problem of global
current account imbalances,

especially the US CA deficit & China’s surplus,
was the most salient global macroeconomic
issue on the eve of the financial crisis.

Imbalances narrowed sharply in 2009;

the US deficit fell by almost ½ ;
 China’s CA fell by almost ½.




Its trade surplus actually dipped to 0 in March 2010.
Problem solved?
The imbalances will now resume widening.
69
Global current account imbalances
– China’s surplus and America’s deficit –
narrowed ≈ ½ in the 2009 recession.
70
Global current account imbalances
– China’s surplus and America’s deficit –
are expected now to widen again some,
with recent recovery in US income & the $.
Economists were (are) split between
those who saw the US deficit as
unsustainable, requiring a $ fall,








Ken Rogoff *
Maury Obstfeld
Larry Summers
Martin Feldstein
Nouriel Roubini
Menzie Chinn
Me
Lots more








and those who saw
(see) no problem.
Ben Bernanke
Ricardo Caballero *
Richard Cooper
Michael Dooley
Pierre-Olivier Gourinchas
Alan Greenspan
Ricardo Hausmann
Lots more
* Some claim that the financial crisis of 2007-09 fits their theories.
72
The events of 2007-09 struck major blows
against both interpretations of CA.

Most of us in the unsustainability camp would have
predicted that something like the US sub-prime mortgage
crisis would cause a big fall in the $.


Instead , the $ strengthened.
Most of those in the sustainability camp had been arguing
that the US has uniquely superior assets (corporate
governance, securities markets, bank regulation…)

Instead, the crisis showed the US system to suffer serious flaws



of crony capitalism like other countries (Simon Johnson, Ragu Rajan)
or – worse – excessive deregulation (Joe Stiglitz)
The answer, for the moment: The $ and US Treasury bills
still play unique roles in the world monetary system.
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 $ (Nov.) .

PBoC Gov. Zhou proposed
replacing $ as international
currency, with the SDR (March 09).
The problem of Greece
• Implications for Europe:
•European leaders have handled the crisis poorly,
• boding ill for the long-term euro project.
• Implications for the US
• In the short term,
possible contagion is the new source of risk for us well.
• In the longer term, it will be good if this gives political impetus
to address the long-standing problems of our own fiscal path.
• Implications for the global financial system:
• The dividing line between advanced countries & developing countries has been erased.
The Greek crisis has begun to affect banks,
especially in euroland.
LIBOR went back above 50 basis points in late May
Banking sector 5-year CDS rates
Source: Datastream, OECD Ec. Outlook May 2010
By 2007, emerging & developing economies
had achieved fiscal balance & debt/GDP ratios
well below those of advanced economies.
The fruits of fiscal discipline:

For the first time, Korea has a higher credit
rating than Iceland or Greece

Developing countries were able to respond to
the 2008-09 recession with fiscal expansion to
moderate the downturn.
Greece, Portugal & Iceland have lost creditworthiness,
Sovereign Debt Credit Ratings for Advanced Economies,
as a result of excessive debt:
Ranked by Current Rating
Ratings are issued by S&P for foreign currency long-term debt
All countries listed are described as "advanced” in WEO, 2010 economies"
6/30/2008
(1)
Australia
Austria
Canada
Denmark
Finland
France
Germany
Luxembourg
Netherlands
Norway
Singapore
Sweden
Switzerland
United Kingdom
United States
Belgium
Hong Kong
New Zealand
Ireland
Japan
Slovenia
Spain
Taiwan
Cyprus
Italy
Slovak Republic
Czech Republic
Israel
Korea
Malta
Portugal
Iceland
Greece
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AA+
AA
AA+
AAA
AA
AA
AAA
AAA+
A+
A
A
A
A
A
AAA
A
12/31/2008
(2)
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AA+
AA+
AA+
AA
AA
AA
AAA
AAA+
A+
A+
A
A
A
A
AABBBA
5/13/2010
(3)
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AA+
AA+
AA+
AA
AA
AA
AA
AAA+
A+
A+
A
A
A
A
ABBBBB+
while East Asian NIEs have gained creditworthiness.
Not used, for now
81