## ROUGH TRANSCRIPT: Stimulus or Stymied?: The Macroeconomics of Recessions

Panel Moderator: J. BRADFORD DELONG (University of California-Berkeley)

Panelists:

• CARLO COTTARELLI (International Monetary Fund)
• PAUL KRUGMAN (Princeton University)
• VALERIE A. RAMEY (University of California-San Diego)
• HARALD UHLIG (University of Chicago)

DELONG: Between 1985 and 2007--the period of the "Great Moderation"--the Federal Reserve and the rest of the U.S. government on the west edge and the central banks and institutions of the European Union on the east edge of the Atlantic Ocean provided a broadly stable macroeconomic environment within which private-sector businesses, workers and investors could make their economic plans. In the U.S., on an annual basis: the rate of nominal GDP growth dropped below 4% for only 3 of those years and rose above 7% for only 2 of those 22 years; the rate of consumer price inflation rose above 5% for only 3 and fell below 2% percent for only 2 of those 22 years; and the civilian adult employment-to-population ratio remained between 60% and 64% for that entire period. And Western Europe experienced a similar "Great Moderation" with low inflation, relatively smooth growth, and diminishing unemployment.

As Robert Lucas put it in those halcyon days: “the problem of depression prevention has been solved”.

Then in 2008-9 the rate of nominal GDP growth in the U.S. crashed to -3%--a major, major downward surprise to anybody expecting and relying on a continuation of "Great Moderation" rates of nominal spending growth--the rate of consumer price inflation on an annual basis bottomed out at -2%, and the employment-to-population ratio dropped from 63% to between 58% and 59%, since when it has flatlined. In Western Europe the initial recession was smaller, but the subsequent labor market performance was even more disappointing, so that now the net fall relative to trend in Western European production and employment exceeds that in the United States.

The problem of depression prevention—and of depression cure—has not been solved.

In this context, we are here to explore four questions:

1. Are there policies the Federal Reserve, the ECB, and the rest of the government could adopt that would quickly move the civilian adult employment-to-population ratio back toward what from 1985-2007 we thought of as "normal"--that could produce in the next couple of years rates of employment growth within shouting distance of those the U.S. economy experienced over the Reagan boom of 1982-1989?

2. If so, what are those policies?

3. If so, are those policies desirable ones that the Federal Reserve, the ECB, etc. and the rest of the government should adopt?

4. How is your view on questions (1) through (3) different today than it was six years ago?

Carlo Cottarelli from the International Monetary Fund?

COTTARELLI: Brad, thank you very much. In answering your questions I will try to exploit my comparative advantage and take an international perspective. I will focus on the role that fiscal policy can play at the current juncture. Let me talk about how our views have evolved over the past few years.

Let me start with 2008. Many of you will remember 2008 as the year when Lehmann collapsed. Other will remember 2008 as the year when the Dow-Jones dropped by the largest amount since the 1930s. But there was an even more unusual event in 2008: the IMF for the first time called for fiscal expansion. This was news. Monetary policy was then seen as the tool to respond to declines in economic activity.

This change was prompted by three factors: First of all, it was felt that the magnitude of the shock was such that there was a risk of things getting out of control—it was not an ordinary recession. Second, it was felt that although the recession had originated in a house price boom and then dysfunction in the financial sector, it has turned quickly into a demand recession—a recession in which lack of aggregate demand was causing a further and further decline in economic activity, and as a result there was rising unemployment and a lot of uncertainty about future economic prospects. This was a world in which the relevant textbook was The General Theory of John Maynard Keynes. Third, it was felt that with credit markets not working properly monetary policy had exhausted its room for activity with short-term nominal interest rates at zero percent and could not provide enough support.

[15:00] So we called for fiscal expansion even though in many advanced economies the state of public finances was not particularly good. Already in 2007 the public debt to annual GDP ratio in the OECD was at a peak that had been significantly exceeded only at the time of the Second World War, and of course we have the further increase in the debt to GDP ratio after 2007.

On top of this, as a result of pressure from rising entitlement spending, debt to GDP ratios are projected to further increase substantially over the next several decades. So it was not a great fiscal outlook, but we felt that the risk of another Great Depression were just too large to be ignored and so we called for bold fiscal action.

Since 2008, two things have happened. First, economic activity has remained depressed, although as you can see there has been a slow recovery. Second, we saw that some of the risk associated with high debt-to-GDP ratios materialized in countries that then experienced full-fledged fiscal crises. These developments started essentially in 2009. By 2011, taking into account the difficulty of maintaining fiscal credibility by promising fiscal adjustment, even in this case we found that gradualism in fiscal adjustment is necessary whenever possible. Some countries are not yet positioned to proceed with gradual fiscal adjustment. They are under heavy pressure from markets. But in general as much as possible we favor a gradual approach to fiscal adjustment—it should not be front-loaded. We have done this for two reasons. First, we feel that the fiscal multiplier is pretty large under current circumstances, essentially output right now is demand-determined. In principle, it would be preferable to postpone fiscal adjustment altogether until some future time in which there is too much private-sector demand rather than implementing it at a time when there is not enough private-sector demand.

