Senate Budget Committee Hears Economists' Assessments of Federal Response to Financial Crisis

On September 22, the Senate Committee on the Budget, chaired by Sen. Kent Conrad (D-ND), heard sharply conflicting assessments about the federal policy response to the financial crisis from Alan Blinder, Princeton University and former Vice Chairman of the Federal Reserve Board, Mark Zandi, Chief  Economist for Moody's Analytics, and John Taylor, Stanford University and  Hoover Institution.
 
Blinder and Zandi published a paper "How the Great Recession Was  Brought to an End" in July, 2010 that is attracting a great deal of  attention. In his introductory Chairman Conrad noted that according to Blinder and Zandi's estimates the federal policy response pulled the economy back from the brink of another Great Depression. In the absence of the extraordinary policy measures taken in 2008 and 2009, there would have been 8 1/2 million fewer jobs at the end of the second quarter of 2010.   Unemployment would have been 16.2 percent instead of 9.7 percent. However, Conrad also noted that current record levels of government deficits are unsustainable and a credible long-term financial plan is needed to reassure financial markets.

Sen. Judd Gregg (R-NH), the Ranking Minority Member of the Budget Committee, agreed about the importance of adopting a credible long-term plan for reducing government deficits, but disagreed about the short-term benefits of the stimulus package.  He said the stimulus package was misdirected. Instead of focusing on capital formation, it provided "walking around" money for appropriators to support programs that would otherwise not have been supported. Uncertainty about increased health care costs, the creation of a new financial regulatory over-structure and possible increases in taxes were also depressing the economy, according to Gregg.  

Both Conrad and Gregg are members of the bipartisan National Commission on Fiscal Responsibility and Reform, which is supposed to make its recommendations to the President on December 1.  Asked for a brief progress report they said deliberations had a seriousness of purpose but had not gotten to the option stage yet.
 
According to Blinder, the purpose of the Blinder/Zandi study was to bring quantitative estimates to a debate over policy that "seemed long on rhetoric, short on analytics, and discordant with the facts." Blinder in his testimony discussed criticisms of the study's methodology. He and Zandi used the Moody's Analytics model, a large-scale econometric model of the U.S. economy, to estimate the effects of a lengthy list of fiscal and financial policies. This model is a statistical representation of the economy based on past history. This model has been criticized because it doesn't represent the economy's true structure, that policy interventions might change it and that it doesn't handle expectations very well. The work has also been criticized as "old-fashioned" by some academics who reject its Keynesian approach.

Jobs Deficit More Important than Federal Deficit

Blinder suggested old ideas are not necessarily bad ideas.  Both Adam Smith's Invisible Hand and the
Declaration of Independence date from 1776, he reminded the panel.  Blinder agreed with thoughtful critics of his work, such as John Taylor, that other models might give different estimates and welcomed alternative efforts to estimate the effects of federal policies. Blinder said that monetary and fiscal policies to spur immediate growth were necessary because the economy was sputtering and actual growth will not be high enough to reduce current high unemployment rates. He agreed that budget deficits are on a long-run path that will eventually require more revenue and less spending, but in the short-run the jobs deficit is more urgent than the budget deficit. He favored temporary tax cuts for new jobs and temporary public employment on relatively low-wage workers as a more cost-effective way of creating new jobs than the stimulus package.
 
Mark Zandi testified that the overall federal policy response was very successful in stabilizing the financial system and averting a 1930s Great Depression. Without extraordinary government action the economy would still be contracting, not hitting bottom until 2011.  Real GDP would have fallen 12 percent peak to trough, compared with an actual decline of 4 percent, and 16.6 million jobs would have been lost, about twice as many as actually were. The policy response was very expensive, but the cost of not responding would have been significantly more expensive, Zandi argued. He defended the Moody's Analytics model as a mainstream econometric model used for twenty years by a large number of non-financial corporations, financial institutions, regulators and government agencies for forecasting, scenario analysis, and quantifying the impact of policies on the economy.
 
According to Zandi the timing of various aspects of the response and the subsequent performance of the financial system and the economy suggest that these policies were very successful. For example, the credit spreads, i.e., the spread between the three-month interbank lending rate and three-month Treasury bills (the TED spread); the spread between fixed mortgage rates and 10-year Treasury bonds; and the spread between below-investment grade corporate bonds and Treasury bonds, rose to record
levels during the crisis, but fell sharply with the adoption of extraordinary financial policies. The TED spread rose from an already high level of 100 basis points to over 400 basis points when Congress failed to pass the Emergency Economic Stabilization Act - the $700 billion Troubled Asset Relief Program (TARP) legislation - and then declined shortly after Congress reversed itself and passed TARP a few days later.  The TED spread hit an all-time high and then declined sharply on October 13, 2008, the day the FDIC federally guaranteed any debt issued by qualifying financial institutions. The timing of further declines in the TED spread matched the adoption of the zero interest rate policy by the Federal Reserve and the bank stress tests.

Delay Tax Hikes Until 2012?

