Economics and Finance Symposium - Economic Policy Challenges: Macroeconomics and Fiscal Policy

FITZGERALD: I'm Deborah Fitzgerald. I'm the dean of the School of Humanities, Arts and Social Sciences here at MIT. And it is my pleasure to welcome you to the afternoon session. I want to say how delighted I am that our school is one of the co-hosts of this terrific event.

And before I say more, I want to just make a couple of thank-yous, first of all to David Mindell and to the 150th Committee, who have conceived of the idea of having these six symposia to highlight the scholarly and really practical aspects of research and education at MIT over the last 150 years. They've done a fantastic job, and I thank them very much.

I want to thank also Jim Poterba for his remarkable organizational skills, his sense of humor, his powers of persuasion-- which many of you have experienced-- his sense of humor, and his grace. He has really been the mind behind this, and he's just done a fabulous job as well.

Economics is one of 10 departments in the School of Humanities, Arts, and Social Sciences. It is the largest department. It has the most faculty. It has the largest undergraduate majors. And it has the largest number of graduate students. It also has the most Nobel Prize winners of all of the departments in my school, oddly enough.

All 10 departments in the School are dedicated to the education of MIT students. Each student at MIT-- each undergraduate-- is required to take eight classes in these fields, humanities, arts, and social sciences, which is quite high by peer standards. And so we see a lot of undergraduates in our school. From all fields across the board, MIT undergraduates tend to gravitate to the Economics Department, drawn by its illustrious faculty as well as by the rigor of the classes that they encounter.

MIT students, in my experience, tend to scoff at material that is not very difficult. And they find in economics a more than adequate challenge to their considerable abilities. I want to note too that there are a lot of MIT undergraduates and graduate students in the audience today. And I'm really delighted that you were able to join us.

Today we're honoring not only the economics field and the Economics Department but also, as this program indicates-- as you see the graduation dates of many of the speakers-- we're also honoring the extraordinary students who have graduated from this department. Like their faculty mentors, these graduates have exerted an impact on the profession and on the world that is really, I think, unmatched, transforming the domains of scholarship, of policy, and of business all over the world.

As this symposium makes clear, while there's a lot to celebrate today in the world of economics, there do remain many challenges in this sphere. And these are challenges that I believe MIT intends to meet.

So again, I want to welcome you to the symposium. And I will now turn things over to Ricardo Caballero. Thank you.

[APPLAUSE]

CABALLERO: Thank you, Deborah. The afternoon is slightly different from the morning. The idea is to discuss policy challenges. And the first of the two panels will be about macroeconomic policy.

The timing of this panel, weather aside, couldn't be better, no? The developed world is still struggling with the aftershocks of an extremely severe financial crisis. In the US, the debate is whether stimulus is still needed or whether the time has arrived to shift the focus to long-term sustainability issues. In Europe, the risks run deeper, and even the future of the euro itself is sometimes doubted by markets-- not by the IMF, but by markets, certainly.

These realities of the developed world contrast sharply with those of emerging markets in China and India in particular, where output gaps have closed and inflation and overheating concerns have reemerged. To illuminate us on these decoupling issues and other fascinating macroeconomic policy issues, we have assembled a superb panel. They have in common to be world-renowned academics and policy makers, and to be also graduates from the best economics PhD program in the world.

They need no introduction. They'll speak in almost nearly alphabetical order. Olivier Blanchard will first give us a global perspective. And then we'll get into specific issues-- emerging markets-- by Pedro Aspe, PhD '68. Do I have it right, Pedro?

ASPE: '78.

CABALLERO: '78. Oops, sorry. I knew something was wrong. I knew something was wrong. And Olivier was PhD '77. Then Bob Gordon, who is replacing Alan Blinder, is a PhD '67. Paul Krugman, who is not here but should be online, is a PhD '77. Greg Mankiw, PhD '84, and Christina Romer, PhD '85. So without further ado, Olivier, the world is yours.

BLANCHARD: I wish.

[APPLAUSE]

Good. Let me first say how happy I am to be back here, if only for one day. It's a very special feeling. Given my current job, as most of you-- I've been the chief economist at the IMF now for two years and a half. I was asked to give you a sense of the global landscape. And that's particularly easy for me to do at this point because two days ago, we published the World Economic Outlook update. So I still remember the numbers, which I will have forgotten probably by next week.