The second reason why we favor a gradual approach to fiscal adjustment is called “too much of a good thing”. It is possible that if you tighten fiscal policy up front with multipliers in their current range, you end up with a decline in GDP growth so large as to be counterproductive, to cause not a decline but an increase in interest rates as markets become worried about the decline in GDP. This involves some degree of market local irrationality or short-sightedness. Markets see that when you tighten fiscal policy there is a temporary deceleration of growth but then eventually growth picks up again. There is some econometric evidence that in 2011 markets were focusing very much on the short-term dynamics of output, and the short-term was that there was too much tightening that was actually counterproductive because it was associated with an increase in interest rates.

We have argued that gradual adjustment should be accompanied by a continuing use of monetary policy to support economic activity because there will be a cost of even gradual fiscal tightening. All of this focuses on the demand side. At the same time we have focused on the need for supply-side medium-term growth from structural reform. Although at present output is demand-determined, over the medium-term it is important for the advanced economies to raise their rate of potential growth. That has huge implications for the fiscal situation over the years.

So this is essentially our view of what fiscal policy should do: gradual fiscal adjustment, as much as possible, accompanied by relaxed monetary conditions for as long as necessary, and structural reform.

I want to conclude my presentation by pointing at some important questions that underlie our position. Our views are conditioned on how these questions are answered. This is an area where I think it would be beneficial to have more economic research. Let me start with five or six important questions:

1. How much of the current output loss is cyclical and how much is structural? There was a large output drop in 2008-9, and our view is that part of this is cyclical and part of this is structural. At the same time if the decline in output were entirely cyclical, then the fiscal outlook would be considerably better than what we currently project, because future potential output would be larger, and as a result fiscal revenue would be larger.

2. For how long will interest rates remain low? This strategy of gradual fiscal adjustment and monetary relaxation can succeed in keeping interest rates low for another few years. But if this is not the case, if the surge in public debt did cause an increase in interest rates, then our current outlook would be optimistic.

3. What is the medium-term fiscal multiplier? The discussion over the past two years on the fiscal multiplier has mostly focused on the impact multiplier. But we are talking about a series of fiscal tightenings at least in countries following gradual fiscal adjustment strategies so it is important to determine what is the medium-term impact of fiscal adjustment.

4. What is the impact of high public debt on potential growth? We have taken the view that high debt even if stable has implications for potential growth over the medium term. This is one of the reasons that we have argued that the goal of the current fiscal-adjustment strategy should not be to stabilize the debt-to-GDP ratio at high levels but should be to bring it down. We have done this based on evidence that when the debt-to-GDP ratio for the general government is above 90%, there is a decline in potential growth. Again, there have been papers showing the opposite—that as long as the debt-to-GDP ratio is stable, then there is no large cost to be paid in terms of potential output growth. More analytical research would be beneficial.

5. Is gradual adjustment possible from a political-economy standpoint? We argue that it is. Others, however, argue that the only feasible fiscal strategy is the cold-turkey Nike approach: just do it.

6. How bad are the long-term fiscal trends? This is the projected increase in health care and pension spending for the advanced economies over the next twenty years. The increases are very large: about one percent of GDP for pension spending, and about three percentage points for health-care spending. The differences across countries are very large for two reasons: demographics, and the different impact based on past experience that technological change in the health-care sector will have on the government budget. When it comes to health-care spending, when we talk about technological progress we talk about new technologies that are much better but also much more expensive. Some countries have managed to control health-care spending by the public sector through reforms, and keep the health welfare state affordable. The key challenge based on this chart for the United States is whether the United States will be able to do so and contain the rise in health-care costs.

7. With this difficult question I would like to stop, and thank you for your time. Thank you very much.

DELONG: Paul Krugman, from Princeton?

KRUGMAN: I think like probably everybody, I read Brad’s questions and then decided to do something that I think hits all the points but not in order. Let me therefore do my best.

Obviously, things are not good. If you had polled people at this meeting three years ago, I think a majority would have thought by now we would be talking about this great economic crisis in the past tense. But it still goes on.

Given the people on this panel, given the research they have done, it seems that the core issue here will be the effect of fiscal policy. Let me try to talk about where I think we stand and what the fiscal-policy issues ought to be.

The basic story—at least as many of us see it—is that we had this really, really dramatic shock to private spending. This is the private-sector financial deficit: gross private domestic investment minus gross private domestic saving as a share of potential GDP as estimated by the CBO. This is not the first time in the post-WWII era we have had a big drop, but it is the biggest: 10% of potential GDP. [30:00] The previous ones in the mid-1970s and early-1980s were associated with tight monetary policy, very high interest rates, and collapses in housing investment driven by tight monetary policy—which, of course, sprang back as soon as the Federal Reserve decided that the American economy had suffered enough.

This time is different. This time it came spontaneously. This time it came in spite of drastic cuts in interest rates to essentially zero.

The question is: “What do we do?”

There is an interesting debate: “When did economics go all wrong? When did macroeconomics go all wrong?” Bob Gordon has rather persuasively made the case that it went all wrong about 1978—that we would have done a better job at macro policy if we had met this crisis with the intellectual panoply we had then and had not had the thirty years since. I saw John Quiggin just made the argument that things actually went all wrong about 1958.

