What Have We Learned about Macroeconomics from the Crisis?

Wednesday, December 14, 2011
Richard Clarida
C. Lowell Harriss Professor of Economics and International Affairs, Columbia University; Former Assistant Secretary for Economic Policy, United States Treasury
Olivier Blanchard
Economic Counsellor and Director of the Research Department, International Monetary Fund
Mark Zandi
Chief Economist, Moody's Analytics

Experts discuss the lessons learned during the financial crisis and the importance of federal economic oversight in addition to regulatory reform.

This meeting is part of the McKinsey Executive Roundtable series in International Economics, presented by the Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

JAMES HOGE: Good morning, everybody, and welcome. It's nice to have you here for this session. We have quite a terrific panel today and a very current subject that has long legs historically as well.

Our speakers are Olivier Blanchard, who's the economic counselor and director of the research department at the International Monetary Fund. There's much more to be said about Mr. Blanchard, but you have full biogs with your papers for today's session.

Richard Clarida is at the far end. He is the C. Lowell Harriss professor of economics and international affairs at Columbia University, and he's a former assistant secretary for economic policy at the United States Treasury.

And in the middle is Mark Zandi, who is chief economist of Moody's Analytics.

Now the topic for today's session—which is on the record, by the way—is: What Have We Learned About Macroeconomics for the—from the Crisis? We'll chat for 25 minutes or so, and then we'll go to the floor.

When we do go to the floor, please wait for a mic, put your hand up so I can see who you are, wait for the mic, tell us who you are and then ask one question nice and concisely.

As I said, it's all on the record today. And this is a McKinsey Executive Series—Roundtable Series.

The topic, as I said, is what we learned from—learned about macroeconomics from the crisis. So let's get started right there and see what our panelists think we have learned or what we still have to learn. Let's start on my left and work our way down.

OLIVIER BLANCHARD: Am I—(inaudible)?

HOGE: Yes.

BLANCHARD: Good. Thank you.

I think there's a cliche answer here which is that we had underestimated the importance of macrofinancial linkages, and that that was the thing that we've learned that was important. The natural reaction—(inaudible)—well, you just need to put that in and then we'll be back to normal. I think that would be the mistake. I think that in fact we've learned that the problems are much more serious with macro, (not ?) with the—with the world surely, but with macro as well.

Just a few points. My sense is that—something I've learned from the crisis is that many small distortions can add up to catastrophic outcomes. I mean, if you look at the financial crisis, it's partly the way rating agencies waited till acting with other financial institutions, it's agency problems in financial firms, it's mistakes in regulation—each of them looking relatively small but adding up to what we saw, which was very close to an economic catastrophe.

The implication is if you're in a world in which there's all these small distortions, then there is not one policy tool which is going to do the job. The Fed funds rate—moving the Fed funds rate up and down by 25 basis points is not the way to end that problem. You have a whole set of tools, regulatory, macroprudential and so on, at your disposal that you have to use.

And that's where things, I think, are infinitely complicated, which is that—understanding how to use this whole set of tools to address these problems. The mapping from the tools to the problems is incredibly complex. The design of the tools is incredibly complex. The use of the tools is politically very complex. And for example, you want to use the loan-to-value ratio as a way of slowing the housing boom, then you get all kinds of people who become very unhappy, and the political process comes in. So redefining the role of the Fed, redefining the role of the state is what is in front of us.

So I would say in general, we've learned that things are much more complicated than we thought before. I'll stop here.

HOGE: Mark?

MARK ZANDI: Well, thank you for the opportunity to be here. It's certainly a pleasure to participate.

I guess I'd say that—and maybe it's a variation of the theme—is that monetary, regulatory, fiscal policy, I think, during crises, need to be massive, creative and experimental. That has lots of implications, one of which is that some of the policy steps you take are going to fail, or they're not going to work. But the policy steps that ultimately are most effective end up being the most surprising, I think.

So for example, if I had to rank order all of the policy efforts to address the financial crisis in the Great Recession here in the United States in terms of effectiveness, the thing I'd put at the top of the list, I think, would be the bank stress tests. So back in early '09 we asked our banking system to go through a very substantive process. The banks had to—the big banks had to capitalize to loss rates that we experienced in the 1930s Great Depression. In fact, I think they had to take the cumulative loss rates—the two-year cumulative loss rates that existed between 1932 and 1933, and we had—the banking system wrote off 10 percent of its asset base in those two years. And they had to capitalize, in this crisis, to those loss rates.

Well, we got pretty significant loss rates in '09 and 2010, but they were 3 (percent), 4 percent, not 10 percent. So our banking system, at least in aggregate—and certainly the big guys, in aggregate, are very well-capitalized. It was a very transparent process. And ultimately, it re-established confidence. It immediately settled the financial system, ended the financial crisis, laid the foundation for the recovery that followed just a few months later.

HOGE: Mark, let me interrupt just on this point before we move on. You put stress testing very high on the list of things that should have and were done and were successful in the U.S. How about in Europe, where stress testing didn't seem to have the same impact?

ZANDI: Yeah, good question. Good point. And I think the European mistake or experience is that they didn't follow the American example. No, in the case of the U.S., the stress tests were stressful. They were transparent. I mean, I could go look at what the regulators were assuming about Capital One's credit card losses out the next couple, three years. You can't do that in the European context. And they were credible because you had the TARP backstopping the whole process, so if the banks couldn't raise capital in the private markets, they knew they would have to take, under punitive terms, capital from the government. So the Europeans—you know, they've gone through three rounds of stress tests and maybe more, but one back in the summer of 2010, 2011 and then most recently. And each round has been better, but even this last round doesn't even stack up to what we went through.

