March 24, 2023

Today’s Economist: Laura D’Andrea Tyson: Lessons on Fiscal Policy Since the Recession


Laura D’Andrea Tyson is a professor at the Haas School of Business at the University of California, Berkeley, and served as chairwoman of the Council of Economic Advisers under President Clinton.

In late 2008, the United States economy was caught in the midst of what proved to be its longest and deepest recession since the end of World War II. Frightened by steep and self-reinforcing declines in output and employment, both the Federal Reserve and the federal government responded quickly and boldly. The Federal Reserve dropped the federal funds rate to near zero, where it remains today, and began its controversial “quantitative easing” purchases of long-term government securities to contain long-term interest rates.

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Fueled by the 2009 federal stimulus package, discretionary fiscal policy was also expansionary in 2009-10, adding to growth during the first year of the recovery at roughly the same pace that fiscal policy had achieved during previous recoveries.

Then, in a sharp break with history, fiscal policy became a drag on growth in the second year of recovery, and since then the drag has intensified. What explains the premature and counterproductive turn toward fiscal austerity despite the high unemployment rate and the large gap between actual and potential output?

Before the Great Recession, there was a near consensus among economists that monetary policy alone could stabilize aggregate demand and keep the economy on its potential growth path. Under normal economic conditions, countercyclical fiscal policy was thought to be unnecessary. It was also thought to be both ill timed, because of lags in Congressional decision-making, and wasteful, because choices among fiscal measures were driven by politics and rent-seeking rather than cost-benefit considerations.

Most economists also believed that changes in discretionary fiscal policy would have small effects on aggregate demand and output — that the multipliers for such changes were small — and this belief was supported by empirical research based on “normal economic conditions.”

But the conditions confronting fiscal policy in late 2008 were anything but normal. Output, employment and stock values were falling at a faster pace than before the Great Depression, and short-term interest rates had fallen to their zero lower bound. At least in the short term, conventional monetary policy alone could not stabilize the economy, so over dire warnings from some macroeconomists, in early 2009 Congress answered President Obama’s request for a large temporary stimulus package to end in 2011, by which time it was hoped or expected that a strong recovery would be under way.

Subsequent empirical analysis indicates that the stimulus worked. New research confirms that the multipliers for fiscal policy are significantly larger during downturns when there is considerable excess capacity and when interest rates are at or near their lower bound. They are also larger when private actors are credit-constrained, so their spending depends more on current income than on future expected income. These were the conditions in 2010-11. Even using a range of lower multiplier estimates consistent with more normal conditions, the Congressional Budget Office found that the effects of the stimulus on output and employment were in the predicted range.

But the depth of the recession and the sluggishness of the recovery had been underestimated. Foreclosures and excess housing inventory constrained residential investment, and high unemployment, falling wages and deleveraging constrained household consumption. In 2011, as the stimulus came to an end, private spending was recovering but at an anemic and fitful pace.

And two years of short-term interest rates near zero and quantitative easing had exposed the limits of conventional monetary policy and raised anxieties about the risks of unconventional monetary policy.

There was a strong case for additional fiscal stimulus in 2011, and that is what President Obama proposed. But this time Congress rebuffed most of his recommendations, and since then fiscal policy has shifted to even more contraction in the form of strict caps on discretionary federal spending, increases in taxes and the sequester. According to the International Monetary Fund, fiscal policy will reduce gross domestic product in the United States by 1.8 percent this year.

Since 2011, proponents of fiscal austerity have repeatedly raised concerns that the large increases in the government deficit caused by both the recession itself and discretionary fiscal stimulus would lead to a spike in long-term interest rates. Bill Gross, the bond-market savant and influential chief executive of Pimco, warned that a spike would occur by the late summer of 2011. The downgrading of United States government debt in August 2011 after the Congressional showdown over the debt limit amplified these concerns.

But long-term interest rates did not spike; instead, they fell to historic lows in 2012 and are currently less than 2 percent, despite further increases in government debt. The experience of the last four years demonstrates that there is no simple predictable relationship between the government deficit and long-term interest rates. The relationship depends on economic conditions. Under current conditions, as long as the recovery remains weak, with considerable slack between actual and potential output, subdued inflationary expectations and highly accommodative monetary policy, long-term interest rates are likely to remain low.

As Ben Bernanke, the chairman of the Federal Reserve, noted in a recent speech, the behavior of long-term interest rates during the last several years has few precedents, but it is not puzzling: it follows from the weakness of the recovery and the implications for monetary policy.