If an economist from 1958 had seen what is going on now, he—and back in 1958 it would have been “he”—would have said: “OK. Private sector does not want to spend. The government should spend. This is a powerful case for fiscal stimulus to prevent this from causing a persistent slump.” We have not done that. We had some fiscal stimulus delivered for a brief period of time in 2009. We have had a fair bit of allowing automatic stabilizers to operate. But at the same time we have had quite a lot of policy austerity. We had a worldwide or at least an advanced-world turn to austerity in 2010 inspired to some extent by the lessons that were drawn—I would say mostly wrongly—from the story of Greece but then applied across the board, and also from a reversion to pre-Keynesian modes of thinking about the macroeconomy. Whatever the reasons—and there are a mixture of political-economy reasons and just plain bad-economics reasons—we made a big turn to austerity. Now we debate: “Was that wrong? How wrong was it? Should we really be doing as much fiscal stimulus as the man from 1958 would say?”

Think about the objections to stimulus. I would put them into three categories:

First, perhaps we do not have nearly as much economic slack as people like—well—me say. Perhaps there is something much more structural going on, and we do not have that much room to expand. We have a huge economic failure, but the failure is not for the most part a simple failure of aggregate demand.

Second—you do not hear this story that much, but it is important to set up the third—is that we should not be using fiscal policy but should instead by using monetary policy. That is a more popular argument in the more informal discussion in the econoblogosphere than it is in academia. But there is the question of what you can do.

Third, even though we are at the zero lower bound, fiscal policy is a lot less effective than the man from 1958 would say it is, and that multipliers are quite low even under urgent conditions.