So I mean, my broader point here is that when I heard about the stress tests and that process back in early '09, I thought, oh, you know, what's this—(chuckles)—this isn't really going to—this isn't going to work, and it isn't going to make a difference. But at the end of the day, that experiment was incredibly successful, and now it's codified in our financial system.

We're all stress-testing all the time. It's not—and that—you know, this sounds like this is what we've always been doing from time immemorial. But, no, this is something that we've implemented over the last several years. And I think—I think it's because of the experimental process.

And I'll just end by saying what really surprises me is that this is actually the lesson of the—of the 1930s and the New Deal. If you go back and you look at what was done to address—(inaudible)—Great Depression, you know, it was—it was just a tremendous amount of experimentation that was going on. I mean, lots of things were just thrown up on the wall. A lot of things fell down; they didn't work. But ultimately, at the end of the day, that's what brought that crisis to an end.

So I think we've got to be able to—and willing to step outside the box in times of crises. And that's one of the key lessons that I've learned.

HOGE: Richard, massive—(inaudible)—our fiscal policy. Is that a lesson that we learned, or should be—(inaudible)?

RICHARD CLARIDA: Well, I'll come to that. Let me begin with a couple of observations. First, I'll resist the temptation to invoke an "I told you so" moment, and that's not because I'm shy or humble because I didn't. But I found that to be a liberating sensation because I can look at this as a scholar, and what I've learned and what I think the profession has learned. I'd make several observations.

The first is, economics and any social science is always about approximations. I believe Milton Friedman once said that if you want a truly realistic model of the economy, buy a phone book, all right? So we're always making approximations, and that—and that's fine. And some approximations actually work quite well for decades.

One thing that I think we've all learned—Olivier alluded to it, and so did Mark, but I'll be even more explicit—is what happened in the academic economics for about 25 or 30 years is essentially a divorce and segmentation of macroeconomics and finance. And I think one thing that we've learned is that that did not serve the profession or policymakers well.

I think the basic macro models that were in use at central banks and by academics and forecasters to study the economy were not bad approximations to the economy, and did not really steer policymakers wrong, under the assumption—which was an assumption—that you had a more or less efficient set of financial markets that were well regulated and supervised. And what—but these small approximation errors and mistakes that Olivier referred to get very big when you've got unlimited access to leverage.

So essentially, what happened during the great moderation—I believe Olivier coined that term—is we had low inflation and we had—and very low volatility and GDP, but at the same time, in the background we had this massive leveraging of the U.S. economy, the U.K. economy, at the periphery, in Europe. And I'm not going to say that that was entirely ignored, but it was certainly not on the front burner, because it was assumed that financial markets were more or less efficient and a particular issue such as counterparty risk and the inability to insure in times of duress were just, you know, assumed away.

So, you know, obviously, those are details that will be encountered being worked out. But the broad, broad theme is that we've learned that, as economists, we have to be careful with our approximations, and always testing how relevant it is to ignore, assume away different factors.

Another thing I'll bring it to, which is, you know, fiscal policy discussion, and one thing we've known for decades, approaching a century, is that there's always a tension between monetary and fiscal policy, or at least the independent conduct of monetary policy, in an economy that has very low inflation, very low interest rates, on the verge of deflation. Because, you know, central banks cut interest rates to zero, and then what? If you're after Lehman Brothers, with a 10-percent unemployment rate, and you cut interest rates to zero, what do you do?

Well, you essentially embark on a version of fiscal policy. And of course, the Fed—you know, Fed did that. You know, we had QE1, QE2; we had various programs. And I think that gets to the point that Mark made, as well. So again, the nice distinction that we would make in more normal times between monetary and fiscal policy, of necessity, oftentimes gets blurred in—you know, in crisis.

And I think I'll stop there.

HOGE: Olivier painted a picture of an awful lot of things that we have learned that obviously we're not performing satisfactorily; many of them highly technical, some of them small, but when you aggregate it all—big problem.

Two questions: One, how did we get such a backlog of things that needed to be addressed?

Was it because we were in such a period of affluence for so long? And secondly, how much of these kinds of problems that Olivier has raised are being addressed or badly addressed by the flurry of regulation that's going on? And how much has to be dealt with a different way?

BLANCHARD: The backlog, at least in the financial sector, came from the very rapid development—financial developments, and the intellectual backlog came from the fact that we did not identify what the problems were.

In terms of addressing it, I must say that regulation of the financial sector is terrifying in the sense that—I'll go back one step. One of the things I did before I went to the Fund is I worked on regulation of the labor market.

HOGE: Right.

BLANCHARD: And it's already very hard. It—how to do it is very complex, but you put in place regulations. If they don't work, 10 years later you see that they don't work, you adjust.

Regulation of the financial system is a game in which you have people on the other side who are as quick or quicker than you are, and the system is constantly changing, partly on its own and partly because of the regulation. And I think there's a deep question as to whether the—we can design good regulations for the financial system because, as soon as we design one that holds, because of the complexity of the issues, the system finds a way around it. You put the new regulation in place to take care of that, it creates another channel.

And the game between the regulators and the financial system seems to be of incredible complexity and there—there've been many mistakes along the way. We see them in what has been passed. Whether we can ever solve it is a question I have.

I mean, some people, they conclude that the system should be very simple, but I think that's an illusion. You can't have a very simple financial system; it will be complex and difficult to regulate.

HOGE: Now, I presume you also cannot have one that doesn't have periodic failures?

BLANCHARD: I think the implication is that there'll be other problems that will come down the line, yes.

HOGE: Mark?

ZANDI: Well, I think one of the reasons why these—

HOGE: I should have mentioned: Please turn off all your machines. It's get in the way of our mechanics up here.

ZANDI: One of the reasons why we had so many errors—and some of them were small, some were large, but they added up to something quite significant—I think, is because in part—and there are many reasons—but in part because no one was really charged with looking at the system in a broad context.

