“Good morning, our subject today is financial crises and policy responses. I’m going to focus mostly on the crisis of 2008, which seems like it has been going on forever.”
So begins Larry Summers in addressing the students attending the 10th lecture of the course “American Economic Policy” that he is co-teaching with Marty Feldstein and others.
“It was a scary moment and had substantial consequences. The US gross domestic product dropped by 10%, and today is estimated to be 10% lower than would be predicted by the pre-crash trend. That’s $1.7 trillion a year, or $20,000 for the average family of four. Unemployment reached highest level since the depression: 10% in the aftermath of this event, and even today there are several million more people unemployed or out of the labour force as a result.”
What I would like to do today is the most basic economics behind a crisis of this sort, and in the next lecture I give to use it to talk about policy responses to crises.
“The plan for today,” says Martin Feldstein as he begins his 8th lecture to the Harvard students enrolled in a course called American Economic Policy, “is to finish up my three lectures on monetary policy.”
It couldn’t come at a better time, because today [February 10th] Janet Yellen is offering testimony on monetary policy. The news stories seems to say she is “on the one hand and the other hand” in her thinking about the future. The labour market is improving, but she is worried about the future slow down because of economic developments in China. But our trade with China is less than 1% of GDP, so why change US policy?
The Fed has a problem, it is pursuing multiple goals, targeting low inflation but also maintaining full employment, but how do you deal with two goals when you have only one instrument? The Dutch economist Jan Tinbergen taught us that we need two instruments for two targets.
Well, I keep saying there is also fiscal policy, and the Fed should keep reminding Congress that they need help.
But operationally how does the Fed balance these competing goals?
Today we are continuing to talk about monetary policy. We have been discussing the issue of how the Federal Reserve Bank should respond to the extent of slack in the economy: when there is high unemployment, the Fed should be increasing aggregate demand, but at full employment more aggregate demand would lead to inflation. It is a difficult problem to find this balance because of lags in the process and host of measurement issues.
I’m going to start talking about monetary policy today, and continue with it in the next lecture, and again next week.
So think about the Federal Reserve, and their decisions directed to monetary policy. They have just met, and decided not to change anything, but they are looking ahead to March to see if they will raise rates as they did in December.
They know where the economy is, and where it has been, and infer where it is going in order to decide to do something to nudge it in one way or another. So I have handed out a sheet, a bit of information certainly used by the Fed, and the investment community in trying to decide what are they going to do.
Table 1 on the left hand side of the sheet shows what happened to GDP and its components in the last two quarters, based on what was released on January 29th. Table 2 on the right hand side shows the contribution of each component to the change in GDP.
The Fed likes to say that they have a plan, but what they actually do is data dependent and they are adjusting policy accordingly. Here is one example of new data, and we have to recognize that there are problems with actually measuring real GDP.
What do I learn from these numbers? And if I were at the Fed I would have to recognize measurement problems in trying to interpret them.
I missed class on February 4th (my bad) when Martin Feldstein of Harvard University gave the 4th lecture of his course “American Economic Policy,” but fortunately my classmate Matthew Tyler took notes and kindly accepted an invitation to post them as a guest on this blog. He also offers some personal reflections on what it feels like to be a left of center observer in a class taught by a self-avowed “conservative economist.” You can reach Matthew on twitter @Matt_B_Tyler .
Feldstein takes to the podium on a relatively mild Cambridge morning for this term’s fourth American Economic Policy lecture. The crowd has thinned slightly since day one, although the rapid tapping of laptop keys throughout suggests those who remain hang on every word. Like sponges, the economists of the future are absorbing the insights of a distinguished five decade career. Today, these eager young minds cover much ground: reflections on the Obama administration’s response to the great recession; the accuracy of real GDP measures; and skepticism regarding the size of the inequality problem in the United States.
It’s December 2008. The National Bureau of Economic Research has just declared the American economy has been in recession for almost 12 months. Both fiscal and monetary policy responses are falling short. $78 billion of tax rebates introduced by President Bush generated only $20 billion of additional consumer spending which was far less than the multiplier predicted by Feldstein, Summers and others. Similarly, traditional monetary policy is not working as the crisis was not caused by rising interest rates.
[In this third lecture of his American Economic Policy class at Harvard given on January 29th, Martin Feldstein explains how he and the profession turned away from Keynesian economics, and how he made his way back.]
The estimates are seasonally adjusted and expressed as annual rate after controlling for price changes. Growth was pretty crummy at an annual rate of 0.7%, down from an annual rate of 2.0% during the previous quarter. Should we be worried? Are we slipping into a new recession?
Consumer spending was growing at 2.2%, contributing 1.5% to GDP growth, and residential construction was good. But fixed investment in structures and equipment was negative and pulled growth down, as did exports and changes in inventories. These negatives added up to 1.2, the pluses to 1.8, so we are left with about 0.7% for overall growth.
This gives you a picture of what was going on. The folks at the Fed have to ask if they will keep raising interest rates.
This is the great thing about being in economics: there is always new stuff happening and new information being released to help you figure it out.