So the headline, if it has to be short, is the global economic recovery continues. And on the surface, the numbers actually look quite good. For example, global growth, growth for the world economy, is forecast to be at 4.5% this year, 2011, which is a fairly high number.

But below the headline, the reality is quite different. The global number is a bit misleading. What we have is what we have called, and many others as well, a two-speed recovery, depending on where you are in the world.

If you look at emerging market countries, and I'm sure Pedro will say much more about this, then they are doing very well. The growth rate that we forecast for 2011 is 6.5% for the group of emerging and developing economies. And as you know, if you go, for example, to China, the forecast is now of 10%. If you go to India, the forecast is of 9%.

Now, it's not only that. It is that this is a statement about the growth rate, the rate at which countries' GDP goes up. But there's also the question of how close we are to potential and why, in the crisis, they went away from potential. Output was lower than potential.

They are now, for many of them, not all-- for example, not Mexico yet. But for many of them, they are basically back very close to potential. And some of them seem to be crossing the line at fairly high speed, so that the challenge for these countries is really just to limit overheating, slow down so as to maintain growth which is consistent with what they can do. In the medium term, their challenges are going to be how to limit inflation, asset price bubbles, and so on.

Now, if you turn to the advanced countries, there the picture is much worse. The growth rate for the set of advanced countries for 2011 is 2.5%. That was actually one of the themes in Davos yesterday. I was not in Davos, but I read the newspaper. It was that within that 2.5%, there are actually two numbers. There's the US, which is growing at 3%. And there's the Euro Zone, which is expected to grow at 1.5%. These are very low numbers.

And again, these are not only low numbers. They're basically more or less normal growth rates for those countries in the sense of what we had seen earlier. But these countries have a very large output gap. And they are operating very far below potential.

Unemployment is very high in some countries, as you know, close to 10% in many countries. And given the kind of forecast we have, this implies that the unemployment rate is going to remain very high for many, many years to come, far beyond the technical horizon, for example, of the World Economic Outlook, which is two or three years. And that's going to be, I think, a very, very big issue.

So this is the general landscape. And I thought I would pick a few issues which are both very hot and very important. And I've chosen two. Another one, which I will not mention but I suspect Pedro may, is that of capital flows. But that I'll leave aside in the interest of time.

The two big issues I see-- the first one you're all aware of-- is what's happening in what's known as periphery Europe, which is a set of countries typically in the Euro. And there, [INAUDIBLE] trouble. I'll come back to it. And then the other issue I want to take up is not the fight, but the tensions between China and the US, and see what it is based on and where it's going.

So on periphery Europe, I think an important point to make is that the countries which are in trouble-- so just to be explicit, surely Ireland and Greece, and Portugal and Spain being not very far from it-- would have been in trouble had there been no global crisis. Basically what happened is that when they got into the Euro, and indeed in some cases before they got into the Euro, they thought that their future was very, very bright.

First, these are countries which used to be able to borrow at very high rates because of a large risk premium. The fact that now they were going to be members of the Euro meant that they suddenly were able to borrow from the rest of the world at a very low interest rate.

And then they had been told by economists that when you join a common currency area, your productivity growth just jumps up, and the future is very bright. And it turned out that was not true, that basically they entered, and their productivity growth did nothing. In some cases, it actually decreased.

So in all of these countries, what happened is at some point, they could continue to borrow. But they realized that the assumptions under which they had borrowed were no longer satisfied. And there was a retrenchment of spending in some countries-- private spending-- in other countries, public spending. But basically just a fairly major recession.

As a result of this recession, on top of a global crisis, then there was a fiscal problem which basically appeared. In most of these countries, the fiscal problem is really the result of the macro adjustment rather than something separate. There is one country where clearly there was fiscal misbehavior even before the crisis. That's Greece. So Greece is combining both a true fiscal problem to start with and a macro problem, which makes it much worse.

Now, this is history. The question is, what happens now? And it's clear that the markets are worried about whether the governments of these countries will be able to repay the debt, or repay the debt in time. And by implication, they worry that the banks which hold the stuff, which hold the sovereign debt, may also have serious problems. So we have the interaction between sovereign and banking problems, and spreads basically are very high on both in some of these countries.