I think the general thinking, certainly at the time, back at the midpart of the last decade, was that the market could figure it out on its own, that it was self-regulating. And, you know, it's obviously not true. There were a lot of mistakes being made, and no one was really paying attention.

Now, one concrete example of that, I think, and perhaps one of the more important examples, is that the process of securitization was fundamentally flawed, that it had lots of moving parts and you had institutions and individuals that were involved in certain parts of the process, but no one looking at the process as a whole and thinking, does this make sense? Is this working in a proper way and are problems starting—going to start to develop? And it was that securitization process that, you know, took all that capital that was flowing into the country, into the developed world, and trying to allocate that in an efficient way, and it was just impossible.

I would also say that, even if you had a well-run securitization system, I'm not sure it would have succeeded, just given the amount of capital that was flowing in. But it clearly was flawed and—because, again, I think, regulators, policymakers—no one was responsible for looking at it.

Now, I think, we're taking a crack at that. You know, if you look at Dodd-Frank, for example, there's lots of things in Dodd-Frank: some of them good I like, some not so good. One of the things I do think is important is there's a process for systemic oversight.

So I now get calls regularly from folks at the IMF, from the institution that was set up to look at systemic risk as part of Dodd- Frank—Treasury's doing this on a regular basis—just asking, you know, what is going on here? What should I be worried about? What should I be thinking about? And that's not something that was being done before. And that doesn't mean we're going to figure it out, but—

HOGE: No, it raises—Mark, it raises, at least for me, a human nature problem, which is when things are good for too long, oversight really doesn't take them very seriously, and we have example after example of that in recent years.

Is the system that's being put in place now, Dodd and all the rest—is that—can that answer that question a little bit better than we did the last time around?

ZANDI: I think it won't address those animal spirit issues. I mean, they're with us forever, and that means we will have further financial crises in the future. At least we have a(n) institutionalized mechanism for trying to take a stab at it, and I think that's progress.

HOGE: Yeah.

Richard, among other things, how much do you support or agree with a lot of the complaints that are coming over the regulations that are being put in place post-crisis?

CLARIDA: Yes, let me say a couple of things on that. One, there's an old saying that, you know, generals fight the last war. And in my observation, in the past 30 years in the U.S., we're actually quite good at fighting the last war. So in the '80s we had a problem with bank lending to emerging economies, and we had the Brady Plan. So after that emerging finance went from being bank- intermediated through being arm's length in a—in a bond market. Then in the '90s we had the crisis in the EM—in the EM bond markets. Obviously, Long-Term Capital was an issue. And in—you know, in this crisis, 2007 and '8, a lot of—you know, a lot of hedge funds went under. That really wasn't the cause of the problem.

So I'm actually very confident that the next crisis, when it happens—and it will happen—will not involve opaque, levered CDOs, not because they'll be regulated out of existence, because nobody wants to buy them. All right. But as Rogoff and Reinhart remind us, there's a—just a human nature, following up on the question, to believe this time it's different. And the next time it will be different. I do think, broadly, if I were a policymaker, one thing I'd want to get right is to follow the leverage in the system and to assess which parts in it—which of my systemically important institutions are most vulnerable to that—to that leverage. And that's sort of a simple, you know, rule to state. It's probably hard to implement.

In terms of—in terms of the regulations, I think in broad scope, a lot of it has been left to the SEC and the Fed and the Treasury. And so there's a lot of discretion that policymakers have, and apparently the discussions on the Volcker rule—the draft is 145 pages—I haven't—I haven't read it—and so I—agreeing with Olivier, I think striking the right balance is tough, and it's not something I have to do right now. But certainly, where financial systems and economies are most vulnerable is that when there is a lot of leverage in the system, which in turn tends to bid up asset values, which in turn tends to make people complacent, and then it creates a systemic problem.

Just one last point on that: One, I think, big issue with the blowup in structured finance that we have to recognize is that it has revealed that relative to the size of the global economy and global financial markets, there is a true scarcity now of nominally default- free assets. Remember, five years ago you could essentially create an infinite supply of default-free assets through tranched securitization, you know, AAA pieces of opaque CDO deals. (Laughter.) And so those no longer really exist, or no one believes that they're AAA. Most sovereigns in Europe are no longer AAA. So we have the irony this summer of the U.S. being downgraded, losing its AAA rating, and the day that happened, U.S. bond yields fell. Why? Because the rest of the world was in even worse shape, and people, you know, flooded into the one market that they knew would not default nominally, which is the Treasury market.

So you know, an irony of this situation right now is that there's a lot of capital, and there's a lot of global—(inaudible)—financial system, but at the same time there is a scarcity of, you know, truly default-free assets, and that is distorting the system relative to where it was.

HOGE: You know, after every great recession or depression, if you will—Paul (Krugman ?) says we're in one again—a number of debates crop up, and one that comes up every time is between what you might call pro-growth stimulus and immediate austerity to get budgets under control. One flavor of that we hear a lot of is do the stimulus now, get the growth going, but let people know what—how debt reduction will be handled in the out-years. But others say no, no, this is crazy; the stimulus isn't really getting you the long-term changes you need, and austerity has to be put in to rebuild consumer confidence. Love to have some comments on that.

OK, go ahead.

BLANCHARD: I'm actually surprised by the intensity of the debate on fiscal policy.

I think most of us I think would agree on a number of things, which is that that levels have to be stabilized and decreased, that it will take some time. And the second is that under most circumstances, fiscal consolidation—which is a nice word for saying austerity—is contractionary. There's no question.

MR. : It's like collateral damage.

BLANCHARD: I think the hope that the fiscal consolidation is going to make people incredibly optimistic about the future, is going to lead to a boom in the economy next year I think is something we should give up. There are some cases in the world in which things were so bad when the government actually showed it was more responsible, things were better. But that's not where we are in the U.S. and that's not where we are in most European countries.