In an effort to avoid the kind of surprise that rocked the bond market in 1994 when the Federal Reserve suddenly and significantly increased short-term rates, driving long-term interest rates sharply higher and imposing sizable losses on bond holders, the Federal Reserve has been transparent about its strategy: as long as current and expected inflation remains near 2 percent, the Fed will keep short-term interest rates where they are until the unemployment rate falls to around 6.5 percent.

When not fixated on bond-market anxieties, proponents of fiscal austerity have focused on variants of the “crowding out” argument that a high and rising government debt crowds out private investment and reduces economic growth. But this argument does not apply under current conditions, when there is significant excess capacity and when the private sector is running a financial surplus, with saving to spare to cover the government’s borrowing requirements.

But what about evidence of a possible negative relationship between the ratio of public debt to G.D.P. and economic growth – evidence that burst into fiscal debates in 2010 with the publication of the paper by Carmen M. Reinhart and Kenneth S. Rogoff purporting to show that over the long term, growth declines sharply when public debt tops 90 percent or more of G.D.P.?

As the authors themselves acknowledge, the relationship between public debt and growth is one of correlation, not causality. Over time, slow growth is as much a cause of high public debt as high public debt is a cause of slow growth.

In our recent paper for the International Monetary Fund, Brad DeLong and I (with assistance from Owen Zidar) find a negative relationship between public debt burden and growth, but the effects are modest: raising the public debt-to-G.D.P. ratio from 50 percent to 150 percent for five years is associated with a growth reduction on the order of 0.6 percentage points per year over the next five years, and controlling for country and decade effects reduces the negative effect on growth by more than half.

This chart shows results for debt-to-G.D.P. above 50. Debt-to-G.D.P. above 200 is set to 200. This chart shows results for debt-to-G.D.P. above 50. Debt-to-G.D.P. above 200 is set to 200.

Like others, we also find that there is no threshold debt ratio beyond which growth drops precipitously. Despite the warnings of fiscal austerians, Mr. Bernanke is right: “Neither experience nor economic theory clearly indicates the threshold at which government debt begins to endanger prosperity and economic stability.”

In recent months, the lessons learned about fiscal policy over the last several years have begun to shift the policy debate. In its latest World Economic Outlook, the I.M.F. raised alarms about excessive and counterproductive fiscal austerity in the United States, Britain and Germany.

A growing number of European political and business leaders are warning that harsh fiscal contraction is consigning Europe to prolonged stagnation or worse. Even Mr. Gross is now asserting that bond markets do not want severe belt-tightening and that austerity is not the way to promote growth.

Unfortunately, Congress is not listening. As William C. Dudley, president of the Federal Reserve Bank of New York, observed in a recent speech, the United States has the opposite of the fiscal policy we need: too much fiscal contraction in a still-vulnerable economy now, without a credible plan to reduce the federal budget deficit in the long run.

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Japan Will Limit Debt Financing, New Minister Asserts

TOKYO — Japan’s new finance minister, Taro Aso, sought on Thursday to quell concern about the country’s weak finances, saying that the government would not rely solely on debt to fund economic stimulus and would try to limit new debt issuance during the next fiscal year.

The government will compile spending requests for a stimulus package on January 7 and finalize the proposal shortly thereafter as Prime Minister Shinzo Abe tries to speed enactment of his agenda of increased public works spending to lift the economy.

Mr. Abe, sworn in as prime minister on Wednesday, led his Liberal Democratic Party to a landslide election victory this month with pledges to spend more and to get the central bank to purchase more debt, but this has fueled worries that the new government will delay reducing public debt.

“We will curb government bond issuance as much as possible to ensure confidence” in Japanese government bonds, Mr. Aso told reporters on Thursday, referring to the budget for the fiscal year beginning in April. “We need to make public finances sustainable in the medium to long term.”

Japan’s previous government limited new bond issuance each fiscal year to ¥44 trillion, or $514 billion, as a first step to prevent Japan’s debt burden from worsening further.

The new prime minister instructed the Finance Ministry to draft economic stimulus measures without worrying about adhering to this cap, Mr. Aso told reporters in a late-night news conference after the government was installed.

The government has not decided on the size of the stimulus package, but Mr. Abe has repeatedly said he wants “big” spending to help narrow the output gap and ease deflation.

