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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