So it is very clear that we have to have the adjustment, and it's very clear that we don't want to do it too fast, because at this stage, too fast would mean negative growth and implications for bank health and also things that we care very much about. So it seems to me everybody should agree that the fiscal adjustment should be a long, drawn-out, credible, medium-term process, and that's what we should be working on.

And that people take extreme positions surprises me. And what worries me also is that under the pressure of markets—and that's true more of Europe than of the U.S.—governments feel that the way to satisfy markets is to actually have very strong, very fast fiscal consolidations. It does satisfy markets in the sense that when this is announced and is credible, markets go up. And then a few weeks later, a few months later, the growth implications come out. There's negative growth in the market, (say ?), well, your economy is in the pits, and therefore, we sell.

So markets are very schizophrenic, I think, also, very—they want fiscal consolidation but they care about growth. Governments respond to these demands from markets, fiscally consolidate. This kills growth and things are worse. So I think it's very, very important to realize that this is something which is going to take—you know, to get back to something like (50 ?)-percent debt-to-GDP ratio, which is probably too high, but a number we should try to aim at, is something which is going to take 10 to 20 years, in most countries, and that trying to do it in two or three years—not 60 percent—but have very, very sharp fiscal consolidations, I think, in Europe, is very risky.

ZANDI: I'd just second what Olivier said. I couldn't agree more. I'd just add that we can do both, and in fact we should do both, that we—when the economy's struggling and recession odds are uncomfortably high, we need fiscal policy to participate, or at least reduce the drag that fiscal policy might—the headwinds—the fiscal headwinds that might occur, so, you know—but at the same time be focused on our long-run fiscal health. So in the current context, you know, I think under current policy, under current federal fiscal policy, policymakers do nothing. Federal fiscal policy will subtract 1 1/2 to 2 percentage points from GDP growth in 2012.

A good economy would have trouble with that. Our economy today, given what's going on in the rest of the world, that's running a really large risk. And if we go back in recession, the cost to taxpayers will be measurably greater than anything we're thinking about contemplating doing here. So I think it's very prudent to take some of that fiscal drag off the table.

And—so for example, if we extend the payroll tax holiday, if we extend emergency UI, we take that fiscal drag from 1 1/2 to 2 percent down closer to 1 percent—it's still drag. We're still—it's still contractionary it's still a headwind, but less so, and we have a fighting chance of making it through this period without going back into recession.

Now, having said that, we should pay for it—meaning not pay for it in 2012, right, but pay for it over the next 2013 through '21 and smooth that adjustment in, as Olivier was saying. And thus you've done both things. You've—you know, you've addressed the near term and you've also addressed the long-term adjustment process.

HOGE: And the bill for that is in the range of 5 trillion (dollars) or so, best we can guess?

ZANDI: Which bill? There's many bills. The—

MR. : (Inaudible.)

HOGE: Budget reduction.

ZANDI: Well, under reasonable assumptions, there's general agreement between Democrats and Republicans—and I concur with this view—that we need $4 trillion in 10-year deficit reduction to stabilize the debt-to-GDP ratio. That doesn't mean we're going back to 60 percent.

HOGE: Right.

ZANDI: What that means is that we're going to stabilize—publicly traded debt-to-GDP is going to stabilize at 80 percent, 85 percent of GDP. That's our—that should be our initial goal, our target.

It's doable. In fact, I think we've done it, to tell you the truth. We got a trillion at the signing of the debt ceiling deal. We've got a trillion in automatic cuts that are coming as part of sequestration because the supercommittee failed. And the Bush tax cuts expire at the end of the year by law. And there will be a piece of tax legislation, but my sense is that we are going to generate revenue, tax revenue, at that point, and we're going to hit that $4 trillion target.

So I think there's—you know, odds are—you know, obviously, a lot of things can go wrong, and it's a political process. But I think odds are rising that we've actually achieved that goal, that very specific goal.

HOGE: Richard?

CLARIDA: Yeah, quickly, two points on fiscal policy: One—and I'm pretty sure Mark knows this, but to remind the rest of you, the CBO assumptions are very sensitive to an assumption that the economy gets back to its pre-crisis trend path of the level of GDP. If, as many of us believe, that at best we will continue to grow at roughly potential on average, which means we never get back to that pre-crisis trend, then the—which, by the way, evidence shows in other financial crises is often the case, at least over a 10-year window—then the implications for the—for the budget are in the range of 4 trillion (dollars).

In other words, if tomorrow Mr. Boehner and President Obama reach an agreement they could get through Congress for this 4 trillion (dollars), and at the same time CBO marked down its forecast in a range that I think is—that they could do at some point, that would wipe out all that deficit reduction.

So all these numbers are very sensitive to an assumption that we get back to where we would have been absent the crisis. And right now, in an economy growing at 2 (percent) or 2-1/2 (percent), that's not in prospect for some time.

The second point I'd make on fiscal policy is I think this is a case where rhetoric gets in the way of reality. In the U.S., because of the way that the political process is set up, unlike a parliamentary system in the U.K., it's actually hard for us to have a coherent fiscal policy, right? So we tend to go from year to year, budget cycle to budget cycle. You know, the sort of example of what we saw in the U.K. with a new government a year and a half ago where, with the majority that they had, the coalition, they were able to get in place something over a five-year window. So I think fiscal policy will continue to be a challenge in the—in the U.S., especially with divided government.

HOGE: Let me ask one more question. Then we're going to go to the floor, so get your questions ready. December 8th and 9th, Europe has a summit; the response to it has been less than enthusiastic. Today's headlines have lots of down measures coming—which raises the question of how much should we be concerned about contagion, not just between developed economies, some of which are teetering, but in the emerging economies on which people seem to be banking a lot to take up some of the slack, and ultimately, the really big economies in Asia, like India and China?

