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.

As a quick review for my students – Our most recent and serious recession came about largely because the prices of real estate and houses accelerated dramatically, and out of proportion to other purchases or investments that the average American could make. When that bubble of high prices popped, financial institutions which had been lulled into thinking their real estate-related investments were safe, found their balance sheets decimated. This has happened several times before in our country’s history, including the technology stock bubble in the late 1990s and 2000, and as far back as the 1800s for railroad properties and precious metals. Even in the 17th century speculation in tulip bulbs caused an economic collapse.

There are two main criticisms about Federal Reserve actions in the last 3-4 years:

1. The Federal Reserve kept short term interest rates too low, for too long a time following the mild recession in 2001. Critics argue that this monetary policy encouraged risky borrowing and unnaturally inflated housing prices.
2. The Federal Reserve was lax in its oversight and regulation of the financial services sector – both over institutions, like banks, and over the risky mortgage lending practices. Regulatory faith in the power of market mechanisms was unearned, and institutions made what we now see as irrational moves.

At a meeting of the American Economic Association in Atlanta this week, Chm. Bernanke rejected the idea that monetary policy caused the housing bubble, but he did acknowledge that weakness in regulatory efforts played a major role.

U of Oregon professor, Mark Thoma, has a nice piece on these issues:

I have been more defensive of the Fed’s actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target.

I’ve gotten on this soapbox before – though the Federal Reserve is a human, fallible organization it is staffed and led by thoughtful professionals and should continue to be protected from political second guessing. There is no member of Congress, including Rep. Barney Frank, who can bring more intellectual and effective knowledge to bear on this issue than Bernanke and his staff.

The central quote…

In fact, right now men’s underwear sales suggest that things have bottomed but not started to recover.

I dare you not to read more.

Wall Street Journal 6/3/09

Revenues to state and local governments are sensitive to economic conditions. Sales taxes are tied to purchases, of course. Income tax revenue is often more problematic. If a state, like Oregon or California, has a progressive income tax structure (higher income citizens pay a higher tax rate) then when incomes drop not only do taxes go down but they go down even faster as people fall into lower tax brackets. Oregon is particularly vulnerable because it does not have a sales tax. California has been buffeted by this phenomenon – seeing wide swings in revenue as economic cycles pass through.

On the costs side economic recessions increase demand for state and local services and programs. These are part of automatic stabilizers, and help a bit with increasing aggregate demand. They cost money, however.

And yet, unlike the federal government most state and local governments are prohibited from running or planning a deficit. They must operate in the black, even in the face of seriously declining revenue and increasing costs.

Not a pretty picture.

Every so often, history serves up an analogy that’s uncomfortable, a little distracting and yet still very relevant.

In the summer of 1933, just as they will do on Thursday, heads of government and their finance ministers met in London to talk about a global economic crisis. They accomplished little and went home to battle the crisis in their own ways.

More than any other country, Germany — Nazi Germany — then set out on a serious stimulus program. The government built up the military, expanded the autobahn, put up stadiums for the 1936 Berlin Olympics and built monuments to the Nazi Party across Munich and Berlin. [...] Germany did escape the Great Depression faster than other countries. Corporate profits boomed, and unemployment sank (and not because of slave labor, which didn’t become widespread until later).

In addition to this analogy, which I recommend reading in more detail, there is an interesting graphic that helps understand the different approach the United States is taking to stimulate demand, versus its European partners.

Most industrialized countries have laws on the books that automatically increase government spending when the economy is slow. Spending on food stamps, unemployment insurance, and other benefits to poor people go up as more people qualify for assistance. And with a progressive tax rate system, a decline in income not only means lower income taxes, but a lower income tax rate. (The result taxes drop more rapidly than income.) We call these phenomena automatic stabilizers. The dark portions of the bars above show these automatic increases in government spending. The lighter colored portions show discretionary spending – which requires an act of the legislature. Great Britain and several European countries have stronger social safety nets, so their automatic spending is greater as a percentage of GDP. The United States is less. So, we are more likely to increase discretionary spending in hard economic times. The members of the European Union, as Leonhardt points out, have been willing to increase government spending, but not to the degree that we have in the U.S. There are more complicating factors – see Germany as an example – but this is an illuminating discussion.

The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones.

A good accompanying read is the Congressional Budget Office’s preliminary estimate of the impact of President Obama’s proposed budget. (CBO was organized in 1974, to give members of Congress an independent, non-partisan ability to project budgets and their impacts. Previously Congress had to rely on estimates provided by the Executive Branch.) The CBO’s director has started a blog, and this post nicely summarizes the CBO estimates:

As estimated by CBO and the Joint Committee on Taxation, the President’s proposals would add $4.8 trillion to the baseline deficits over the 2010–2019 period. CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.

CBO’s projections of future deficits are higher than those coming from the Administration. The differences are greater than rounding error, and point to the importance of having a separate group crunching the numbers.

The greater question, however, is whether this ballooning Federal deficit is good policy or not. Now back to Robert Frank’s comments. As he points out, there is a kind of quiet consensus that, in the short term, we must endure significant Federal deficits as we try to stimulate demand and climb out of the recession. The greater debate is whether the additional costs proposed by the Administration – that go beyond short term stimuli – are good investments. I happen to think so (in general – more details to learn) and there’s no question that Congress will do more than tinker with the plan. Even so, the deficit estimates are sobering.

This story and accompanying audio clip from National Public Radio features an interview with a member of the NBER committee, and is a clear, minimum-jargon description of the issues. As Jeff Frankel, a Harvard professor, notes – there are no formal forecasts for how long this recession will last, but at 11 months it is already longer than the recessions of 1990-91 and 2001.

After the terrorist attacks of 2001 deflated the economy, Mr. Lauder [Chm of the Estée Lauder Companies] noticed that his company was selling more lipstick than usual. He hypothesized that lipstick purchases are a way to gauge the economy. When it’s shaky, he said, sales increase as women boost their mood with inexpensive lipstick purchases instead of $500 slingbacks.

Part of their statement and deliberations include concern about inflationary pressures. So they have to balance the need to stimulate a sluggish economy with the need to prevent an inflation price spiral.

When the FOMC changes a target interest rate, there are some near term, almost immediate changes in a few, related interest rates. One example is the prime rate, which banks charge their best, usually corporate, customers for short term, unsecured loans. The prime rate follows the direction of the Fed Funds Rate target pretty closely.

The economic impact of these changes doesn’t hit right away, however. In fact it can take six to nine months for the impact to work its way through the economy. That means the FOMC is looking at current economic conditions, but it also is trying to predict what conditions will be like in six to nine months. They wouldn’t want a stimulus accommodation (lower interest rates) to hit just as the economy is picking up speed and adding pressure to inflation.

So, like duck hunters, the FOMC must aim not for where the duck is now; they must aim for where the duck will be.

Click to see 3′30″ video clip