Now comes the incredibly difficult climb out of the recession trough. We’ve started climbing, with two successive quarters of positive real GDP growth. The newspapers, cable, talk shows, and blogosphere are filled with opinions, warnings, and predictions. I’m in no position to give a complete prescription for future economic policy, but this is an excellent time for students to be thinking through the issues. They need to separate out the fundamental building blocks of a strong economy and push aside alarmist claims.  Here’s a list of things to think about:

1. Monetary policy and the Federal Reserve: In a mild recession the Fed is our policy instrument of choice. They loosen the money supply, which in turn lowers interests rates a bit, which in turn  helps consumers buy goods and businesses to invest in the future. In the recession that started December 2007, the Fed started with this response but the depth and seriousness of the downturn outstripped the ability of routine monetary policy. They then turned to extraordinary steps to provide stability and liquidity in the financial markets, and have worked to maintain a banking system that will receive deposits from trusting depositors and make loans to worthwhile borrowers. To do this they pumped billions (over a trillion) of dollars into our system.They are now focused on how to retrieve that excess money, so that a more active economy doesn’t use it to spur inflation. They’ve been thinking about this a lot, and Chairman Bernanke insists they will be able to gradually reverse the steps they took, without sending the economy in a tailspin. The Fed also has to decide when to reverse the “normal” monetary policy and started pushing interest rates up. As I see it they are working in kind of a LIFO (last in; first out) order. The most serious and unusual interventions will be corrected first, and then the milder interest rate policies will be corrected as the economy approaches a more normal course.
2. Fiscal Policy and the Congress and Administration: Congress correctly passed a large stimulus spending bill over a year ago. The economy  needed it; routine monetary policy was not going to be sufficient to end the recession; and it would have been political suicide not to take action. The stimulus bill was not perfect. It was probably not large enough. It had some favorite son policy objectives that hindered speedy impact of the spending on the economy, and it had some not very effective tax cuts in order to garner bipartisan support.I’ve learned to appreciate a “prime the pump” analogy for fiscal policy actions like this. If you’ve ever had to use a hand pump you know that sometimes you have to add water in the top in order to get the process working. Government stimulus funds are like priming the pump. They immediately add something to the GDP, since government spending is one component of GDP. The real test of a fiscal stimulus is whether the priming works. In an ideal case, the initial injection of spending prompts a cascading series of new spending decisions in the private sector. This is the essence of what my students learn as the multiplier effect. New spending on roads means more wages for road workers, who hopefully become more likely to spend, and the establishments where those workers spend have the same opportunity. There are plenty of signs that the initial stimulus money started improving GDP. Whether that money has successfully primed the pump is an open question. Some policy experts are calling for more stimulus – a second priming. Others (not including those who object on philosophical grounds to more government spending) worry that another fiscal stimulus would boost the economy just as it is getting better on its own, and could spark an inflationary spiral.There has been a flurry of “job bills” discussed by the administration and Congress. Many of these are responses to a perceived (probably real) concern among the American voter that jobs aren’t coming back quickly enough and something needs to be done about it. I don’t know enough about them to comment thoughtfully. Based on past performance it is easy to guess that some proposals will do little to make a permanent shift in the employment picture, and that some will have serious side effects. One quick example – just about any “Buy American” restrictions will hurt our economy in the long run and have minimal benefits in the short run. The Smoot-Hawley act passed in the early years of the recession is our number one example of the problems of drawing up the bridges and protecting our own workers at the expense of other world markets. On the other hand jobs bills that can reduce structural unemployment through retraining, relocation, and other adaptive strategies are money well spent.
3. Federal Deficit and Debt: This is the trickiest balancing act. It also has the most heat and the least amount of light in media discussions. Here’s what the Congressional Budget Office says about the near term situation:

CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest.

One way to look at this issue is represented by Paul Krugman:

Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

Gregory Mankiw is less happy about projected deficits:

The troubling feature of Mr. Obama’s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration’s own numbers, the budget deficit under the president’s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

My own take? Closer to Krugman than Mankiw, but I worry that a partial economic recovery or some call for fiscal stimulus will produce not-well-thought-out-spending plans. These won’t help much, in terms of recovery, they are likely to be persistent beyond the current economic problems, and they won’t help re-establish a deficit closer to 4-5% of GDP.

I get asked this question a lot lately. First, despite the inference of the video provided by the Bureau and Engraving and Printing (see below), the Fed has not been running the money printing presses for extra shifts in the past few months. Instead the Fed can buy U.S. Treasury bills on the open market, and can find a number of other ways to pump money into the economy. The way the money gets created is that the Fed credits the account of securities dealers, banks, and other institutions – each of which have accounts at various Fed district banks. So the balance on these accounts is higher, which gives banks in particular the freedom to lend out more more or somehow make use of the cash. And when the Fed and other policy folk measure the amount of money in circulation they count not only hard currency, but also the balances in checking and other demand deposit accounts.

So, now that we know that money isn’t really being printed, we still need to be concerned by the significant increase in money (represented by currency and checking account balances) injected by the Fed. The inflation concern is real and important. It is a concern not lost on Federal Reserve officials. There is no question that in normal times a significant increase in the money supply usually leads to inflation.

This article in today’s Wall Street Journal explains what has been happening, and also describes how the Federal Reserve will be able to bring back much of that money as the economy improves.

‘We are thinking carefully about these issues,’ Mr. Bernanke said in a speech in Atlanta last week. ‘Indeed, they have occupied a significant portion of recent [Federal Open Market Committee] meetings.’

Ideally the Fed will “reel in” the money in a manner that avoids inflation while not prompting another downturn. Reducing the supply of money generally means higher interest rates and a dampening of economic activity. You’ll see in the article that Federal Reserve officials are thinking a lot about this issue right now. You’ll also see some cautionary opinions from others who are skeptical that the Fed will be able to get the timing right. These critics worry that the Fed, for a variety of reasons, will be slow to turn off the money spigot and turn on the money vacuum. If they are slow, inflation can catch on and that is hard to stop or control.

So, when I’m asking about the risks of inflation due to all of this money printing, I agree with the inflation concern, but express my hope and confidence that Fed officials have thought this through and will reduce the money supply at just the right moment.

But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices. Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains.

What he is pointing out here is a reminder that our global, electronic system for investments has led to investors buying and selling commodities, like oil and wheat. It is not simply that wheat is grown and sold somewhere to be processed and consumed. Instead, investment organizations buy contracts for the future delivery of these commodities and then hold onto, or sell, or leverage these contracts in order to make money. To do this kind of investment requires credit. Lower interest rates means cheaper credit. And this in turn makes it easier for these investors to hold onto these contracts, waiting for prices to rise further. It becomes self-fulfilling, and meanwhile the commodities don’t get delivered to those who need them.

Feldstein further argues that high commodity prices have a particularly chilling effect on the economy of developing nations, where a high percentage of consumption (and thus GDP) is linked to purchases of these goods. He suggests that those governments then must subsidize purchases or support lower prices, which drains government resources away from longer term, beneficial investments.

We need to keep watching the issue of rising food prices. There are already news reports of riots and political instability driven by rising food costs. Feldstein’s further caution about the opportunity cost of paying for food is important.