And so the question is, what can be done? Is it hopeless? Is there some hope? Let me describe what I think should be done. And that's going to be normative. Then I'll turn to the descriptive, what's likely to be done. And let me give you the answer to the second part, which is, I think what will be done is what should be done, except a bit late. This is the way Europe operates. So I think by giving you the normative--

CABALLERO: Is it the same?

BLANCHARD: Yeah, it's the same thing, just three months later. We'll come to the debating part later, right? So let me tell you. Many, many people, and international organizations, and the EU, and so on have said, well, Europe has to have a comprehensive package. But it's one of these magic words. I mean, you say we need a comprehensive package, but the question is, what is it?

I think it has three parts. There are things which need to be done very urgently. There is, on the part of investors, a lot of skepticism that the banks have told the truth about their balance sheet. And many investors believe that in fact some of the real estate loans that they have are really worse than they said, that the proportion of sovereign debt that they hold is off the books, and so on and so on.

So it is absolutely essential. I think the investors are probably pessimistic, but the only way to disprove their fears or allay their fears is basically to make these balance sheets more transparent. This is known as the need for stress tests. What's important is not really the stress test part. It is really just the understanding of the balance sheets of the banks.

And I think that's terribly urgent. I think when this is done, the markets will realize that the numbers needed to recapitalize the banks are actually not enormous. It has to come with plans to recapitalize them, if needed. That's also not quite in place yet, and that's very urgent.

So I think this is what has to happen over the next few months. At this stage, in line with the remark I made earlier, there is a plan to have stress tests done by June or July. And I'm not sure that the time is there to do that. But that is clearly something which needs to be done.

The second is looking at the medium run, not just the next few months but the next few years or beyond that. There is an expression in French which I like very much, which is, donner du temps au temps, which I translate by "giving time to time." Which I think is actually quite important in this context.

I mean, it is very clear that the adjustment process that these countries will have to go through, both on the macro and the fiscal side, is not going to be over in three years, in five years. It will probably take 10 years before these countries actually get back to health.

I think we have to understand it, and we have to understand that the initial period is going to be a very tough one. It's going to be one of fiscal consolidation in an adverse environment, probably with negative growth, which we're seeing. And eventually things will turn around. And eventually, we hope, things will get back to some kind of normal.

Now, I think it's much too early to basically decide that this has failed. So far, for example, for the programs-- the IMF has two programs, one in Greece, and in Ireland. So far, the numbers are turning out as we forecast, and aren't great. But things are not worse than we anticipated, and the government is delivering on the fiscal actions that it has to take, the structural reforms and so on. So I think that's very important, to have that time horizon in mind and not just to panic.

Now, you have to take out of the picture the panic scenarios, which are always present. This is an environment which is rife with multiple equilibria. If the markets decide that you're not going to make it, then they decide that they have to charge a much higher interest rate. And then the debt dynamics are such that you have absolutely no way of paying back, and therefore the markets were right to decide that you could not.

So it's very important to eliminate, I think, these multiple equilibria for the time being. And what this means is that the countries have to know that as long as they are taking the right measures, they'll be able to borrow at an interest rate which is not too high.

And that's exactly what the IMF programs do. They say, you can basically borrow, in the case of the two countries I mentioned, that you can borrow at between 5% and 6%, for sure, for the next two years, and then we'll see. So this eliminates the possibility that they have to pay much more, at least for the time being.

The other thing which has to be done-- and the ECB is not eager to do it, but has done it and has to continue to do it-- is once these programs are in place, then the ECB has to provide liquidity to the banks. Because again here, you have the possibility of multiple equilibria, which is people believing the banks are bad, taking their money out, and making the banks collapse. There, the ECB so far has been basically providing liquidity, lending against collateral, and has to continue to do so.

The last point on this is that time to time is good, but things have to happen meanwhile. I've talked about the fiscal and structural measures, but more has to be done. And there has to be rules about what we call burden sharing. Which is basically if somebody is not going to be able to repay, who among the creditors takes the hit? And that's true both for sovereigns and for banks.

And at this stage in Europe, these rules are not ready. They have to be put in place. It's very delicate to do from a communications point of view because every time you talk about it, the markets get very edgy. But it is essential to do it. Under the scenario I've given, there is time to do it, but it has to be done.