There is a whole literature trying to identify structural issues—what does the shift in the Beveridge Curve mean—that would be an entirely different discussion. I think the most important argument that has the biggest impact is the argument: “If we have all that economic slack, where is the deflation?” When we look at core inflation, it dropped a lot in the crisis, but has been fluctuating in a 1-2%/year range since then and has not been declining. You will see the argument, which is consistent with what most Principles of Economics or Intermediate Macroeconomics textbooks say or would have said before the crisis, that if we really had a large output gap we should be seeing not just low but declining inflation. The stability of the core inflation rate is an indication that there is not a lot of economic slack. The most recent speech by James Bullard makes that case. The San Francisco Fed has a nice updated chart estimating the output gap by backing it out of a linear expectational Phillips Curve and comparing it to the CBO output gap which is a gussied-up trend. The difference is striking. The stability of inflation says that there is hardly any output gap. Comparing us to the pre-crisis trend says that there is still a very large output gap: $900 billion/year of potential non-inflationary production of goods and services is simply not happening. Brad asked: “What have we changed our views about?” The inflation process is one area in which I have changed my views. It has become much more apparent that downward nominal rigidity—not just stickiness but people don’t like to cut nominal prices and wages—is a very significant factor. When you have a depressed economy in a state of initially low inflation the zero bound not just on interest rates but on wage changes becomes a really big deal. Again, more San Francisco Fed stuff: they have tried to back out how many people are literally getting zero wage change. The answer is: “a lot”. That suggests that we are indeed an economy in its depressed state, and that the reason that average wages continue to rise is that we have truncated the left edge of the distribution, not that we have anything close to full employment. That is very important, if true. Among other things, it means that the whole basis on which we constructed monetary policy during the Great Moderation, which is that stabilizing inflation and stabilizing output are the same thing, is all wrong: you can have a sustained period of low but not negative inflation consistent with an economy operating far below its potential productive capacity. That is what I believe is happening now. If so, we are failing dismally in responding to this economic crisis. This is in contrast to what some central bankers are saying—that we have done well because inflation has stayed relatively stable. Monetary policy: When I arrived at Princeton in 2000 there was a group of us—“Japan worriers”. I am the only one still there. Mike Woodford, Lars Svensson, who is now run off to the Riksbank, me, and Ben Bernanke—I wonder what happened to him? All of us were very concerned by what was happening to Japan in the 1990s. Some people looked at it and said: “That just shows how messed up the Japanese are.” Some of us looked at us and said: “Surface differences apart, Japan looks a lot like us: big advanced country, lots of room to maneuver, government officials who might not be the most brilliant but who were not complete idiots, and if they could get trapped in this sort of deflationary stagnation then it could happen to us.” Sure enough, it did. At the time, all of the discussion was about what you could do by way of monetary policy. Could the central bank by unconventional purchases of non-standard assets move expectations? The simple fact is that dramatic changes in the simplest measures of what central banks are doing—the size of the monetary base—have been invisible in their effect on either inflation or output. I think we have to say that at this point to make the argument that if only the central bank really wanted to we would be doing much better needs to be accompanied by a very clear explanation of how that it is supposed to work and why the effects of monetary policy to date have been so limited. There is in principle the expectations channel. If a central bank can credibly promise that it will allow a higher inflation rate over the medium term then it ought to be able to reduce real interest rates and have a significant expansionary effect on the economy. The problem is how do you in fact make that promise credible. There are multiple hurdles that you have to cross. First, you have to cross the threshold of the political acceptability of the policy of changing the inflation target, which has proved virtually impossible to tackle in part because people do not think that this is a permanent crisis. They may be right. But that means that it is then very very hard to say that we should change the price-level target for five or ten years in the future to deal with a crisis that everybody expects will be over in a year . Then, how do you make it credible? Why will the people running the central bank five or ten years from now—who are not the people running it now—go through with it? In an unfortunate phrase I used back in 1998 about Japan, they have to credibly promise to be irresponsible. That is the issue. It has turned out, I think, that, as Michael Woodford says, while in principle unorthodox monetary policy can deal with a situation like what we have now, in practice it is really really hard to see how this could work. And that makes you lean on fiscal policy. Last comes the question about the effectiveness of fiscal policy. Valerie Ramey will present evidence on the size of multipliers. What are multipliers? That is a critical issue. The trouble is that fiscal policy is very hard to assess econometrically from the historical record. The basic rule is that when all is said and done, no matter how much effort we put it and in spite of all the valid work we do, unless you can show clear natural experiments people are not convinced. Even with natural experiments people are often not convinced, but it is your best chance. And convincing natural experiments are hard to come by. The clearly-exogenous changes in government spending are pretty much those associated with wars. This is just the very simple stuff that Bob Hall did just a little while back. They clearly show that expansionary policy is expansionary. They also show that the multiplier is less than one, which is not what an enthusiastic advocate of Keynesian fiscal stimulus would like to see. Again, the IMF tried recently very carefully to tease out the answer, and again found that expansionary policy is expansionary and contractionary policy is contractionary, but once again multipliers are less than one. The IMF has changed its mind, or at least Oliver has changed his mind. But that’s where we are. The question then becomes: is this historical evidence relevant for what we face now? The historical evidence incorporates a lot of crowding-out. The question is then: where is this crowding-out coming from? One answer is the old textbook crowding-out: crowding-out via rising interest rates. That is clearly relevant to the historical cases but not relevant now. A second answer is that in wartime other things are happening. I believe that a lot of the literature on this understates the seriousness of this issue. It’s not just that the multiplier is lower at full employment. During World War II there was severe rationing of consumer goods. During World War II—I have not seen this mentioned at all—there was essentially a prohibition on private construction. You look at World War II and say “private spending fell”. What relevance does that have? We are not about to have such controls on private investment. [45:00] We can look at periods that do not have war complicating the picture, and the problem is that there is not a lot of that. For the U.S., the World War II period before wartime controls come in is about a year and a half, six quarters. If you are going to use VAR time-series methods, you can look at quarters that have both high unemployment and large changes or news of large changes in military spending, the problem is that the impulse response period extends well into the period of wartime controls. It is not at all easy to get past that. Finally, Ricardian effects. It is really important to understand how many people misunderstand that. There are many people who believe that higher government spending now means higher taxes later and this will crowd-out private spending now. But higher spending now means higher incomes now as well. In the simplest Ricardian setup, if you believe that resources are unemployed and if interest rates are zero, the multiplier is not zero but one. It is very difficult to come up with a story in which the current multiplier would be less than one. Invoking the expectation of future tax increases as a reason for a multiplier less than one is a much more difficult story to tell than people seem to imagine. Our evidence is not great. The closest thing to a really good natural experiment is what is happening now—the scary policies of recent years. It is not perfect. But look at the euro area countries—we talk about the great mistake of 1937, Roosevelt’s turn to austerity, but his turn to austerity was less than 3% of GDP. Compare that to what is happening to Greece or Ireland now, that is nothing. In Greece, if the whole program is implemented, we are talking about austerity on the order of 16% of GDP. These are enormous shocks. And if you do a simple regression it looks like a multiplier of 1.3. The immediate objection is that causation is not reversed? This is where the Blanchard-Leigh stuff comes in: They look at forecast errors in output growth and forecast errors in future policy, and find that their forecasts of output growth which assumed a multiplier of 0.5 underestimated the true multiplier by about 1.0, systematically understating economic contraction in countries with larger-than-expected degrees of austerity. I think their work is good. Of course, it fits what I wanted to believe, so you have to be careful. But very important stuff, if true. The final point is policy: Are we sure that expansionary fiscal policy is the right thing to be doing and that austerity is a terrible, terrible mistake? No. We are absolutely sure of nothing. But