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Economic Policy Challenges: Macroeconomics and Fiscal Policy

01/27/2011 1:15 PM Kresge
Ricardo Caballero, PhD '88, Ford Professor of Economics and Department Head, MIT; Pedro Aspe, PhD '78, Co"Chairman, Evercore Partners and Chairman and CEO, Protego; Olivier Blanchard, PhD '77, Class of 1941 Professor of Economics, MIT and Chief Economist, International Monetary Fund; Paul Krugman, PhD'77, Professor of Economics and International Affairs; Woodrow Wilson School of Public and International Affairs, Princeton University; N. Gregory Mankiw, PhD '84, Robert M. Beren Professor of Economics, Harvard University; Christina Romer, PhD '85, Class of 1957 Garff B. Wilson Professor of Economics,; University of California, Berkeley; Robert Gordon, PhD '67, Stanley G Harris Professor of the Social Sciences, Northwestern University

Description: These economists, MIT PhDs all, ponder what remains in the macroeconomist's toolkit to pull the U.S., and much of the developed world, out of recession. They discuss aspects of fiscal and monetary policy that may prove useful in spurring recovery, as well as the complicating matter of politics.

IMF chief economist Olivier Blanchard describes a "two"speed recovery" around the globe, where emerging market countries like China and India are growing at a brisk clip of around 10%, and developed nations like the U.S. are lagging behind, with growth rates 3% and below. Stronger Eurozone states are struggling to prop up debt"laden Ireland and Greece. Blanchard hopes to avoid a larger European calamity by opening up the books of European banks to allay investors' fears and help recapitalize the banks at appropriate levels.

The U.S. and China represent another hot spot for the IMF, with the U.S. running a vast current account deficit (due to years of high U.S. consumption and low household savings), and China a large current account surplus. Both nations want to reverse the situation, but their timetables differ radically. China fears increasing domestic consumption too rapidly and overheating its economy, so is thinking in terms of years. The U.S. wants faster action. If net exports do not improve in the U.S., says Blanchard, then it will be "confronted with a difficult choice: either it does fiscal consolidation, risking slowing growth, or continues large deficitsThere are reasons to think one might want to worry."

Emerging markets "have learned lessons from previous crises," says Pedro Aspe, and are generally rebounding from the downturn. In Latin America, they have followed the lead of Chile, adopting an independent central bank, trade liberalization, pension reforms, and flexible labor markets. When they need a stimulus, they lower interest rates and keep public debt low. Aspe also raises red flags around debt and financing in the Eurozone: "You take more financing, and then the private sector knows this game wellThey squeeze economies. Face the debt overhang fast."

Robert Gordon replaces the word overhang "with a more evocative word: hangover." The U.S. economy is still weighed down by consumer liabilities, although the household savings rate has improved. There remains an oversupply of residential housing and nonresidential structures, and continued unemployment, only to worsen as state and local governments shed more workers. "What do we do?" he asks repeatedly. "Monetary policy is out of steam." On fiscal policy, Gordon says, "We have to pretend we're a benevolent dictator and ignore political paralysis." He recommends cutting corporate income tax, extending unemployment compensation and making food stamps more generous. He also endorses a new jobs tax credit, but admits it will be "hard to design."

Paul Krugman confesses having "nightmares for about a decade before this thing actually happened." What is "worse than he anticipated" is the "apparent inability of policy to come to grips with this." Our paralysis has arrived in part because "we've run into the limits of Samuelsonian synthesis." The traditional levers of monetary and fiscal policy to correct minor market failures have failed. The academic consensus around Keynesian economics has broken, making it less possible to "push through the strong policies you really need at a time like this." This leaves an opening for people "who really believe government should keep its hands off," who don't believe in the need for monetary policy "to be adventurous and unconventional just to avoid utter catastrophe."

In addition, "a prolonged period of financial stability" made people careless, leading to mountains of debt. The resulting financial crisis demands aggressive fiscal policies that are politically impossible. "If you'd asked me five years ago what would happen if the U.S. had unemployment in excess of 9% and every prospect of continued high unemployment levels, I'd have said there would be overwhelming political demand for government to do something. In fact there isn't. We have had a near collapse of the idea that government can do anything about this."

N. Gregory Mankiw describes how times of economic crisis periodically challenge macroeconomists' consensus of how the business cycle works, and how to fix it when it breaks. In the past few years, "the rock has rolled back to the bottom of the hill." Mankiw believes he and fellow macroeconomists "need to be humble" and "recognize there are a lot of things we don't know." For instance, the conventional take was that monetary policy was the main tool for dealing with recession: cut interest rates, stimulate borrowing and investment, increase aggregate demand. But today, the Fed cannot realistically lower its interest rate below zero. If he tried to increase target inflation rates, Ben Bernanke would "soon be former chairman," says Mankiw, who finds the long"term fiscal picture "extremely worrisome." The administration's last budget "has debt to GDP ratio rising as far as the eye can see." Without major reforms on entitlements and the tax code, there must be another revenue source, and Mankiw "is expecting a value added tax."

"In my heart, I feel deeply that actions taken in the last two years were incredibly effective and played a role in the recovery we're seeing," says Christina Romer, a forceful advocate for such strong fiscal policy as the administration's $787 billion stimulus package. Legislation passed during the recent lame duck session of Congress should help blunt the loss of stimulus money. Nevertheless, the "U.S. economy is still suffering from a tremendous shortfall of aggregate demand," with factories and workers unoccupied. She worries that policymakers' anxiety about the long"run fiscal deficit will prevent the kind of immediate measures "we desperately need," that would jumpstart recovery. She argues for "high quality additional fiscal stimulus coupled with a signed, sealed and delivered agreement for deficit reduction starting in 2012 or 2013." This agreement would tackle "the true driver of the deficit, long"run entitlement spending on Social Security and Medicare," and "must surely raise additional revenue."

About the Speaker(s): Ricardo J. Caballero is also a National Bureau of Economic Research (NBER) research associate in economic fluctuations and growth. A native of Chile, he received his B.S. and M.A. in economics from the Pontificia Universidad Catlica de Chile and his Ph.D. from MIT. His academic interests are macroeconomics, international economics, and finance. His current research focuses on global capital markets, speculative episodes and financial bubbles, systemic crises prevention mechanisms, and dynamic restructuring.

Caballero is a Fellow of the American Academy of Arts and Sciences, and of the Econometric Society. He has been a visiting scholar at the European Central Bank, the Federal Reserve Board, the Inter"American Development Bank, the International Monetary Fund, and the World Bank, among other institutions. His work has been published in prominent economics journals.

Host(s): Office of the President, MIT150 Inventional Wisdom

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