Kennedy School of Govt Analysis

8/6/2019 Kennedy School of Govt Analysis

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

It May Be Slow, But atIt May Be Slow, But at

Least Its AnLeast Its AnEconomic RecoveryEconomic Recovery

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


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2

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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3

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

PeakPeak TroughTrough ContractionContractionQuarterly 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 months131388

11111010

8810101111161666

1616

8888

1818

Average, all cycles:Average, all cycles:

1854-2001 (32 cycles)1854-2001 (32 cycles) 1945-2001 (10 cycles)1945-2001 (10 cycles)

17171010

June 2009 (II)
http://www.nber.org/


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Source: Jeff Frankels 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 3 rd quarter of 2008.


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Much of the confusion can beeasily 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 topoint in different directions,have measurement error,and be revised.

We cant declare the end of a recession until we arereasonably sure that a hypothetical new downturn (doubledip) would count as a separate new recession.
http://www.nber.org/http://www.nber.org/


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National output gives a prettyclear answer

though GDP & Gross Domestic Income look slightly different.

Figure 1. Monthly Output, Jan. 2006 -Indexed to Dec. 2007 = 10

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d e x

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Trough


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Some other indicators such asindustrial production so

similar datingFigure 6. Index of Industrial Production vs. A

Mar. 2006 - Aug. 2010

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103

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d e x

V a

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Peak

Trough


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Figure 5. Average Employment vs. AvMar. 2006 - Aug. 2010,

Indexed to Dec. 2007 = 1

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d e x V

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Trough

The labor market lags behind,as usual


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,responds first.

Firms delay hiring until they are

confident of the need.Figure 4. Employment vs. Aggregate Hours, M


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d e x

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Trough


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OECD Econ.Outlook , April2010

The banking sector normalized in Q3 20

Start of USsub-primemortgage

crisis

Lehmanfailure

Interbank lending spreads are the bestmeasure

of the extraordinary financial crisis that led to

global recession

OECD Economic Outlook , April2010


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Danger o a ou e-anger o a ou e-dip?dip?

Demand growth in the 1Demand growth in the 1 stst year of recoveryyear of recovery

came 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 2010The withdrawal of fiscal stimulus is now slowing growth.The withdrawal of fiscal stimulus is now slowing growth.

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

I put theI put the odds of a double dip recessionodds of a double dip recession asasrather small,rather small, butbutbig enoughbig enough to have persuaded the NBER to wait untilto have persuaded the NBER to wait untilSeptember.September.


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Soon we must return toward fiscalSoon we must return toward fiscaldiscipline.discipline.

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

Tax revenue Tax revenueLet President Bushs tax cuts expire for the rich in 2011.Let President Bushs tax cuts expire for the rich in 2011.Introduce a VAT or phase in auctioning of tradable emissionIntroduce a VAT or phase in auctioning of tradable emissionpermitspermitsCurtail expensive and distorting tax expendituresCurtail expensive and distorting tax expenditures

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

All politicallyAll politically very very difficult, needless to say.difficult, needless to say.

Any solution requires:Any solution requires:Honest budgetingHonest budgeting (e.g., Iraq war on-budget, etc)(e.g., Iraq war on-budget, etc)

PAYGOPAYGOWise up to politicians who claim they want to do itWise up to politicians who claim they want to do it


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SpendingSpendingCuts in farm subsidies for agribusiness & farmers, incl. ethanolCuts in farm subsidies for agribusiness & farmers, incl. ethanol

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

Social securitySocial securityRaise retirement age just a littleRaise retirement age just a littleProgressively index future benefit growth to inflationProgressively index future benefit growth to inflationIf necessary, raise the cap on social security taxes.If necessary, raise the cap on social security taxes.

Health careHealth careEncourage hospitals to standardize around best-practice medicineEncourage hospitals to standardize around best-practice 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.


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When will US adopt the toughmeasures to get back to fiscal

sustainability?Ideally, we would now adopt measures that would begin to gointo 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 !


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When will the day of reckoning come?

It didnt come in 2008: The financial crisiscauseda flight to quality which evidently still means a

flight to US $.

Chinese warnings in 2009may have augured a turning point:

Premier Wen worried US T bills will lose value.He urged the US to keep its deficit at an appropriatesizeto ensure the basic stability of the $ .

