Academic journal article Business Economics

A Tale of Two Crises: One We Missed and One We Can't Afford To

Academic journal article Business Economics

A Tale of Two Crises: One We Missed and One We Can't Afford To

Article excerpt

The current economic crisis seems to be waning, largely due to effective federal government and Federal Reserve responses. Economists deserve credit for helping to avoid the abyss, but we failed to predict the crisis and warn policymakers so that the crisis could have been mitigated or avoided. We must not miss predicting the next crisis, however, as it is staring us in the face. We can see clearly that federal debt will severely damage the U.S. economy within several decades under current policy. Moreover, simulations that take into account the effect of debt on interest rates indicate that the depressing effect on the U.S. economy will be even worse than official projections suggest.

Keywords: economic crisis, fiscal policy, federal deficits, government debt, debt-to-GDP

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1. The Current Crisis

As of October 2009, the global economy is just beginning to emerge from the worst economic and financial crisis since the Great Depression. When NABE met a year ago--in early October 2008, roughly three weeks after the collapse of Lehman Bros.--we stood at the edge of the abyss and looked down a very deep hole. Nobody knew how deep that hole was, but nobody wanted to go there.

Monetary policy was forcefully swinging into action. The Commercial Paper Funding Facility, for example, was announced on the morning that Chairman Bernanke addressed our meeting. The Federal Reserve was so clever and so innovative that the number of Federal Reserve facilities got to be so large that our effort to keep track of them in a table spilled onto two pages. The Treasury, with the support of the Fed already received from Congress the authority to establish the TARP.

Subsequently, the American Recovery and Reinvestment Act was passed. Some have argued that an uglier piece of legislation has never been enacted. That may be true with respect to some of its details, but with respect to the larger thrust, namely implementing a combination of very large tax cuts and spending increases aimed at providing fiscal stimulus, it was pretty much what the doctor ordered. In my estimation and that of my colleagues, it has provided significant support to aggregate demand as early as the second quarter of this year, and will continue to do so for at least a few more quarters.

Yes, the details of some of these initiatives were initially vague, and not every action seemed to be exactly what each of us might have preferred. But, at least we got the impression that some very smart people were putting in some very long hours to make sure we did not get so far down the slippery slope at the edge of that abyss as to fall in.

Well, we did not fall in. The actions taken helped to avert an even worse crisis that would have severely damaged our standard of living for a very long time.

I admit there is room for debate over just how well we did escape the abyss, and reasonable people can disagree about the strength of the recovery. But there is very broad agreement that we are in the early stage of a recovery. As the tail risks continue to recede and as growth returns, we can all breathe a little easier. To the extent that economic science informed, motivated, and shaped many of the actions taken in response to the crisis, we should feel good as a profession. Put one in the plus column for us!

As this conference amply demonstrates, already the search has begun to better understand the causes of the crisis. Efforts are underway to design and put in place measures that will prevent the kind of toxic asset contagion we just experienced--the classic Minsky Moment (1)--from again bringing the global financial system to its knees, and threatening another Great Depression.

There is also some hand wringing and finger pointing over how this could have happened. Economists have not escaped blame, not for causing the crisis, but for not seeing it coming earlier. Although measures of default risk on pools of subprime mortgages did spike early in 2007, it was in August of 2007 that the financial markets more generally began to show severe strains of the spreading subprime meltdown, and risk spreads began to widen appreciably. …

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