the consequences, if that is the truth, and I think the evidence tilts that way, is that what we are doing right now is absolutely disastrous. And that is where we are right now. DELONG: Valerie Ramey, from UCSD, who is lucky enough to have this weather all the time. RAMEY: First of all, I would like to thank Brad DeLong for stepping in to run this panel. This panel had become an orphan because the person who organized it disappeared and did not answer any emails. And Brad stepped in after Christmas as a moderator and he set up the very nice session that you are enjoying right now. Brad listed the questions he had. I want to give my answers to them in a more general way. First, I think that the government spending multipliers right now are probably below unity. I think tax multipliers based on the Romer and Romer estimates are probably higher, but they only attain their full effects after at least three years. I don’t think that there is much that monetary policy can do right now. So what I am going to argue after talking about why I think multipliers are not the size that we would like them to be is that we should stop looking or quick fixes and undertake structural reforms now in a credible manner as the best way to help the economy now. Why I continue to think multipliers are low. I had some previous work—several papers, one in the QJE—finding multipliers that could be between 0.8 and 1.2. This was using data from 1939 to the present. In the same session two days ago where Olivier Blanchard presented his work that Paul Krugman cited, we presented joint work where we extended some of the analysis that I had done in my QJE paper and some of the analysis that Auerbach and Gorodnichenko had done. We extended back historical data for the U.S. and Canada. We wanted to look at history because we wanted to answer the very important question: are multipliers higher in times when economic slack is high, and there is some recent research—Auerbach and Gorodnichenko—that does suggest this. To do this—let me just show you the U.S. historical data—the first thing I had to do was read news sources going back to 1890. I had previously done that for 1939 to the present. What I was trying to do was find changes in government spending that were not responses to the state of the economy. That is why we focused on military spending. I was trying to find changes in government spending that were big—that is a second reason to focus on military spending. And, third, I found that it is really important to figure out when that spending was anticipated. That is why I have to go through news sources. The top graph shows you the news that happens about military spending. You can see that the big ones are World War I, World War II, and the Korean War. But there is also the Spanish-American War—I learned a lot about the dreadnoughts under Teddy Roosevelt and all kinds of things. You can see how small the Gulf Wars are. The unemployment rate is on the lower graph. The shaded areas are the “Bernanke regions”: those are when the unemployment rate is above 6.5%. We looked at other thresholds, but this is a nice focal point. What we wanted to do was, using much richer data than you can get from the post-WWII period, figure out whether the multiplier was higher when the unemployment rate was higher. World War II is, of course, the most influential observation. And Paul is absolutely right: you have to worry about rationing. Those worries have kept me up at night. They have kept me in the library. What I have figured out is that the unusual circumstances of World War II probably led the multiplier to be greater. It would not be good to use World War II to estimate the government multiplier for residential investment—obviously, nobody was investing in houses then. But if you just want to see how much total output can expand, total output expended more in World War II because of two key factors. As I showed in my NBER conference volume paper, labor force participation rates just skyrocketed during World War II. We would never expect that to happen during ordinary times. The average of productivity growth during World War II was 7%/year. We would never expect find a peacetime time like that. Now the rate of change of real GDP is going to be the sum of the increase in labor and the increase in productivity. The growth rate of labor was higher than you would ever expect in any non-war time. The growth rate of productivity was higher than you would ever expect in any non-war time. So I think that World War II might well be giving us exaggerated estimates of multipliers. When we look at this, what do we find? We were really surprised—we thought that multipliers would be higher in periods of high slack, and Auerbach and Gorodnichenko found this for the post-WWII period (although when we use their second-wave estimation we did not find this for the post-WWII period either). We estimate it several ways. The high unemployment multiplier? It is still about the same: 0.5, 0.6, 0.7. The low unemployment rate multiplier is in fact slightly higher. I should say that for Canada we have somewhat limited data and somewhat limited time periods and want to do more work on that, but we are finding differences in multipliers based on the level of unemployment. We found one as high as 1.6 in times of slack for Canada. But that is based on very preliminary data and we want to look at that more closely. But for the U.S. we could not find significant multipliers above 1 even for periods of high unemployment. We tried varying the threshold, and could not find it. A little bit more on World War II. My earlier study did a case study of the labor market during World War II. What I find was the most important part of the reduction in unemployment—well, why does anybody think the Keynesian model is applicable? Well, first of all Keynes wrote so brilliantly. But also everybody remembers the example of World War II. The unemployment rate was very high. Government spending increased. The unemployment rate went down to 1%. Isn’t that obvious? When I started looking at the labor market, I found that a big part of the picture was simply military conscription. Between the enactment of the draft in September 1940—World War II really did start for the U.S. before December 1941—and the peak of unemployment—and March 1945, the peak of employment, the number of workers unemployed and on low-wage public work-relief programs decreased by 7 million but the number of people in the armed forces increased by 11.5 million. Where did all these extra people come from? From the increase in the labor force participation rate. Yes, private employment did go up some during World War II. There was some private employment effect, although I could not get it to be statistically significant. Big a part was military conscription. Thus to answer one of Brad’s questions, yes, the government could adopt a policy that would quickly reduce unemployment: large-scale military conscription. If the problem is with employment rates for young males, this is a great way to do something about that, but I don’t think anybody thinks that policy would be welfare-improving. What would I do? I think a key structural reform that would significantly help the economy—the labor market and also the long-run budget deficit—would be to reform the health-care sector. I spend a lot of my time teaching micro pubic policy. There are huge potential efficiency gains, as I will show. I think the link of health care to the employment relationship is probably really hurting the labor market right now. I don’t have detailed statistical evidence on that like I do on multipliers, but that is my gut reaction. Rising health-care costs are the source of our long-term deficit problems. The recent reason it looked like that wasn’t going to be so bad was because they were going to cut Medicare physician reimbursement rates by 23%, but they undid that on January 1 of this year. The Affordable Care Act is unlikely—it tries to do certain things but it is unlikely to have a big impact. Here are some numbers. This is health spending as a share of GDP in 2010: Canada, the OECD average, the UK, and the U.S. [60:00] Red is the part spent by government as a share of GDP. Blue is the part spent by private—either out-of-pocket or private insurance. Canada’s public spending covers close to 100% of its population. The red there is about 8% of GDP. The U.S.’s public spending covers only 25% of its population. But it spends the same 8% of GDP. But on top of what the government does for 25% of the population, we have all this private health-care spending. Are we getting anything for this extra spending? There is all this wonderful economic research going on and more and more evidence is accumulating that we are not getting very much at all for this extra expenditure. The obvious sort of thing—this life expectancy-spending graph is a great thing to show undergrads to show diminishing marginal returns. On average, you spend more on health care you get greater life expectancy but at a diminishing rate. But look at the outlier: the United States, with very high spending and much lower than predicted life expectancy. It is clearly well inside the production-possibility frontier. People say: “yes, but we do these things better”. More and more evidence is accumulating that a lot of the good things in health care that the U.S supposedly does are not in fact the case when you delve down into the statistics. One thing is that the U.S. is very good at early detection—mammograms every year. The NEJM just figured out from a Norwegian study and an additional study in the U.S. that 30% of those early breast-cancer diagnoses would have disappeared on their own—but in the U.S. because we screen so well they treated them with surgery, radiation, chemo. In Europe they only screen every five years. So conditional on diagnosis it looks better in the U.S. But it is not clear that the U.S. is in fact doing a better job. So there are all kinds of studies suggesting that we are just not getting very much for our money. Suppose that the U.S. spent only 11% of GDP on health care, like Canada, rather than the 17% we do. That is$950 billion dollars extra per year. That is more than the peak of U.S. defense spending. That is $15,000 per student in K-12 education. Or you could give every person in the 99% an extra$3000/year. These are huge numbers, and they are every year. These are huge numbers.