The National Bureau of Economic Research found that the Great Recession ended on June 2009, Zandi noted, the month the fiscal stimulus reached its maximum.  In addition, Zandi indicated that the free-fall in production and jobs in the US automobile industry both bottomed out August 2009, the date the cash-for-clunkers program was in full swing.  Given the fragility of the economic recovery, Zandi would not increase any taxes now.  He recommended delaying any tax hikes in 2011 and then phasing-in higher rates on upper income households beginning in 2012.  He recommended temporarily reducing the payroll taxes of businesses for new hires and more aggressive lending by Fannie Mae and Freddie Mac.
 
Taylor criticized the Blinder/Zandi study because it runs the federal stimulus through one model but does not compare these results with what actually happened or discuss the results from other more modern models.  For example, the evidence from models used by an International Monetary Fund study finds government spending impacts that are a fifth of those found in the Zandi/Blinder study.  In general, Taylor argued, old Keynesian models like Moody Analytics show large effects for government spending and more modern models that take account of expectations of the future show much smaller effects.

He asserted that we need to go beyond the models and examine the actual data, which he has been doing as part of a research project at Stanford over the last three years.  This project provides a comprehensive empirical evaluation of policy based on empirical studies of the individual components of the stimulus package and based on economic theory.  His bottom line is that the federal policy response did not stimulate the economy much if at all and left it burdened with debt and with concerns about future tax increases. Programs like cash-for-clunkers and subsidies for first-time home buyers moved purchases forward by a few months, but did not increase economic growth on a more permanent basis.
 
The stimulus package did increase people's disposable income by sending checks, temporarily increasing tax credits and reducing withholding, but aggregate personal consumption expenditures did not increase by much if at all.  Taylor emphasized that this is what well-known economic principles,
i.e., the permanent income theory and the life cycle theory of consumption, would predict from temporary payments. Neither, he indicated, did the government purchases part of the stimulus package stimulate economic growth.  Changes in government purchases did not correlate with the changes in economic growth from recession to recovery.  One reason for this is the part of the $862 billion package devoted to federal infrastructure projects is quite small - $2.4 billion on infrastructure spending or only three tenths of a percent of the total.  Federal grants to the states were a large part of the stimulus package, but both government infrastructure and government consumption purchases at the state and local level have declined since the economic crisis began.
 
Taylor evaluated monetary policy in response to the crisis during three periods 1) pre-crisis August 2007 to the panic in late September 2008; 2) the period of the panic from late September through October 2009, and 3) the post-panic period.  According to Taylor the confusion about ad-hoc bailouts and about TARP led to the severe panic. The FDIC bank debt guarantees and the clarification that the TARP would be used for equity injections were the major reasons for the halt in the panic. The large scale asset purchase programs during the post-panic period have had mixed results. For example the Fed's $1.25 trillion mortgage backed securities purchase program had a rather small and uncertain effect on mortgage rates once one controls for prepayment risk and default risk and it could, Taylor suggested, restraining the recovery.

Keep Existing Income Tax Rates Permanently?

 
Looking forward Taylor argued that existing income tax rates should be made permanent, the worker's tax credit proposed by President Obama should be permanent and not temporary, and the government should adopt a credible plan to balance budget.
 

Conrad said this was exactly the type of serious debate on economic policy the country needed and asked Blinder, Zandi, and Taylor to comment on the testimony.  Blinder questioned the budgetary and political feasibility of permanent cuts in income taxes.  He said that in some cases temporary
policies such as temporary liberalization of depreciation have stronger effects by pulling spending forward.  Zandi agreed with Taylor on the need for consistent and clear policies. The financial crisis, he remarked, was caused in part by treating each financial institution that requested a bailout differently.  But how can you go through a financial crisis like this and not have regulatory reform?

Taylor said temporary policies won't get the economy growing again because they won't provide the necessary incentives for work and investment. He noted the massive increase in government purchases as a share of GDP from 18.2 percent in 2000 to 24 percent in 2009 and the Congressional Budget Office  projects the government's share of output will rise to 30 percent to 40 percent so there is a lot of room for spending cutbacks.
 
Gregg criticized the Obama Administration for not coupling the short-term policies to address the financial crisis with long-term plans.  Blinder said he was part of the Clinton economic team at the
beginning of that administration and it would have been a tall order for the Obama economics team in its first six weeks in office to both address the short-term financial crisis and come up with a credible long-term plan to balance budgets.

Sen. Debbie Stabenow (D-MI) asked what policies should the nation adopt to help manufacturing. Blinder said manufacturing is the most cyclical component of GDP and is already rebounding from the Great Recession.  He also pointed out that there has been a significant decline in the role of manufacturing over the last fifty years in the United States and in every other developed country, which he expects will continue. He recommended a carbon tax that starts at zero and rises on a predictable schedule as a stimulus to the development of energy saving techniques by US manufacturing.

Zandi disagreed with Blinder about the future prospects for US manufacturing. The manufacturing businesses that have survived the Great Depression have been tested and provide a good solid basis for growth, Zandi noted. He recommended accelerated depreciation, pressure on the Chinese to devalue their currency, and private/public sector partnerships to rebuild US infrastructure.
 