Mark, do you want to start?

ZANDI: (Chuckles.) I think we should be very concerned that --you know, in my baseline world view, where the U.S. is able to avoid recession in 2012—and I'm assuming the payroll tax holiday and UI is extended—my other working assumption is that Europe—that's in a recession, in my view—will suffer a mild recession; that the downturn is three, four quarters, it's a couple of percent of GDP from Q3 2011 to, say, Q3 2012. But for that reasonably sanguine scenario to come to pass, Europeans have to get it, you know, roughly right—now, immediately. If they don't and they suffer a more severe downturn in Europe, then it's going to be very difficult for us to—the U.S. to get through this without experiencing its own downturn.

There's a number of different linkages. The most obvious and most immediate is the equity market. I mean, the U.S. economy is very sensitive to equity prices, much more so than I think Europe and anywhere else on the planet. The banking system: lots of different links; not well defined, but, you know, I think that's important. And then, trade: You know, that hasn't kicked in at all yet, but that will as we move into next year.

So it's key, you know, that the Europeans are able to—I don't—I don't think they're going to be able to end the crisis—that's not going to happen—but at least be able to manage through it reasonably well so that their economy—the eurozone hangs together and the economy continues to move forward.

HOGE: Richard?

CLARIDA: I agree with that. I think that a—you know, a modest recession—you know, zero to, you know, minus-1 percent—with the status quo now in terms of credit markets, is probably not going to tip the U.S. into recession. But a more significant slump in Europe, I think, through—would.

And I think through the financial contagion—not just equity markets, but also borrowing costs, credit spreads—have already shown that they're correlated to Europe and, you know, the situation with the Fed can't cut interest rates, so higher borrowing costs, the lower equity prices Mark mentioned and then more severe contagion.

So this is, you know—and not to be too wonkish here, but I think the response is very nonlinear in terms of a Europe slowdown. So a modest Europe slowdown, which I think even Mr. Draghi now acknowledges is in place, is the—is one thing, but a 2 (percent) or 3 percent decline in European GDP would be quite another. And then, of course, the left-tail risk of a total unraveling of, you know, the euro project is, you know, something we all don't want to even contemplate. So—

HOGE: Let me ask this—(inaudible)—can comment on.

BLANCHARD: I can say a few things.


BLANCHARD: If Europe does not contain its short-term crisis, then clearly the world will be affected in major ways.

But even leaving this aside, supposing they continue to muddle through or find some kind of solution, next year in Europe is not going to be nice.

That is for two reasons. The first one is—(inaudible)—in the first place. Fiscal consolidation is happening on a very—in a very strong way. Bank deleveraging is proceeding, intensifying. That's going to have—this is going to be a major drag on Europe even if they avoid the catastrophe. The question is what will it do to the rest of the world, and I think there, there is enormous ambiguity. And deleveraging, in part, by European banks is done by basically getting rid of assets in other countries. There is strong political pressure on them to do so, but that's—that may be better for Europe, but it's worse for other countries. So for example, if you get emerging Europe, they might be in deep trouble.

Now, the question is what will it do to the U.S. You can think of a number of factors at play: an increase in risk aversion; you can think of decreasing trade. When we—(inaudible)—we don't get enormous effects on the U.S. I mean, we don't get the recession from that in the U.S. But one has a sense, looking at the reverse case, which is 2008-2009 and the effect of what happened in the U.S. on Europe, that there are all these more complex channels between the two sides of the ocean, which are such that I think the U.S. could suffer quite a bit from what's happening in Europe.

HOGE: OK, questions from the floor.

Back there. Way back. You.

QUESTIONER: Thank you. Can you—hello. Mahesh Kotecha, SCIC. It would seem to me one lesson that we have learned is that we sometimes don't apply macroeconomics, as witnessed—the setup of the euro, the way it was done without fiscal policy considerations.

So my question to you, in terms of what have we learned from macroeconomics is, how do we think about a multi-country macro policy, which is what you have in Europe, without an overall—we seem to apply one-country model to a multi-country problem.

HOGE: Who would like to start? (Laughter.)

CLARIDA: Well, I'll only begin by saying the IMF has a very good multi-country model. (Laughter.) So whenever I have a question on that, I read the world economic—I read the world economic outlook.

But I think the gentleman does raise a very good point, that not only are there more countries in the world, but the—but then the number of interactions and linkages goes up exponentially. And one of the—you know, we're all—we all patted ourselves on the back for 25 years of the benefits from the great globalization, but one of the realities of the great globalization is that the macroeconomic and financial interactions are much, much more complex—forget forecasting, just to monitor, you know, in real time. So, you know, I think—I think that we're all honestly on the learning curve on that.

HOGE: Olivier.

BLANCHARD: Yeah, I'd understood your question not as about the world but about how you make something like the euro function. And at this stage, there is this emphasis on fiscal integration and the decisions taken last week. That's needed. But that's clearly not enough. If one takes a long view—I'm not talking about the euro in the next few weeks but the euro over the next 20, 30 years and the assumption it will—it will continue—financial consolidation, cross-border resolution, similar regulations across countries, a euro- level deposit insurance system—all these things are very important. You have to put them in place.

If I had my druthers, I would probably have put this above the fiscal issues.

And then even if you have this in place, one has to understand that a common currency area comes with benefits, which are very substantial, but costs, which is that when countries are affected by different shocks, they need to do relative price adjustment, which is difficult to do on the fixed exchange rates.