To paraphrase Lucas—and obviously Lucas’s numbers for development was much bigger—I cannot look at these numbers without seeing possibilities. The potential gains to the American economy are absolutely staggering. And once you start thinking about these numbers, it is very hard to think about anything else.

People start asking: why do you think about health care? You are a macroeconomist! I say: macroeconomists have no trouble studying manufacturing which is 11% of GDP, and since health care is 17% of the economy it becomes macroeconomics.

How to reform health care? Of course, that is the hard question. I think that health insurance needs to be decoupled from the employment relationship. Health-care benefits need to be taxed like wages. That is something you could change that would, I think, really help the logjam. You want to give people an incentive to do something out of pocket, but it’s after tax out of pocket. One option is a national health insurance system. If we could get a good one, it is better than what we have now. My worry is that the U.S. government wastes enormous amounts of money treating 25% of the population, do you really want them to cover 100%? Could we just have Canada run the system for us?

Another option is to do what the U.S. does best—come up with innovative ways to get the incentives right. The U.S. innovated in tradeable permits for pollution and externalities. Can we come up with some kind of innovations like that for health care? With the right incentives we might be able to get Wal-Mart innovation so that the U.S. health care system could become the most efficient in the world. Right now the incentives are all wrong. I don’t think there are any quick fixes. I wish the government spending multiplier was 2. I wish we weren’t at the zero lower bound. But given that we are, I think structural reforms of health care would help—everybody knows something needs to be done about the government budget deficit, and just delaying the uncertainty just cannot be helping the economy. If they could do something about health care it would free up resources for the economy both in the private sector and in the rest of the economy and it would do a lot to solve the long-term deficit problem. I think that that would help the economy in the intermediate run.

DELONG: I am not sure whether Valerie is calling for all the macroeconomists to stop working on macro and start working on health care, or whether she is telling them to stay away—lest they do to the economics of health care what they have done to business cycle research. Harald Uhlig, from the University of Chicago?

UHLIG: Thank you for having me on this panel. I have been engaged in research in macroeconomics since 1978—for me that is when macro began.

The question in this session is: can fiscal stimulus get us out of recessions. And let us go back and look at how we got out of previous recessions: did fiscal stimulus have a lot to do with how we got out of previous recessions? What is this about private activity?

Here is a really simple picture. You just take government spending—the business cycle component—and do the same for real GDP. Government spending is cyclical. If you look at postwar data for the United States, government spending is simply the most cyclical macro variable that is out there. The U.S. economy got into recessions without government spending. It got out of recessions without government spending.

That does not mean that you should not do government spending to get out of recessions. But just as a fact, if you try to understand business-cycle dynamics you should not be thinking much about government spending. It has to be about private activity. And given that we got out of previous recessions with private activity, with things that have nothing to do with government spending, that’s the place we ought to be looking at right now.

There is a huge literature. Let me just pick one line of research that is recent. Much of the job dynamics has to do with what young enterprises do. Young entrepreneurs, young small firms starting up and hiring people and eventually becoming large firms. That is really where much of the dynamics in the labor market comes from. 50% of entrepreneurs’ decisions to enter or not to enter has to do with upside and downside risk. The more upside potential there is the more likely entrepreneurs are to enter. The less downside risk there is the more likely entrepreneurs are to enter. That suggests as a way of looking for policy solutions that what you want to do is encourage the upside potential for young entrepreneurs to enter and you want to take government risk off the table. I don’t think you are doing that at all with fiscal stimulus. Having all these talks about taxes going up and going down—that is not helping along this dimension at all.