PBoC Gov. Zhou proposedre lacin as international


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More on the crisis of 2007-2009

1. Six root causes of thefinancial crisis

2. Policy response:

How did we avoid a GreatDepression?

3. Intellectual implications

1 f hf h


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1. x root causes. x roo causes of theof the financial crisisfinancial crisis

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

options;options;golden parachutesgolden parachutes

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

3.3. Politicians slant excessivelyPoliticians slant excessivelytowardtoward homeowner debthomeowner debt

Tax-deductible mortgage interest; Tax-deductible mortgage interest;FFannieannie MMae & Freddie Macae & Freddie Mac ;;Allowing teasers,Allowing teasers, NINJANINJA loans, liar loansloans, liar loans

MSN Money & Forbes


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

4. The4. 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 policy5. Monetary policy was too loose duringwas too loose during2004-05,2004-05,

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

6. Financial market participants6. Financial market participants

grosslygrossly 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.

US l i 0US l i 0


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US real interest rate < 0,US real interest rate < 0,2003-042003-04

Real interestReal interestrates


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In 2003-07, market-perceived volatility, asmeasured by options(VIX), plummeted.So did spreads on US

junk& emerging marketbonds.

In 2008, it all reversed.

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


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Th bl k Th bl k


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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 couldinvestors thought housing prices could

never go down.never go down.

Fi i l l dFi i l ltd b k db k d


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Financial meltdown:Financial meltdown: bank spreadsbank spreadsrose 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).


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Monthly GDP

Figure 7. Macro Advisers Real GDP vs. AveraJan. 2006 - June 2010,


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N ti l i h bNational income has been more


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National income has been moreNational income has been morereliable than GDP,reliable than GDP,

even though they are supposed to measureeven though they are supposed to measure

the same thingthe same thing ..

Recession of July 1990

March 91

Recession of Mar. 2001 Nov.

2001

Recession of Dec. 2007

June 09


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. o cy esponse --How did we avoid

anotherGreat Depression? We learnedWe learned

important lessonsimportant lessonsfrom the 1930sfrom the 1930sand, for the mostand, for the mostpart, didnt repeatpart, didnt repeatthe mistakes wethe mistakes wemade then.made then.


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We learnt from the mistakes of theWe learnt from the mistakes of the1930s.1930s.

Monetary response:Monetary response: good this timegood this time

Fiscal response:Fiscal response: relatively good,relatively good, but but ::constrained by inherited debtconstrained by inherited debtand 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 steelBut we did not repeat 1981 auto quotas or 2001 steeltariffstariffslet alone Smoot-Hawley !let alone Smoot-Hawley !

Financial regulation?Financial regulation?

l


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U.S. PolicyU.S. PolicyResponsesResponses

MonetaryMonetary easingeasing waswasunprecedented,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 easing: Then we had aggressive quantitative easing:the Fed purchased assets not previously dreamtthe Fed purchased assets not previously dreamt

h d l d d d


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The Fed certainly didThe Fed certainly did not not repeatedrepeatedthe mistake of 1930s: letting thethe mistake of 1930s: letting the

money supply fall.money supply fall.

SourcSource:e:

IMF,IMF,WEOWEO ,,AprilApril20092009BoxBox3.13.1

1930s

2008-09

Federal Reserve Assetse era eserve ssets ($ billions)($ billions)


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Federal Reserve Assetse era eserve ssets ($ billions)($ billions)more-than-doubled in 2008more-than-doubled in 2008 ,,through new facilities, rather thanthrough new facilities, rather than

conventional T bill purchasesconventional T bill purchases

Source: Federal Reserve H.4.1 report

P li RPolic Responses


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Policy Responses,Policy Responses, continuedcontinued

succeeded in getting the financial systemsucceeded in getting the financial systemgoing 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 theContrary to almost all commentary at the

time of TARP:time of TARP: The conditions imposed on banks The conditions imposed on bankswere enough to make them balk at keeping thewere enough to make them balk at keeping thefunds.funds.

The banks have now paid back the taxpayer at a The banks have now paid back the taxpayer at arofit.rofit.

The policy of The policy of financial repairfinancial repair


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Financial reform.Financial reform.