So is this going to happen? Well, one can always think of other scenarios. I think there's a good chance it happens.

I think that if, for example, just to take an example, if Spain decided that it needed a program, and there was not enough money in the funds which had been put aside by the European Union to help Spain, then I'm quite sure that the Germans and the French would discuss, and it would be messy, but eventually the funds would come. I think that basically India-- and that's what I said earlier. India and, I think, Europe does what is needed. It just doesn't do it as quick as one might dream.

So this was the first issue. Let me turn to the second and last one, which is the US and China. Why is it that they seem to be unhappy with each other?

I think the way to start is to think about the US and to think about what was driving growth before the crisis in the US. And what was driving growth before the crisis in the US is so-called US consumers. Basically, US consumption was the driving force for-- the household saving rate had gone nearly to zero. It was driving growth.

Crisis has come. People have realized that it is unwise to save on the assumption that asset prices will go up by 20% a year. So the US consumers, lo and behold, have basically started acting reasonably, rationally. And the saving rate has increased in the US from very close to zero to something like 6%.

Now, that's a very good thing in the long run. But in the short run, as we teach in 14.02, that creates a problem of demand when people save more. And so something has to come in in order to sustain growth from the demand side. If it's not consumers, who is it going to be?

Well, so far it has been fiscal policy, which basically substituted higher private saving with larger public dissaving, larger deficits. But we all understand that that cannot go on forever. So there is a limit to that. What else can come? Investment can come, but at this stage, it can help for a while. It cannot help permanently. We had a reasonable investment level. It's hard to think it can be much higher for very long.

And so if you just take the identities, what has to happen is that sustained growth in the US, looking forward, say, five years or more, has to rely on an improvement in net exports. Or put another way, the US has to decrease its current account deficit.

Now, identities are kind of useful here because they tell you, well, if the US must improve its net exports, then some other countries, the rest of the world, must actually do the reverse. So net exports have to decrease somewhere in the world. Or another way of saying this, current account surpluses have to decrease somewhere else in the world. And the question is, well, who? Who does it?

And there, all eyes turn to China. Why? Because it has a very large current account surplus. And it is not the only country to do so, but it is very large. And so there is the notion that China should, for the sake of the US and for the sake of world growth, decrease its current account surplus.

Now, as luck would have it, that's also something that China wants, for very different reasons-- not particularly to help the US but because they think it's good for themselves. Because at this stage, what the current account surplus of China indicates is growth which has been based very much on net exports and not very much on domestic consumption.

And what's happening in China is that there's a feeling that domestic consumption-- partly for social reasons, partly for political reasons-- has to increase. So China actually wants to change its growth path from net exports towards domestic consumption. And that would be good for them, and it would be good for the US for the reasons I gave.

The problem is that they are not eager to do it very quickly. Because for them, it's a very large economy. It's a very large change in direction. They don't know how it's going to work. They know how to export. They are not sure how to basically satisfy the domestic market.

So their approach is to say, well, let's increase domestic consumption. Let's increase domestic demand. And if the economy starts overheating because we're still producing a lot of exports and now satisfying domestic demand, then we'll do something. And probably what we'll do in this case is let the Yuan appreciate so as to basically shift production towards domestic demand.

Now, what they have in mind here is for the end horizon of many years. They just don't want to do it quickly. But the US needs it fairly urgently. And so the tension at this point is really there, which is the US would like China to appreciate now, which would allow other countries which worry about competitiveness with China to also appreciate. This would start the process now. And China would like to do it, but at their own pace, which is probably a few years down the line.

So it's not as if the two players are totally at odds. But there's this problem of timing, which is a serious one.

So just to end, what happens if this is not resolved? If net exports do not improve in the US, I assume that Greg and others on this side will talk about it.

And well, then the US is confronted with a very difficult choice. Either it does fiscal consolidation-- but there is a risk that this decreases demand and slows down growth, which would be bad for the US, probably bad for the world-- or it continues to have very large deficits in order to push demand in the absence of the improvement in net exports. And then we get questions like the questions that we're now getting for Europe, which is, is the fiscal path sustainable? And there are reasons to think that one might want to worry.