I mean, I'm always struck by the interpretation that people give of the European crisis as a fiscal crisis. Well, if you look at Spain, it is no way a fiscal crisis. I think Allen Blinder had something in the—in the newspaper, in The Wall Street Journal yesterday. And Spain had a housing boom and had an extremely responsible fiscal policy throughout and increasing its budget surplus throughout, but it turned out it was not enough. But surely, the problem in Spain was not irresponsible fiscal; it was something else. It was basically a boom, which led to an appreciation, which has to be undone.

These problems are going to be there, I think, for quite a while. So when countries think about whether they should join a common currency area, they should think about all these dimensions before they decide.

HOGE: I think you wrote somewhere recently that it's not a debt problem essentially, it's a structural leadership problem.

BLANCHARD: Well, I would say it's—(chuckles)—well, I said it's a relative price problem. I don't know if it's the same thing as a structural leadership problem.

HOGE: All right.

QUESTIONER: (Inaudible)—with Reuters. (Coughs.) Harold (ph)—(inaudible)—with Reuters. (Coughs.) I seem to have a little (physical ?) crisis. (Laughter.)

I read with great interest, Mark, again, the—an Allen Blinder analysis of the effects of TARP and the stimulus, emphasizing TARP. And now you're emphasizing rather more the stress test, and I appreciate that. One lesson I took, looking back, is that if you're going to do a stimulus, do a stimulus. And one thing with political consequence is now one of the dirty words in political lexicon to join "climate change" is "stimulus."

You gave stimulus a bad name by doing it very badly. How far would you agree with that?

ZANDI: Well, I'd say that you think back to February of—first, I'd say there's lots of different stimulus packages, right? I mean, the first one was under the Bush administration, those rebate checks that we got in the summer of '08. If you add everything up and you throw in the payroll tax holiday extension, you're right, we're going to—the total stimulus as I would define stimulus, temporary tax cut, spending increases, would be $1.5 trillion. That's 10 percent of GDP. So that's not inconsequential. I mean, that's rather significant.

QUESTIONER: (Off mic.)

ZANDI: Most people when they think of stimulus is of the '09—February '09 package.


ZANDI: That was, you know, $800 billion out of the $1.5 trillion in total. You have to remember back to that time and the fact that policymaking was being done very rapidly on the fly in a political cauldron. I mean, they just had to get it done. And so there were a lot of compromises.

So in the context of that environment, I think the package that actually got put together was pretty good. You know, it isn't what I would have done if I were king for the—I'd probably need to be king for a week, but, you know, if I were king for the day, I would have done it differently. But given that context, I actually think it was quite impressive.

And by the way, I think it succeeded, I mean the—by reasonable goals. The goal was—of stimulus, of that package—was to end the Great Recession and jump-start a recovery. Well, in February of '09, we passed the recovery act. In June of '09—and by the way, February of '09, we lost 750(,000), 800,000 jobs. That's February '09. By June of '09, the National Bureau of Economic Research says the recession is over.

By February 2010 the job losses have come to an end. And here we are almost two years later. Private sector job creation, after you get all the revisions come in, will be about 3 1/2 million jobs, which, you know, isn't what I'd like to see in the context of an 8.6 percent unemployment rate, but you know, given, you know, what we went through, I think that's, in my—by my definition, that was success.

Now, again, I would have done it differently. I would have made it larger, bigger, if I had—you know, if I had—(inaudible). But given the constraints, I think it was—

HOGE: Richard, how does that assessment strike you?

CLARIDA: I don't have much to add other than to say—and this is one thing I actually did say at the time, so I will alert that—(laughter)—I think the challenge with a fiscal stimulus in a financial crisis it that the usual Keynesian channels by which you get a multiplier effect are impaired when your financial system is not working. So when you teach econ 101 or intermediate macro and you—and you go through the multiplier analysis, you know, the gentleman gets the check, the transfer of payment, you know, government job, and then that spending in turn encourages people to go out and buy refrigerators or buy a house or a car. And when the financial system doesn't work, it impairs the multiplier. So I think that was a headwind for any stimulus package, no matter how well-designed.

MR. : I'd be very curious what Olivier thinks about it.

HOGE: Well, we're about to get him. Yes.

BLANCHARD: I think the general world stimulus of early '09 was a success. As you know, it came largely from a call from the IMF saying we need to actually have a 2 percent—on average, a 2 percent stimulus in the world. And our analysis, which I think is correct, but I cannot prove, is that the world economy was very close to the cliff and if there had been another minus 2 percent growth then, then we would have seen bankruptcies on a major scale and something much worse.

What we saw indeed was not a full recovery right away, but a turnaround. And we'll never know what would have happened if there had not been the stimulus, but I'd prefer not to know than to have seen it.

On this, now I hear people say: Well, you know, we now have these very high levels of debt; and look at what you've created, you've created a monster; you started with the stimulus and this has added to a very high level of debt which we now have to get down slowly—and painfully. I think the point there is that the part of the increasing debt which is due to the stimulus itself, as opposed to the decrease in revenues coming from the low growth, the negative growth, is of the order of one-fifth to one-fourth. And much of the increase in debt is not due to misbehavior; it's due to the fact that revenues like GDP have been dismal, and therefore this led to a large deficit.

So in retrospect, no, I have no doubt that this was the right course. Again, we'll never know the counterfactual. That's where—that's where the Barney Frank remark comes in, which is: Economies can use counterfactuals; politicians cannot, but—(laughter)—

HOGE: Next question is from right over here on this post, and then right at the second post.

QUESTIONER: I'm Dick McCormack from Bank of America. The—you correctly mentioned that there's a lot of deleveraging going on with the European banking system right now. We estimate that it may be in excess of a trillion dollars going forward. And I'm wondering if—in combination with all the other contractionary measures, whether this might in fact result in a larger macroeconomic impact on Europe than any of us currently contemplate.