LendingLendingMortgagesMortgages

Consumer protection, including standards for mortgage brokersConsumer protection, including standards for mortgage brokersFix originateFix originate toto distribute model, so lenders stay ondistribute model, so lenders stay on thethe hook.hook.Remove pro-housing bias in policy.Remove pro-housing bias in policy. (But politicians remain in favor.)(But politicians remain in favor.)

Banks:Banks:Regulators shouldnt let banks use their own risk modelsRegulators shouldnt 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 then do(The worst is to say no and then doyes.)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 dont think so.)(I dont think so.)


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Financial reformsFinancial reforms continuedcontinuedExecutive 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.

SecuritiesSecuritiesRegulateRegulate derivativesderivatives ::

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

Reduce reliance on ratings: AAA does not meanReduce reliance on ratings: AAA does not meanno 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 stimulusfiscal stimulus passedpassed Feb. 2009.Feb. 2009.Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the principle that spending provides more stimulus than taxEven the principle that spending provides more stimulus than taxcuts returned;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 USPerhaps also too big to reassure global investors re USdebt.debt.

Bottom line ofBottom line of


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Bottom line of Bottom line of macroeconomic policymacroeconomic policy

response:response: The monetary & fiscal response was The monetary & fiscal response wassufficient to halt the economic free-fall.sufficient to halt the economic free-fall.It wont be enough to return us rapidlyIt wont 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 inGiven the path of debt that was inherited in2009, perhaps not much more could be done.2009, perhaps not much more could be done.

Chinese officials already questioning ourChinese officials already questioning ourcreditworthinesscreditworthinessRisk of hard landing for the $Risk of hard landing for the $


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3: Intellectual3: Intellectualimplications of theimplications of thecrisis for economicscrisis for economics

The return of Keynes The return of KeynesAnd 4 others who mainstream theory hadAnd 4 others who mainstream theory hadforgotten.forgotten.

8 economists who got parts right8 economists who got parts right


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M i i f iM i i f i


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Motivation for macroeconomicMotivation for macroeconomicinterventionintervention

The view that Keynes stood for The view that Keynes stood forbig government is not really right.big government is not really right.

He wanted to save market microeconomics fromHe wanted to save market microeconomics from

central planning, which had allure in the 30s & 40s,central planning, which had allure in the 30s & 40s,by using macroeconomic demand to return toby using macroeconomic demand to return toequilibrium.equilibrium.

Some on the Left reacted to the 2008 crisisSome on the Left reacted to the 2008 crisis& election by hoping for fundamental& election by hoping for fundamentaloverhaul 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 bubblecollapse, 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 Hayeks credit cycle,Add in von Hayeks credit cycle,KindlebergerKindleberger 7878s manias & panicss manias & panicsthe Minsky moment,the Minsky moment,& Fishers debt deflation.& Fishers debt deflation.

The origin this time was The origin this time was not not a monetary contractiona monetary 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 asset2003-04 monetary expansion showed up only in assetprices.prices.

Wh i f i i hWh t i f it i ht


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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 assetBIS (Borio & White): Too-easy credit, via assetprices,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 beingGramlich: Homeowners are beingsold mortgages that they cant repay.sold mortgages that they cant repay.Rogoff: This Time IsRogoff: This Time Is Not Not Different.Different.

Roubini: The recession will be severe.Roubini: The recession will be severe.


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Appendix:

US fiscalpolicy


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The US public discussion is framed like a battle betweenconservatives 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 allowsurpluses 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 bethe aim of liberals, in the 19th century definition, not conservatives. My point is different: those who call themselves conservatives in practice tend toadopt policies that are the opposite of fiscal conservatism. I call them illiberal. Republican & Democratic Presidents Have Switched Economic Policies Milken Inst.Rev. 2003.
http://www.hks.harvard.edu/fs/jfrankel/RepubDemoSwitchMIR-rSS.pdfhttp://www.milkeninstitute.org/http://www.milkeninstitute.org/http://www.hks.harvard.edu/fs/jfrankel/RepubDemoSwitchMIR-rSS.pdfhttp://www.hks.harvard.edu/fs/jfrankel/RepubDemoSwitchMIR-rSS.pdfhttp://www.hks.harvard.edu/fs/jfrankel/RepubDemoSwitchMIR-rSS.pdf