When you talk about fiscal stimulus, doing back-of-the-envelope estimates, it is always surprising how different people look at the same data in different ways. For example, in 2009 did fiscal stimulus help us? Well, there is one view that suggests that it did not do very much because whatever the federal government did was offset by the states anyway. Maybe the dynamics has something to do with unemployment insurance, but fiscal stimulus has not done much. The other view is that if they had not done fiscal stimulus we would be really in a great depression. It is hard to say what the counterfactual is.

You look at Japan. Japan has a debt to GDP ratio that is way in excess of 200%. Boy have they tried fiscal stimulus! Look where they are! It does not look like a huge success story to me, but of course you can make the case that if they had not done that they would be in much worse shape. So again, how do you tell these things apart?

You remember episodes of stagflation in the 1970s. I remember these charts when you were a kid where you could choose between 5% unemployment and 5% inflation and eventually you were getting all of that combined with high government debt. It took us decades to get out of these traps again. So I do not think that these episodes are encouraging. I know you can look at them and think that they are encouraging. But ultimately you have to do research. Ultimately you have to look at data to come to some conclusion here.

Much of the excitement of recent research that is done in that area emphasizes the importance of the zero lower bound in inflation and interest rates. So there is a lot of theoretical modeling, a lot of empirical modeling. We have already seen some things. I was involved in that literature as well. Let me just say that I really love the work that has been done and we should consider that. There are also people who disagree. If you look at the recent work by Auerbach and Gorodnichenko, they do these fiscal multiplier calculations based on booms and recessions and they find substantial fiscal multipliers in recessions. It is interesting work. You have to look at that and think about that. That is great stuff.

Let me talk more about the theory side—quantitative theory. Most important theory is dynamics. We are beyond shifting IS-LM curves around. There are periods. There is 2013, and 2014. Life goes on. We use dynamic models. And there are lots of theories that try to look at that. For example, this comparison exercise where they looked at very quick stimulus: what does it do? They assume sticky prices—Keynesian features and all these other features, non-Ricardian agents, and so forth. They find a fiscal multiplier that is larger than one. That is informative. That is useful. That is good. But this is not the kind of fiscal stimulus that they have seen.

What Cogan and Taylor have done in their paper is to say let us look at the actual American Recovery and Reinvestment Act and see what is in there, and you get the old story that it is too little too late. There is a dynamics to the whole thing and eventually the fiscal stimulus is foreseeable and so forth. And I have put on top of that the distortion of taxation, because eventually eventually you have to repay the debt that arises from the fiscal stimulus with rising taxes. Once you do that, what you might want to look at is not just what happens right now but the discounted present value of the fiscal multiplier because the distortion of taxes down the road will decrease incentives to work, create capital, and so forth. And what we find is that the long-run multiplier is zero and even negative. In the short run, fine, you get a kick. If that is all that you care about, that is all right. But there is a long-run cost. Keep that in mind.

Let me talk about sticky prices. Much of the literature assumes sticky prices. We love sticky prices. We love to assume them. Are they there in the data? This is a plot from Julio Rotemberg, from his JME paper. That is looking at the retail and wholesale prices of Nabisco premium saltines. If somebody had shown me this series and asked me what was going on I would have said that we should write papers on the excess volatility of prices. These prices change a lot. Now everybody looks at these prices and says we know what is going on there is a regular price and a sales price, and so forth. I do not know where you shop. They are hugely volatile. The question is what is going on there. The idea that these prices are somehow sticky, an assumption that we love to make is just not supported. I am not saying that that is a typical price series. But it is not that atypical looking into these issues. It still does not mean that monetary policy does not have an effect. But from a perspective using [1:15:00] rational inattention for example would be much more fruitful or perhaps sticky innovation—read Mankiw—is much more helpful than thinking about sticky prices. It is an exciting development in this direction and it helps us understand what we do.

But this was at the heart of the previous theoretical modeling. The sticky price assumption is a great assumption when you want to say that there are somehow some sort of coordination failures in the economy but you don’t quite know how to get them so let us assume sticky prices. It gets us there a little bit. Yet we need to be really, really careful when we go to policy conclusions in overstating our confidence in that assumption. Something else is going on there. We have to spend a lot of time thinking about it. Once we know that we can think more clearly about fundamentals.

There are fiscal limits. And they are serious. Valerie Ramey has shown us the plot on health care spending. I wish Alan Auerbach were here. He always shows these plots from the Congressional Budget Office that if we keep on going as we are with Social Security you eventually reach a debt-to-GDP ratio of 500% or 600% in 2100 or so. Ridiculous numbers. Clearly something is going to happen before that. But we do not want to wait until then. We want to get our fiscal house in order way head of that. It is a ticking time bomb. We should do something about this. And we should not be complacent about this.