BLANCHARD: I can give the beginning of an answer to this. Yes, there are some numbers going around which actually go to 2 trillion (dollars). If there is deleveraging by European banks on a 2 trillion (dollar) scale, then 2008 and 2009 would look small in terms of what would be happening to the economy.

The more relevant number is—you have to take out what—first, they're not going to do as much; and the second is, much of it is going to be selling assets—subsidiaries, branches—to foreigners. So that it is not deleveraging on the world scale; somebody is taking the opposite position. But it is true that the amount of deleveraging defined as selling of loans, things which affect the economy directly, can be quite large. And the effects on Europe may well be quite large.

That's where the political economy considerations, which I talked about at the beginning, come in, which is that clearly European banks have to increase their capital, their capital ratio. There are two ways of doing it, right? One is you increase your capital, and the other is you decrease your assets. Clearly, the right thing to do at this stage is to force these banks, to the extent possible, to actually increase their capital rather than to deleverage, because even if (for them ?) the first is better, for the economy it's much better that it happens through capital rather than through deleveraging.

But that's where the political economy considerations come in. And the banks in many countries have convinced governments that they really cannot raise the capital and they have to deleverage. The reaction of governments have been to say, well, do the best you can, but if you're going to deleverage, please don't do it at home. The problem with this is you do it to somebody else who then does it to you.

So I think there is a great danger that deleveraging will have major implications for Europe and, by implication, for the rest of the world.

HOGE: Any other comments on this point?

ZANDI: Oh, by the way, that's why the U.S. experience has been—worked out much better, because we—

BLANCHARD: (Inaudible)—example.

ZANDI:—we didn't say to the banks, go get your Tier 1 capital ratio to 9 percent; we said, go get capital, and they raised 300 billion (dollars) in capital within a few months.

And then, of course—(inaudible)—banks couldn't raise the capital sufficiently, they went to TARP and they got government money, which is another 250 (billion dollars), $300 billion in total.

HOGE (?): Right.

ZANDI: So that was therapeutic because it stopped the deleveraging process, or at least slowed down the deleveraging process. Whereas in the case of Europe, they say, OK, go get a 9- percent Tier 1 capital ratio; I'm not sure how you do it, but just to go do it. First thing that happens is that, you know, sovereign debt yields rise because they're selling sovereign bonds. That's actually what you would do. If I were a bank, I—that's the way I would try to get to my 9-percent Tier 1 capital ratio.

So that was a mistake, I think; that the answer should be, we should—you should go raise capital and, by the way, here's a fund—a bailout fund that, if you can't do it, you know, you're going to have to take this money under punitive terms.

HOGE: Next question right there.

QUESTIONER: Stephen Blank. In the past few months we've had an unusual opportunity to get to know the Republican candidates for president, one of whom may well be the next president in a—elected in a year. We have had a sense of their views on many issues: on the deficit, on the stimulus, on the Fed, regulatory environments, markets, even a drift toward devolution of authority. Can you suggest, in all of this, a coherent macroeconomic policy that's likely to emerge in a new administration in a year?

HOGE: Richard, you want to start on that one?

CLARIDA: Oh, sure. (Laughter.)

Well, as I've said, I think that the—history shows us that, with some rare exceptions, fiscal policy in the U.S. tends to be done on a year-by-year basis. You know, there are some examples that have—that have been more, you know, longer-term. We—you know, we had some of that in the first Bush administration and then in the—in the—in the Clinton years, you know. But, you know, thus far I've not really picked up enough from the press accounts to really see the contours of what we're likely to expect.

I will jump off on something that Mark said. Because of the expiration of a number of the tax cuts December 31st, 2012, you know, there's an old saying that, you know, inertia is a very powerful force, especially in Washington. So if nothing happens in Washington, then in 13 months, you know, you're essentially going to go back to the tax code that prevailed in the year—in the year 2000, but that means both that the income tax level, and as well as on capital gains and dividends. And so, you know, many people think that that will be enough of an incentive to bring whoever the president is and the Congress together at that time. But on this—I'm from Missouri, you know, on this case. You have to show me. I'll believe it when I—when I see it.

HOGE: Yes, right there. Yes.

QUESTIONER: Marty Feldstein. Can I go back to the problems in Europe and ask what do Italy and Spain have to do to convince the financial markets that it's worth buying their bonds at interest rates that are in the range of 5 (percent) or 6 percent or lower?

HOGE: (Inaudible)—Olivier?

BLANCHARD: I think the way to think about the problems of Italy and Spain is two-fold. The first one is that they have to show that the reasonable interest rate, and with reasonable policies, they are solvent. And once this is done, as we know, they now convince the markets sufficiently quickly, and therefore, they need to be able to actually borrow these low interest rates, which is the liquidity aspect of the problem. So there's a solvency aspect to a problem and there's a liquidity problem—a liquidity aspect to a problem.

The first one to be solved is (purely the ?) solvency aspect: Is it the case that these countries can make it at reasonable market conditions? And (there ?) our assessment is that they can, that low interest rates, these countries are not in great shape, but the effort which is required is feasible.

How can they increase the credibility (of its statement ?)? Well, by—first by putting in place people who are technocrats and have the support of politicians. And this has happened in Italy. And we think that the—clearly the Spanish team is also quite competent.

The second is if they want—and this is something which has been asked—(inaudible)—and asked to be monitored by an outside organization, such as the IMF, to just say—(inaudible)—that they are actually delivering on what they are doing.

And then they just have to go at it.

I think, relating to something I said earlier, they have to go at it, but not too quickly. This is a marathon, and therefore asking them to have extreme fiscal consolidation next year would be counterproductive. Basically, there has to be a path, with measures voted in, which basically is credible. When this is done, there's still the worry that for awhile the markets are still going to ask 6 (percent) or 7 (percent) or 8 percent, and therefore there has to be something which says, well, if you're doing what you have promised to do, you can borrow at the lower rate.