So there are other issues in the world, but these are the two that I wanted to focus on. And with this I shall stop.

CABALLERO: Thank you very much, Olivier. Pedro?

[APPLAUSE]

ASPE: I am delighted to be back at MIT and to see my professors again. And I'd like to thank Jim Poterba and Ricardo for the invitation. Let me make three comments, one comment on emerging markets that Olivier referred to, how they are recovering. But then I will want to make a comment on the US and a comment on the indebted countries.

So first, on the recovery, as Olivier was saying, the emerging markets' recovery is here and is fast. And especially they're basically two speeds, as Olivier was saying. At the fast speeds, of course, China and India. But there are several Latin American countries, for instance, that are growing up around 6% to 7%-- Peru, Brazil, Colombia, even Mexico. We are lagging behind, but we're growing at 5%. So that's the emerging markets.

There are some laggards there too. In our continent, the emerging markets that are not growing are very easy to find. There's Venezuela, Cuba, Ecuador, Bolivia, Nicaragua. And it's perfectly easy to find zero growth or, as two of them, falling even in this year.

So let me talk a little bit about this growth of emerging markets. I think many emerging countries, we have learned the lessons from the previous crises. And I think there are some rules that are more or less accepted-- not all of them, but most of them will have.

On each part of the world, there's one emerging market which is the role model. In Latin America, it's Chile by far. We all would look at them. They were always ahead. And certainly Chile fulfills all these points. Let me go one by one.

One is the independent central bank. That's something that we have learned the hard way. Most of the emerging markets have gone that way. It's tough to do it, but finally we have it. And the reason is that you want to have a sound monetary policy, and independent from the government, and especially to keep inflation low. Why? Because we learned the hard way that when you have high inflation, to bring it down is too costly. So that's the first point.

The second lesson is trade liberalization. I think that's really, really, really important. And that's something that we have learned. It is a pain in the short term. But once you do it, you have permanent jobs, and you grow lots more, and you can grow faster without inflation. So I think trade liberalization is really one of these key pieces of policy.

By the way, I concentrate on liberalization of trade because the financial sector is a different thing. I will come back to that later.

Third, extremely important for emerging markets, the pension reforms. That's something that again, it was created first in Chile. Thanks god, I was minister when we copied that in Mexico. And 15 years later, 20 years later, it is maturing now. And so we have $180 billion of long-term financing for the first time ever. So the pension fund reforms a la Chilean is really important. Brazil has done it. Peru has done it. Colombia has done it. And this is really, really important.

The fourth, flexible or more flexible labor markets. There, you can learn the easy way or the difficult way. The easy way is that you convince everybody, and you pass labor reforms to allow more flexibility. The tough way is that you have so many crises domestically that finally the markets learn how to have contracts that are flexible. But this is very, very important.

For instance, in 2009 in Mexico, we lost, during the September 15, the Lehman, and the following 12 months, September to September, 2008, 2009, we lost almost a million jobs, 900,000. And the good news is that we have recovered them completely. But this flexibility is key.

Then another important thing is how the emerging markets behaved last year in terms of the stimulus. I think that the stimulus was clearly-- we used monetary policy a lot. And we used fiscal policy somewhat, but not a lot. It was lots more lower interest rates, maintain lower interest rates during the crisis. And that was, with some fiscal spending, very focused, very focalized. And I think it has come OK. Now we're dismantling this stimulus.

Finally, two points. Keep the public debt low because you need to keep the public debt low. In Latin America we have a rule of thumb, which is once it reaches 80%, you don't grow. And there are a lot of countries that are reaching 80%. And that's dangerous. Latin America, on average, it has 40. Chile has only 10%. Mexico has 30. Brazil has 55, 60. But that's really key. Once you reach the 80s, 90s, then growth immediately diminishes.

And finally, we have learned two things on the financial sector. And we have learned the hard way. One is, don't liberalize too fast. Be extremely careful there. And second, watch out with capital inflows. You will have to have huge reserves to allow this thing. And you have to be very, very careful. Thanks god, the new inflows are different from the past. They are more medium term than short term.

So we have learned the hard lessons because of mistakes that we made or because big triumphs that others did. But now it's a common culture that these things have to be there.