The government could tap reserves and front-load some public works spending in rural areas to limit new debt needed to fund a stimulus package.

It may be necessary to spend around ¥10 trillion, but the government needs to collect spending requests before it can decide, said Kozo Yamamoto, an L.D.P. lawmaker who is working with other politicians to compile the party’s stimulus package.

Mr. Abe’s grand plan to stimulate the economy and end deflation is to combine fiscal spending and monetary easing with steps to encourage private-sector investment.

The government should revise the Bank of Japan Law that guarantees the central bank’s independence, to make it more accountable to the government, said Koichi Hamada, professor emeritus of economics at Yale University and a special economic adviser to Mr. Abe.

The Nikkei 225-stock average hit a 21-month high on Thursday and the yen hit a two-year low on expectations that the L.D.P.’s business-friendly stance and desire to weaken the yen would shake the world’s third-largest economy out of its protracted funk.

“I believe expectations are high. We will work hard so that expectations will not remain just expectations, and that market expectations are realized,” Economics Minister Akira Amari told reporters Thursday.

Japan’s public debt burden, more than twice the size of its $5 trillion economy, piled up during the Liberal Democratic Party’s more than half a century of almost unbroken rule in Japan.

Now that the L.D.P. is back in power after three years in opposition, investors are looking for signs of how far the party will increase spending.

Japan’s economy is in a mild recession because of a big slump in exports but is likely to escape next year, economists say.

Crafting bills for fiscal spending to ensure economic recovery is likely to take priority over revising the law to limit the Bank of Japan’s independence, but other political parties are also interested in changing the central bank’s mandate.

A small party called Your Party submitted a bill on Thursday to make the Bank of Japan responsible for achieving stable employment and allow it to buy foreign debt, which could draw more attention in the regular session of Parliament next year.

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The Agenda: What Romney’s Words Tell Us If He’s Elected

For nearly four years, Mr. Romney has attacked President Obama’s responses to the worst economic crisis since the Depression, the decisions that have defined the Obama presidency — on the stimulus package, auto industry rescue, home-foreclosure measures and financial regulation.

Mr. Romney has been less clear about what action he would have taken instead. What follows are snapshots of his reactions then and now, which provide a sense of how he might have responded if he had been in the Oval Office and how he might approach economic policy should he be elected president on Tuesday.

STIMULUS Mr. Romney was an early advocate of some government action and criticized President George W. Bush for not seeking a stimulus measure before departing. But mostly he slammed Mr. Obama, within days of the inauguration, for the $831 billion package of spending and tax cuts that a Democratic-led Congress soon passed. He called it bloated with spending that would take too long to help the economy. (The total grew to $1.4 trillion as some provisions were renewed.)

By the end of 2009 Mr. Romney declared the stimulus a costly failure, though nonpartisan studies found that it had helped create or support millions of jobs. He cited a weak recovery, slower than even the Obama administration’s projections, and a stubbornly high unemployment rate.

But Mr. Romney’s own prescriptions were mixed. In February 2009, as the stimulus bill was being enacted, he suggested $450 billion in tax cuts for middle-income Americans and federal money for unspecified “urgent priorities.” He called tax cuts “twice as effective” as spending for spurring the economy, a contention that many economists dispute.

That December, Mr. Romney called for Washington to pull back, though unemployment had hit 10 percent. “Shrinking government and reducing government jobs is healthier for the economy, but this option was never seriously considered,” he wrote.

His position mirrored that taken by many conservatives at the time in the United States and in Europe, which became something of a laboratory for the idea that Keynesian policy had been proven ineffective and that slashing spending and reducing deficits would lower interest rates, promote investment, shrink the government’s interference in the marketplace and put the economy on a sounder footing for the long run.

Britain and other nations that adopted austerity policies encountered deeper economic troubles. In the United States, few nonpartisan economists support government austerity in a downturn. Mr. Romney, suggesting some belief in the central tenet of Keynesian economics — that government spending can temporarily make up for a lack of demand in the private sector — has subsequently said that he would enact budget cuts he supported with an eye toward whether the timing would have a negative impact on a still-weak recovery.

AUTO BAILOUT In late 2008 President Bush approved $25 billion in aid for General Motors and Chrysler. Ford, in better shape, declined aid but backed it for the others since liquidating two of the Big Three automakers would bankrupt many suppliers, imperiling Ford.

