About a year and a half ago—in the days after the forced merger of Bear Stearns into J.P. MorganChase, say—there was a near consensus of economists that an additional dose of expansionary fiscal policy was unlikely to be necessary. The Congress had passed a first round of tax cut-based stimulus, the impact of which in the summer of 2008 is clearly visible in disposable personal income and perhaps visible in the tracks of estimated monthly real GDP. The near-consensus belief back then, however, was that that was the only expansionary discretionary fiscal policy move that was appropriate.There's a lot more very interesting material. Go read the whole speech.
With the Bear Stearns forced merger it appeared that the Federal Reserve and the Treasury had settled on a policy: they would punish as severely as they could the shareholders of and the managers at institutions too-big-to-fail that required rescue, but that they would insulate bondholders and counterparties. The incentives to avoid bankruptcy would thus be concentrated on those who actually had power to do something to manage organizational risk. As for the rest—well, the markets interpreted the forced merger as the Federal Reserve guaranteeing and making riskless essentially all the unsecured debt of all the large commercial and investment banks in the country.
The resulting “approaching liquidity tsunami,” as more than one senior policymaker described it to me, meant that the risk of a deep recession was very low—or so the situation looked in the spring of 2008.
By the late summer of 2008 things looked significantly different. The tax-based expansionary fiscal policy of early 2008 had had less than the desired effect—perhaps it had prevented a decline in the economy and kept things marching in place, but it effect was not overwhelming and not entirely obvious. It was clear that the formal announcement that the economy had fallen into recession was only a matter of time.
By August 2008 Lawrence Summers was writing of a gap between actual and sustainable production of $300 billion at an annual rate, forecasting that that gap was likely to more than double over the following year, and predicting sustained weakness thereafter—“unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances…” in a time when “the remaining scope for monetary policy to stimulate the US economy is surely very limited…” Take an initial output gap growing from $300 to $600 billion over the first year and then declining to zero over the next three and you have a cumulative output gap of $1,350 billion in a situation in which monetary policy on it own can do little to correct it. Suppose that a prudent use of fiscal policy would be to enlarge the government’s budget deficits by a third of the forecast output gap, and you have an estimate of the appropriate size of expansionary fiscal policy as the situation looked in August 2008: $450 billion in cumulative deficit spending spread out over the next four years.
Then came the nationalization of Fannie Mae and Freddie Mac on September 7, 2008; the bankruptcy of Lehman Brothers on September 15, 2008; and the nationalization of AIG on September 22, 2008. In the aftermath it was immediately clear that the recession problem was at least twice as bad as it had looked in August, and over the next four and a half months until the February 17, 2009 signing of the ARRA the magnitude of the likely cumulative output gap doubled again as the magnitude of the financial crisis’s impact on the real economy became clear.
If $450 billion was the appropriate size of a short-term deficit-spending program for the $1,350 billion cumulative output gap anticipated as of August 2008, then simple extrapolation suggests that the appropriate size of the boost to short-term deficit spending as of February 2009 was $1.8 trillion (over three to four years).
What we got was a cumulative number of $600 billion—roughly 1/3 aid to states, 1/3 tax cuts (in a good-faith effort by the Obama administration to propose a bipartisan plan that legislators of both parties could sign on to), and 1/3 infrastructure and other direct government purchases intended not so much to slow the decline as rather to boost the recovery. We also got an extension of the AMT and other measures that no economist I have talked to believes are properly counted as part of an effective fiscal boost under any currently-live theory of how the economy works. Figure an increase in deficits of $200 billion per year spread out over the next three years. At the technocratic level, the disproportion between the size of the response and the magnitude of the need is obvious.
- I love the part where he looks at arguments against stimulus and tears them to shreds.
- I love the bit where he points out that Nobel prize winner Robert Lucas cashed out of equities and is 100% into cash because he panicked, just like most other investors.
- I love the bit where he maps out where some short term deficit spending would be useful.