Let me make a comment on the world adjustment that Olivier referred to. It's key that the US diminishes this current account deficit. And it's key that China does the reverse adjustment that reduces its surplus.

And I think here the inflation fears in China will help because now that inflation starts being an issue there, you have two choices, the good one and the bad one. The good one is to revalue, if you have space. The bad one is to put the monetary and fiscal brakes and to dampen growth. So I think that the Chinese eventually-- at their pace-- but they will do the good one and revalue instead of putting the monetary and fiscal brakes.

There are some emerging markets that are having inflation problems, and they have used the exchange rate already so that they cannot appreciate anymore. And that's tough. They will have to use the fiscal and monetary brakes, and that's tough in the short term.

Finally, let me make a comment on those countries in Europe the have a lot of debt. I suffer. When I was minister of finance in my country, we were up the debt up to here. And it was horrible-- horrible! And it lasts forever.

I remember when I was coming to the US. And I was listening to Olivier, so I have to tell this story. We made a really good story and we said, we cannot take more debt. I mean, that's impossible that we take more debt. It would be highly irresponsible. So we come to Washington. I remember Jim Baker was the secretary of the treasury.

So I arrived and I said to him, look, I need you to listen to me for 20 minutes, the 20 reasons why we have a debt overhang problem, that we cannot ignore debt, et cetera, et cetera, and that we will have to face a debt negotiation.

And I remember it as if it was yesterday, that Jim Baker said, Pedro, come on, don't worry. Don't worry. You are our neighbor in the south and our friend, and we are going to give you financing. And I said, ay, ay, ay, ay, ay, ay, ay, ay, that's the-- no, no, I said, financing is more than-- no, no, no, financing is for growth. And you know? Okay.

I was reminded of that because Nicholas Brady, the later secretary of the treasury with whom we did finally the debt reduction-- and I was invited by the Greeks and the people in Europe to talk a little bit about the Brady plan. And of course, as Olivier was saying, the problem is the banks, no? It is not the US government problem. It is the US banks' problem when we have the problem, or the European problem.

And that takes time. That takes time. In the meantime, everybody is giving financing to them. And you look at the numbers-- impossible. Debt overhang-- horrible. The more it takes time, the more costly it is.

Let me tell you what happens in the second phase. So you take more financing, as we did for one additional year. And then the private sector, of course, knows very well this game and start saying, we're not going to give you any financing. So if you want to import anything, zero financing, zero trade financing. And then if you want to import, they say, ah, first you have to give me the financing, and then I will send you the goods. So really the squeeze on the economies are terrible.

So it takes time, I know, but for this debt overhang, the things we have learned is face them. Face them fast. Thank you.

[APPLAUSE]

CABALLERO: So next is Robert Gordon, who has kindly accepted to do this 10 minutes ago. So thank you very much, Bob.

GORDON: I'm delighted to have the chance to tell you much of what Alan Blinder would have told you if he had been here. And I know that because he and I have had active email exchanges over the past few months, identifying the small nuances in our generally overlapping views.

I try to think of two reasons why Jim Poterba might have chosen me out of the audience. I do have the requisite requirement of an MIT PhD, from 1967, the same year as Bob Hall. And probably just as important is that given my last name, if you replace Blinder by Gordon, the rest of the panel stays in the same alphabetical order.

[LAUGHTER]

I wanted to take off from two remarks I heard this morning, one by Bob Solow on macro in the 1970s and one by Bob Hall-- several remarks by Bob Hall-- on the causes of a long slump. Bob Solow identified a vacuum that occurred in the mid-1970s when Keynesian economics was confronted by an inflation the did not originate in excess demand, but rather from adverse supply shocks. That vacuum was filled with amazing speed.

And the MIT connection here is not particularly the articles that were written, promptly, to fill that vacuum but the fact that in the spring of 1978, two textbooks appeared that completely integrated supply shocks into Keynesian aggregate demand macro, complete with a formal dynamic supply-demand model, a diagram with inflation plotted against the output gap, with supply and demand curves in inflation space with the usual slopes. And those two textbooks were by two MIT professors, Rudi Dornbusch and Stan Fischer, who also had an MIT PhD, and then mine, also with the MIT pedigree.