That help proved insufficient. Mr. Obama, advised by a task force he formed after taking office, forced G.M. and Chrysler through a government-managed bankruptcy, lending them $60 billion more so they could keep operating while restructuring. This amount, like the first, had to be repaid.

The decision was politically risky, given the growing populist backlash at the time to bailouts like those already given to banks. Mr. Romney opposed the actions by both Mr. Obama and Mr. Bush to provide direct government aid to Detroit, and in November 2008, he wrote an Op-Ed article in The New York Times calling for the companies to be given new management and restructured through the bankruptcy process, with the prospect of government loan guarantees only afterward. He has defended that stance even as the bailout helped the companies return to profitability and add jobs.

Mr. Obama’s plan also required a bankruptcy that forced new union contracts, new managers and investments in fuel-saving technologies. The difference was that Mr. Romney ruled out any bridge loan from taxpayers. He said the government should only guarantee private loans, and only when the companies emerged from bankruptcy. “Detroit needs a turnaround, not a check,” he wrote in the Op-Ed article.

Kitty Bennett contributed research.

This article has been revised to reflect the following correction:

Correction: November 3, 2012

An earlier version of this article said that of two rounds of financial aid to General Motors and Chrysler, only the second round had to be repaid. Both the first and the second were required to be paid back.

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Economix Blog: Bruce Bartlett:How Politics Came to Dominate Payroll Tax Debate


Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of the coming book “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”

Virtually all of the coverage of the debate over extending the temporary cut in the payroll tax has centered on the politics. Almost none has examined the economics of the issue. Indeed, it is nearly impossible to tell exactly why Republicans were so adamantly opposed to extending the tax cut. I’m still not sure.

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The first thing to know is that the payroll tax cut was not originally part of the $787 billion stimulus bill enacted in February 2009. Another tax cut, the Making Work Pay credit, was the principal tax cut in the legislation. It provided a $400 to $800 tax cut for every person or family with a positive tax liability and an income below $75,000 for individuals and $150,000 for couples.

The stimulus legislation also contained a number of other tax cuts for individuals and families that consumed 30 percent of the budgetary cost of the legislation. All tax provisions taken together, including those for businesses, added up to $326 billion – more than 40 percent of the total cost of the stimulus package, according to the Joint Committee on Taxation.

At the end of 2010, all of the tax cuts enacted during the George W. Bush administration were scheduled to expire, as well as the Making Work Pay credit. Although President Obama wanted the tax cuts for the rich to expire on schedule, Republicans insisted on an all-or-nothing strategy. Republicans also asked that the Making Work Pay credit be replaced by a temporary two-percentage-point cut in the employees’ share of the payroll tax.

Cutting the payroll tax fit better with Republican economic theory, because the rate of taxation would be reduced. Tax credits, by contrast, which are subtracted directly from one’s tax liability, generally don’t affect economic decisions at the margin because tax rates are unchanged.

(Of course, the phasing in and phasing out of tax credits such as the earned income tax credit can have marginal rate effects. But Republican economic policy tends to ignore such effects and focuses almost exclusively on statutory tax rates.)

Since the beginning of the economic crisis, many Republican economists had insisted that a temporary payroll tax cut was the best possible stimulus, including the former chairmen of the Council of Economic Advisers, Michael J. Boskin and N. Gregory Mankiw, and the former director of the National Economic Council, Lawrence B. Lindsey.

Economists at Morgan Stanley predicted that the payroll tax cut would help power the economy to 4 percent growth in 2011. (Real gross domestic product growth has actually been less than half that rate.)

The following distribution table from the Tax Policy Center, on Dec. 14, 2010, shows more clearly why Republicans favored the payroll tax cut over the Making Work Pay credit – the benefits are much more skewed toward those with upper incomes.

It also shows why the Obama administration went along – the average tax saving was almost doubled, thus increasing the aggregate fiscal stimulus. The administration also thought the payroll tax cut would be more apparent to workers than the largely invisible Making Work Pay credit.

Tax Policy Center

When the legislation was debated in the House of Representatives on Dec. 16, 2010, the House majority leader, Eric Cantor, pointed to the abolition of the Making Work Pay credit as a key reason why Republicans should support it.

In short, the payroll tax cut was a Republican initiative. So why did they turn against it? The answer is unclear.

To be sure, some Republicans were unenthusiastic about the payroll tax cut in the first place, as were some Democrats who feared damage to the Social Security trust fund. (The Treasury has reimbursed the trust fund for the lost payroll tax revenue.)