This is the issue of liquidity. This is what's being discussed as to how it could be done. Some people believe the ECB should be the one doing it. Some people believe that it should be a mix of the ECB and the IMF and others. That's very much on the table—the FSF, the ESM and so on. That's very much on the table.

But I think these are the two things which are needed. If these can be put in place reasonably quickly, I think that will avoid the catastrophe.

HOGE: Mark, Richard, any different views?

ZANDI: I was—I was just going to say we've done some work recently with a—(inaudible)—concept called "fiscal space," you know, trying to get at how much room countries have before—if they don't do—the policymakers don't do something extraordinary, they'll need a bailout or they will default on their debt. And out of that process, you can back out—under assumptions—survival—so- called survival interest rates. So the interest rate—the borrowing costs rise above this level and stay there for any extended period of time, the country's finances unravel.

And out of that work, we're finding—and again, it—you know, it does depend on your economic forecasts and other assumptions. But under our work, we're finding Italian 10-year sovereign survival interest rate is 5 percent, and in Spain, it's 6 percent. So right now yields are measurably above that.

And I think the—it's going to take two things. One is I think it's going to take more IMF oversight. I don't think—until the IMF is really engaged in a more substantive, day-to-day way, I don't—I'm not sure that there's going to be enough confidence there that things are proceeding in an orderly way. And the second is that I think markets have to be convinced that the ECB is going to step in when necessary, that, you know, they don't—they may not become the Federal Reserve lender of last resort, but it has to be clear that if—that interest rates are rising above that survival rate and staying there that they are going to step in and make sure that it comes back down.

HOGE: OK, we're getting close to our cutoff, so let's see if we can take two questions—same time. Yes, sir, you. And do we have another one? Right there.

QUESTIONER: Ni Sabwa (ph) of Pace University. Is one of the lessons that you learned is tracking various financial and economic variables such as P/E ratios and house prices to median incomes, and if they are, let's say, beyond two standard deviations, the policy authorities should do something about that?

HOGE: Well, yes, right there.

QUESTIONER: Howard Weinberg (sp). Macroeconomics is a product of the academy, and there's been a lot of criticism of the—of the theory and its applicability. What should—what do you think the academy should be doing? Should there be a change? Should there be more experimentation, for example, a broader range of study of issues and the fine-tuning of the—you know, the dynamics (to cast external equilibrium of ?)—

HOGE: OK, let's go right down the line, starting with Richard.

CLARIDA: I have one—I have one on that one. I was—I met with a monetary policymaker in Europe about a year ago, and he asked me that exact question. My answer was, sir, you've got a number of very, very good economists here, and I think the cutting-edge work on these issues, monetary policy in particular, but also the interplay globally and fiscal policy to some extent, is going to be done at places like top central banks, the IMF. These institutions—I mean, there's a set of tools that can be used to deploy these—(inaudible). And I think—I think a lot of the best work is going to be done, really, by policymaking institutions and not exclusively the domain of academia.

HOGE: Mark, anything on tracking?

ZANDI: I kind of missed the question. So you're saying what can academics to do to—

QUESTIONER: What should (we ?) do differently, I mean, given that the tools that you need—Olivier's, you know, challenge of the incredible complexity?

ZANDI: Yeah, you know, my sense, in the context of the United States, is that we've actually made a lot of progress, that we are really very close to getting—righting the wrongs that got us into this mess and the economy engaging. I know there's a deep pessimism among the business community, among policymakers, among economists.

You know, Richard's harking back to Rogoff-Reinhart: That perception, that view now pervades academia and the—and the economics community. I think it's overly pessimistic. I think we've actually done a tremendous amount of work, and that will begin to shine through. And I don't think at this point we need, or should engage in any significant fiscal or monetary policy changes.
What we've got—what we should do now is on the margin, and make sure that what we have done is working well, because we've done a lot of things, and a lot of things that are—you know, we're down into the gory details of making these programs work. And instead of changing things, we need to be focused on making them more effective.

So at this point, in the context of the United States—not in the context of Europe, but in the context of the United States—I think we're there; we just—we just have to follow it through.

HOGE: Olivier?

BLANCHARD: Good. So there were two questions, right?

HOGE: Yes.

BLANCHARD: So the tracking financial indicators—

HOGE: Right.

BLANCHARD:—(inaudible)—since the question is hard. What do you do when you've tracked them? How do you put them together? And here, I think we're still a long way from knowing exactly how to look at them. And there is this—there's a number of cliches, such as we have to track systemic risk. Well, if I knew what systemic risk was—(laughter)—I would track it. (Laughter.)

I think that there is a whole lot of work—which is actually happening—on how you use these different indicators to get to some measure of systemic risk, but we are a long way away from doing it. But that's clearly something which needs to be done.

On academia, I think it—(I have ?) slightly different views from Richard and Mark. What I'm struck by is how much academic research has actually responded to the crisis. If I look at the working papers of the NBER, the proportion of working papers which are about the crisis in some way is very substantial. And Martin (sp) might know the number, but I would guess 30 (percent), 40 percent—I mean, some very, very large number. And of these papers, many are useful. (Chuckles, laughter.)

HOGE: Ah, the diplomat.

BLANCHARD: Where I would—where I would disagree—that would be my final remark—is with Mark. I still feel that we're a very long way from knowing how to use the tools. I've been—we've been struggling at the Fund, for example, on how to think about capital controls. Well, I think we've made progress relative to where we were a few years back in how we think about it and what advice we give to countries. I still feel that there is a very long way to go before I feel good about the advice I give.

So, yes, progress; but, fortunately for academia—(laughter)—a few more things to do.

HOGE: (Laughs.) Join me in thanking this expert panel. (Applause.)

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