Now turning to Bob Hall, I think it's interesting to see how we can take the traditional macro, a la those textbooks, and ask what sort of the minimum stuff we have to add in order to understand the crisis in the long slump. Well, we already started with a consumption function that depended on transitory and permanent income, a channel from interest rates to consumer durables, and a real net wealth effect a la Franco Modigliani.

The first thing I think we have to do is to make it clear that real net wealth is assets minus liabilities. And both are a problem for households and for consumer spending. Of course, we had the assets dragged down by the end of the housing bubble and the collapse of the stock market after October 2007. But we also had household liabilities rising from 90% of disposable income in the mid-'90s to a peak of 135% in 2007. So the households are sagging under all this debt while their assets are collapsing in value.

But we need a third channel besides interest rates and real net wealth. And that is something I would like to call credit conditions. And I'd like to illustrate it with a startling story from a mortgage broker friend who, believe it or not, is still in business.

He puts together deals and then presents them to banks, like Chase and other more obscure places, to try to get them approved. He reports that in 2005, only 5% of his proposed deals were turned down. And it's now 80%.

I checked his number with the chief economist of Wells Fargo, who I happened to meet a couple of months ago. He says for Wells Fargo, it's more like 50% to 60% turned down. So you have a quantitative credit constraint on top of the voluntary response of households to changes in real net wealth.

And I wanted to remind you that the Hall diagnosis is absolutely correct. You've got a demand side and a supply side. You've got the overbuilding leading to excess supply of houses, but you've also got the debt, which doesn't go away just because the house prices go down. And remember that each foreclosure raises the supply of houses by one without raising the demand for houses by anything, because the foreclosed household is not allowed to borrow to buy a new house.

It's very instructive to compare the recent episode with three earlier bubbles, the late '20s Japan and the US in the late '90s. There are a lot of similarities in the setup of the US housing bubble and 1927 to '29 episode, which involved not only the stock market. It involved residential overbuilding and a leverage-like phenomena of corporate holding companies, which translates in today's language into excess leverage.

Now, we know that the aftermath of the late '20s was a disaster, made worse by bad policy. We had a near disaster this time, with policy stepping into the breach in a very effective way. We know that Japan has had virtually two lost decades. Why was the stock market collapse of the late '90s different?

Simple word, leverage. The Fed had raised margin requirements from the 10% of the late '20s to a stable 50% during most of the post-war. So most of those stocks that were being bought in the late 1990s were not like the houses, with minimal down payments. People were putting up 100% when they were buying stocks for their retirement accounts.

So to replace Bob Hall's word "overhang" with the much more evocative word "hangover," here is our economy as I see it. We've got the household liabilities weighing down the consumer. We've got the end of cash-out refinancing. All this has led, as Olivier said, to a jump in the household saving rate, with more perhaps in line.

On the side of investment, we have the oversupply of residential houses. We have an oversupply people don't mention very often of hotels, office buildings, and other non-residential structures. And we have the well-known problems of the state and local governments, which have shed 200,000 employees in the past year. And they're just beginning. Cook County has mandated a 20% cut in budgets of every department. And that's just a small slice of the country.

So what do we do? Here we would turn to policy. I agree with Bob Hall that monetary policy has run out of tools. And in Alan Blinder's evocative language, thinking of World War I, we've run out of ammunition for the machine guns and the howitzers. We're in the trenches, and all we've got left to fight with are swords and throwing stones. So the Fed is pretty much out of the picture.

I might add, however, that the Fed failed in the housing bubble period to realize that it's got tools besides its blunt instrument of the Fed funds rate. The Fed controls marginal requirements for the stock market. It could very well have raised minimum down payment requirements, and it didn't. So Bob Hall's story, again, is lack of regulation, or actually a movement toward less regulation.

So that leaves us with fiscal multipliers. And I wanted to start with how do we estimate them. How do we know what they are? Robert Barro first brought my attention to a paradox, that the three big movements in government spending as a share of GDP that give us the potential to measure the effects all were connected with wars, World War II, Korea, and Vietnam.

And the problem is that while you don't have interest rate crowding out in those episodes, you do have capacity constraint crowding out. The government is literally crowding out industrial capacity and requiring that some kinds of production come to a halt.