As early as last summer, Republican leaders began trashing the payroll tax holiday. House Speaker John Boehner called it a short-term gimmick and Paul D. Ryan, chairman of the House Budget Committee, branded it “sugar-high economics.”

In August, The Wall Street Journal editorial page came out against extending the payroll tax cut. A Heritage Foundation study in September argued that it was ineffective because it was oriented toward average workers rather than wealthy job creators.

Yet, there is precious little evidence that the payroll tax holiday did much, if anything, to stimulate growth or job creation. The Congressional Budget Office rated it as among the least stimulative fiscal policies. Some economists have argued that the Making Work Pay credit provided more bang for the buck.

In the end, economic arguments had little to do with how the payroll tax cut extension played out.

Republicans were in a weak position arguing against it because, historically, they have never opposed any tax cut, no matter how ill-designed or costly. And it was too easy for Democrats to press their political advantage, even though many had doubts about the efficacy of the payroll tax cut.

Sadly, we will probably go through the same exercise this time next year.

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I.H.T. Special Report: Global Agenda: More Stimulus May Not Be an Option for China

Yet with inflation high — food prices in August were 13.4 percent higher than a year earlier — the family is still finding it difficult to pay the bills. This year they had to sell much of their farmland near the town of Lichuan to the local government for a low price, as officials across the country rush to buy land to finance local development.

The changing fortunes of Ms. Qun’s family echo the changes in China since 2008, when the government enacted a 4 trillion renminbi, or $626 billion, stimulus program to help the economy weather the global financial crisis.

Those changes also show why China is reluctant to introduce another stimulus package now, despite growing nervousness about the possible domestic impact of Europe’s debt crisis. Stimulus would only add to inflation, as well as spur more local borrowing to finance development, which would pump air into an already bubbly real estate market.

As China travels to the annual meetings of the International Monetary Fund and World Bank this weekend, it is deeply concerned about contagion from economic difficulties in Europe, its biggest trading partner, and in the United States, one of its largest debtors.

But Beijing’s main message to the multinational lending community is likely to be a pragmatic one: we may be growing, but we have our own worries, so don’t expect much help from us.

“The government will be relatively cautious and take a wait-and-see attitude” at the meetings, said Wang Tao, a Hong Kong-based economist for UBS. Until there are clear signs of global growth tumbling, she added, “they are unlikely to do anything” to stimulate growth at home and thus demand from foreign markets.

China’s economy is robust, Ms. Wang said, despite the fact that indications of a slowdown in global demand have led senior officials to predict growth of less than 9 percent for 2012, and banks estimate 8.7 percent or even 8.4 percent.

“Who says China has to grow at over 9 percent a year?” Ms. Wang asked.

“China’s not going to collapse,” she continued. But the country has “other concerns, such as inflation, debt and asset bubbles in the property market.”

Stephen Green, an economist in Shanghai for Standard Chartered, said “China is facing a bunch of challenging issues.” He, too, singled out local government debt and inflation, both burgeoning in large part because of the last stimulus plan.

Consumer prices in August rose 6.2 percent on average across the country. That figure is down from the July average of 6.5 percent, but still high.

Local government debt is growing at a pace that alarms some economists. The government says local debt stands at 10.7 trillion renminbi, but Moody’s Investors Service has estimated the total local debt at 14.2 trillion renminbi.

Mr. Green, of Standard Chartered, puts the sum at around 14 trillion renminbi, or about a third of China’s 2010 gross domestic product of $6.05 trillion.

He also estimates that up to 9 trillion renminbi of that is nonperforming and will require a government bailout. If he is right — and he is not alone in his prediction — that raises an important question: after the United States’s debt crisis of 2008, and Europe’s of 2011, is China facing one of its own?

“I think we can only do things this way for about four or five years more, and then there will be a debt crisis,” said an economist based in China, who asked for anonymity because of political sensitivities. Debt levels since the 2008 stimulus have shown an “unsustainable pickup,” the economist said.

Some economists do think that China has the tools to avert a bust, or at least to mop up after one. That is because the central government, having in essence created the problem, can then take virtually unilateral action to solve it.

China’s debt problem isn’t “commercial loans that went bad because of an asset bubble popping,” but rather “public infrastructure financed through the banking system,” with local government support, Mr. Green said.

“At the central level it takes a lot of time to make a decision, but when they do they implement it with force,” he added.

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