Sen. Jeff Sessions (R-AL) suggested the departure of most of the Obama Administration economic team leaves us with more uncertainty. He asked Taylor if he agreed with the testimony of Gary Becker and Kevin Murphy in February 2009 that the net stimulus from increased government spending will be modest. Taylor agreed with Becker and Murphy and said that budget restraint needs to start now if any long-term plan for reducing budget deficits is to have credibility.

NAS Research Universities Panel Holds First Meeting

When the National Academies' released Rising Above the Gathering Storm in 2005, the report provided Congress with a blueprint for improving research and science education in the United States.  Congress adopted most of the recommendations in the America COMPETES legislation enacted in 2007.  Although the reauthorization of COMPETES remains stymied and the authors of Gathering Storm suggest that things have not significantly changed (see other story), all agree that America's major research universities must remain strong to overcome the storm.

In 2009, Congress prodded by the major higher education associations, asked the National Academies' to examine the future of America's research universities.  Under its Board of Higher Education and the Workforce, the Academies appointed an Ad-Hoc Committee, chaired by former Dupont CEO and current Bank of America Board Chairman Charles Holliday, to produce a consensus report, scheduled for release in May 2011.  Holliday noted the "eclectic nature of the group" and the importance of having business people on the panel.  Other members of the Committee include college presidents Teresa Sullivan of Virginia, John Hennessey of Stanford, Francis Cigarroa of the University of Texas System, and Heather Monroe-Blum of McGill.  Former Presidents James Duderstadt of Michigan and Walter Massey of Morehouse, who were also National Science Board Chairman and National Science Foundation director in the late 1980s and early 1990s, are also on the Committee.  There are other representatives from the private sector, as well as economists Laura Tyson of the University of California, Berkeley, and Ronald Ehrenberg of Cornell.

On September 21 and 22, the panel held its first open meeting to begin its consideration of the  following question in its charge:  "What are the top ten actions that Congress, the federal government, state governments, research universities, and others could take to assure the ability of the American research university to maintain the excellence in research and doctoral education needed to help the United States compete, prosper, and achieve national goals for health, energy, the environment, and security in the global community of the 21^st century."

Charles Vest, former President of MIT and now head of the National Academy of Engineering, told panel members that they should focus on specific steps. Like Gathering Storm, they should provide a blueprint for Congress to enact, for state governments to implement, and for the private sector to engage with.  He noted the changing world and the oft-cited examples of China and India, and their increasing interest in research and higher education, as well as the discouraging results of American students' achievement.  Yet, the American university system is still top rate, the only game in town for fundamental research, and produces the people who are going to move the country forward in the knowledge age, Vest concluded.  

                                                AAU and APLU Leaders Make Their Case 

Peter McPherson, President of the Association of Public and Land-grant Universities (APLU), and Robert Berdahl, President of the Association of American Universities (AAU), both testified before the panel suggesting according to McPherson, that "the funding of research universities is at a critical juncture given their significant impact.  It demands a national solution." 

Citing the decline in state appropriations to state colleges and universities and the lagging salaries of public universities' faculty, McPherson recommended:  1) keeping state funding at viable levels; 2) rebalancing the Federal-University partnership; and 3) seeking supplemental federal funding for items the states are unlikely to sufficiently fund.  In addition, public universities, McPherson asserted, should also play a role by "recommitting to our public purpose," including increasing retention and graduation rates, reducing educational costs, improving effectiveness, providing non-traditional routes for earning degrees, and ensuring public accountability. 

From McPherson's perspective, rebalancing the partnership means increasing the ability of universities "to recover a greater portion of the cost of doing research."  The supplemental funding, according to McPherson, could include a large doctoral trainee program resembling the 1958 National Defense Education Act, and a U.S. Chairs Program that would provide federally funded endowed chairs at universities across the country.

For Berdahl the current challenges to universities stem from the recent disastrous economic situation, the growing global competition in research and the growing attraction of foreign universities to international students, the changing demographics of the U.S. college population, the increases in tuition leading to growing indebtedness of graduates, and the difficulty in persuading decision makers of the importance of graduate education across all disciplines.

He recommended:  1) stop fluctuations in research spending - "set national goals and fund  research to reach them;"  2) recognize the federal role in graduate education; 3) support young faculty - more debt forgiveness programs to keep them in higher education; 4) federal support for facilities; 5) review regulatory requirements; 6) more incentives for private donors to provide support; 7) emancipate flagship state universities from state control - as state financial support dwindles there is no reason to maintain strong state regulatory oversight; 8) avoid mission creep in state institutions - not all can be major research universities; 9) state boundaries should not preclude regional inter-institutional collaborations; and 10) universities have to address the cost situation.

The Committee will have a colloquium to further discuss these issues on November 22 and meet again on November 23 and 24.  For more information go to:  http://sites.nationalacademies.org/PGA/bhew/researchuniversities/index.htm.