So what do we do? Well, people for years have been looking at 1941 and seeing that the official unemployment rate was 10% and saying, oh, that looks like a good episode. There's excess capacity. What are the fiscal multipliers? And if you look at the annual data, they're very small.

Well, in recent research, and Bob Hall's student Valerie Ramey has played a role in this, it is possible to construct quarterly data by two different methods for 1940 and '41. And that is the classic period. The share of total government spending in GDP went up from 12% in June 1940 to 25% the day before Pearl Harbor. It more than doubled.

But the economy, the durable goods manufacturing sector, had run out of capacity in the last half of 1941. In quarterly data, both consumption and investment fell in the second half of 1941.

But if you stop your study of the multiplier in the middle of 1941, lo and behold, you get multipliers of two, very much like those that Alan Blinder and Mark Zandi found for the postwar economy. And very close-- I think Christy Romer will be glad to hear this because I think that kind of multiplier, around two, is what the administration was thinking about in making its estimates of the effects of the Obama stimulus.

Problem was, the Obama stimulus did not budge the share of government spending in potential output at all. It did not rise in quarterly data at all from the end of 2008 until right now. And that's because the very modest increases in spending achieved by the federal government was not enough to offset the decline at the state and local government level. Just about the same thing happened in the 1930s. The share of government spending and GDP in early 1940 was about the same as it was in 1934, a slide for state and local and a rise for federal.

So this leads to the question, what do we do? And monetary policy is out of steam. What do we do on fiscal policy? We have to pretend we're a benevolent dictator and ignore political paralysis. So this is going to seem like a dream world to even make some suggestions.

I would start with the Blinder-Zandi litany of multipliers, where the very, very bottom, with the lowest multiplier of all, is what President Obama was hinting at in the State of the Union speech. Cut the corporate income tax, a multiplier of about 0.4. At the very top of the list, with multipliers of 2 and 1/2, are extending unemployment compensation and making food stamps more generous, things that directly aim at the liquidity-constrained households.

So in addition to doing things for people who are living from hand to mouth, I think the payroll tax cut would be dominated by a new jobs tax credit. It's very hard to design, but not impossible. We did have one in the late 1970s.

And then we've got a problem about infrastructure. The problem about infrastructure-- and I'm an expert on this because the Recovery and Rehabilitation Act that Christy helped to design tore up the main street in front of Northwestern University all last fall. And I drove by every day. And Bob Hall was in the car with me one day. And I pointed this out to him, that there would typically be 10 machines and 5 workers. And God knows how much all this cost. Much of the Obama stimulus went to renting construction machinery rather into the wages of construction workers.

Well, that's enough provocation to get Christy and Greg going.

[LAUGHTER]

[APPLAUSE]

CABALLERO: Thank you very much, Bob. I have never heard you agreeing so much with Bob Hall, though. I'm very--

[LAUGHTER]

Anyway, now we will try to connect with Paul Krugman. Paul, are you there?

KRUGMAN: Hello? I'm here.

CABALLERO: Okay. We're all listening.

KRUGMAN: Okay. So I guess the first thing I should say is that clearly we have a major case for increased investment in the intercity transportation infrastructure because I am actually stranded in New York City at the moment.

So okay, let me actually weigh in here. In a way, I want to follow on quite closely on where Bob Gordon was. So my view of where we are, of what this depressed state of the advanced world is about, is pretty much what previous speakers have been saying.

I think it's not deeply mysterious. It is a problem of debt overhang. It's a balance sheet crisis. It's something that, if we didn't fully anticipate-- certainly nobody can really claim to have called this exactly as it was going to happen-- nonetheless isn't out of the realm of things that a number of economists have thought about.

And the whole setup, the problem of monetary policy at the zero lower bound, the problem of balance sheets constraining spending, is something that particularly those of us in the international macro area and those of us who pay a lot of attention to both Japan and to the Asian crisis countries in the '90s had sort of been worrying about, having nightmares about, for the United States for more than a decade before this thing actually happened. So we're in the universe, at least a part of the universe, that was very much a part of some of our imaginations before we got there.

What's really striking, and I think is worse than I anticipated, is the apparent inability of policy to really come to grips with this. And Bob Gordon said at the end about let's set the politics on one side. I'm going to not do that. I'm going to try and talk at least a little bit about why it is that we're in this state of paralysis.