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Three pieces of evidence to support the claimthat fiscal conservatives are not:

(i) The voting pattern among the 258 Congressmenwho signed an unconditional pledge not to raise taxes:As of 2004, they had voted for more spendingthan those who did not sign the pledge. [2]

(ii) The pattern of spendingunder 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.
http://www.urban.org/publications/1000670.htmlhttp://www.urban.org/publications/1000670.htmlhttp://www.urban.org/publications/1000670.htmlhttp://www.hks.harvard.edu/fs/jfrankel/TaxCutSnakeOilSept16-08.pdfhttp://www.epi.org/http://www.epi.org/briefingpapers/221/bp221.pdfhttp://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2010/03/31/red-states-blue-states-and-the-distribution-of-federal-spending/http://www.flickr.com/photos/dannysullivan/4388741546/http://www.google.com/imgres?imgurl=http://www.september11news.com/March_March11WhiteHouseCeremBushFlag.jpg&imgrefurl=http://www.sodahead.com/united-states/obama-weak-on-domestic-terrorism---no-new-news-weve-been-weak-since-george-w-bush-left-office-rig/question-1229609/&usg=__WVJMVHZIWa0Yqiqr0viTQAX7ilU=&h=341&w=450&sz=17&hl=en&start=42&zoom=1&um=1&itbs=1&tbnid=AMe-a8fxuz3DYM:&tbnh=96&tbnw=127&prev=/images%3Fq%3Dgeorge%2Bbush%2Bwhite%2Bhouse%26start%3D40%26um%3D1%26hl%3Den%26sa%3DN%26rlz%3D1T4GGLL_enUS309US342%26ndsp%3D20%26tbs%3Disch:1http://www.google.com/imgres?imgurl=http://en.academic.ru/pictures/enwiki/67/Capitol_Building_Full_View.jpg&imgrefurl=http://en.academic.ru/dic.nsf/enwiki/19662&usg=__vmQVTSDK3OZa_-kHSnMZPJE1h-A=&h=3072&w=7168&sz=10149&hl=en&start=20&zoom=1&um=1&itbs=1&tbnid=H8suM4NSnlst8M:&tbnh=64&tbnw=150&prev=/images%3Fq%3Dcapitol%26um%3D1%26hl%3Den%26sa%3DN%26rlz%3D1T4GGLL_enUS309US342%26tbs%3Disch:1http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2010/03/31/red-states-blue-states-and-the-distribution-of-federal-spending/http://www.epi.org/briefingpapers/221/bp221.pdfhttp://www.epi.org/http://www.hks.harvard.edu/fs/jfrankel/TaxCutSnakeOilSept16-08.pdfhttp://www.hks.harvard.edu/fs/jfrankel/TaxCutSnakeOilSept16-08.pdfhttp://www.urban.org/publications/1000670.htmlhttp://www.urban.org/publications/1000670.htmlhttp://www.urban.org/publications/1000670.htmlhttp://www.urban.org/publications/1000670.htmlhttp://www.urban.org/publications/1000670.html


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(iii) States ranked by federal


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(iii) States ranked by federalspending received

per tax dollar paid in 2005versus party vote ratio in precedingelection

Republican states take hoRepublican states take hosignificantly more federalsignificantly more federal(relative to taxes paid)(relative to taxes paid)

than Democratic statesthan Democratic states

redstates

bluestates low inflow of US $

big inflow of US $
http://www.flickr.com/photos/dannysullivan/4388741546/


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U.S. fiscal policy in 2010-2011?

What changes in American fiscal policywould 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 recoveryis 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.


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U.S. fiscal policy in 2010-2011 , continued

Maximizing bang for the buck fiscal stimulus thatgives 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 taxcuts 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, andextending 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.


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But spending boosts demand more than tax cuts do, because the latter are partly saved.

Extend elements of the Obama stimulussuch as infrastructure investment and

giving money to the statesso that they don t have to lay off teachers, policemen,firemen, subway drivers & construction workers.


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How does one take steps todayto 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.


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One big reform might work best: pass legislation today to put Social Securityon a sound financial footing in the long term.

It would consist of a combinationof 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 .

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