Right now it is easy to be complacent in the United States because you say well interest rates are really low so we could do a lot more spending and run up more debt and postpone adjustment into the future. What is there to worry about? Once this becomes a problem it will be signaled because interest rates will rise a little bit. Well they don’t. Interest rates in financial markets on government securities—once financial markets start to have doubts on whether governments are serious about repaying their debt they have a tendency to jump. And once they jump the catastrophe is there. Let’s not wait until that happens. I am not saying that that is going to happen anytime soon in the United States, but the dynamics you want to have in your mind is a dynamics where you keep on piling up these fiscal problems and eventually the problem hits you overnight. You may not have much time to react.

You see lots of European countries that got precisely into that trap. Here are some plots: Spain, Italy, Greece—Greece is off on its own scale. You can see how in the middle of 2010 these things just jumped up. Things were going fine and smooth and all of a sudden there is a catastrophe. And it is because all of a sudden financial markets had doubts that debts would be repaid. That is the real fiscal cliff. You want to stay away from that.

I use a fairly simple neoclassical growth model to think about the Laffer Curve—how much taxes could you possibly extract from the economy if that is really what you want to do. And then you can ask how high are the interest rates you could possibly sustain. How worried do you have to be? Let me just show you a table from the paper. Capital taxes by the way don’t do very much because the tax base is small and when you think about the general equilibrium effects. Of course you could also have consumption taxes. That’s another topic altogether. The second column shows the maximum interest rate given the debt-to-GDP ratio in 2010 if you tried to maintain it forever that you could face on financial markets. These are real interest rates, not nominal interest rates, so you might want to add inflation to that.

I don’t want to be alarmist about the United States. In the United States there is still quite a bit of fiscal room. I think we still have some time to change paths. But in other countries—they are squeezed. See Greece there. The interest rates they are facing are just unsustainable. They cannot possibly repay them. You also get some of the other countries that are supposed to be the guarantors in the European system like Germany and France. We have to be really careful. Once financial doubts emerge their room for maneuver is not that high either to extract tax resources to be able to credibly say higher interest rates no problem. We can repay them.

The federal debt-to-GDP ratio has risen dramatically and is now at World War II levels and I want to get that genie back into the bottle, and I want to get it back into the bottle by getting the government out of private activity because it is private activity that makes stuff happen. That is how we get out of recessions. And so we have to cut back on fiscal spending rather than doing more fiscal stimulus.

This is a summary. These are some talking points. The exit from recession really comes from private activity. I am not saying that you know exactly what is going on there. Maybe government can help there. It is not about stimulus spending. Paul made some counterarguments. Stimulus encourages rent-seeking. Now you create enterprises to get these government contracts. Maybe you are waiting for the government to do something in your area rather than do it now because they are going to come in and build roads or do some construction so let us wait until they come out. These are bad things for the economy. There is too little too late. We had that debate in the 1970s. We are having that again. Sometimes it looks like we haven’t learned anything from that experience. Maybe you get GDP up, but the economists’ perspective we really want to take is whether you get welfare up. Consumption response is what you really want to think about. Here is a little bit of a challenge: you also want to think about the employment response, because in our models if people work harder that is a clear loss in welfare. Right? It would be great if you could consume all the resources we get to consume by not working at all.

Whenever you say that, it sounds a little bit funky. But why are we worried that people are unemployed? We are worried because consumption drops. Maybe you get nervous about finding jobs. There are all these things. You want to think about welfare, and the welfare issues in these stimulus debates often do not come up. Hiring people to dig holes and fill them again—it is true, it increases GDP. Why? Because you measure that activity by the amount of money the government spends on that. You get GDP up. You get employment up. But does that increase welfare? It doesn’t. You just have the same people digging the holes. Now the fact that they are getting paid and consume more—they are happy with that. But this digging the holes stuff doesn’t help.

Now in the longer run we have to worry about taxes, we have to worry about debts, we have to worry about long-run sustainability with the Social Security system. These are real obligations. These are not nominal obligations. We cannot inflate them away. We have to get our house in order. We have to do something about them. And if we don’t, doubts in financial markets will lead to a situation in which disaster strikes.

Thank you.

DELONG: One thing I wanted to do with this session was to amuse myself and abuse my role as moderator by tormenting the panelists somewhat. I wanted to turn it into somewhat of a self-struggle session. That was why my fourth question asked how they had changed their minds on microeconomic issues over the past six years, and what they had changed their minds about. How did they think differently now than they did then? The only one who I heard give an answer to that was Paul Krugman. He said that he wished that Paul Krugman of 2002 had paid a lot more attention to Akerlof, Dickens, and Perry in the Brookings Papers and Truman Bewley on the consequences of a world with not just price stickiness but with sharp downward nominal rigidity in which employers really do not want to diss their workers by cutting their nominal wages. And he also said that he had become significantly less monetarist—that Krugman 2002 would have said that if in 2008 in response to a financial crisis the Federal Reserve was going to take the high-powered money supply from $700 billion to$3 trillion, was going to take the federal funds rate down to zero and promise to keep it there until 2015, and then also start buying $1 trillion a year of long-term bonds, then the economy would recover fairly quickly from whatever depression the financial crisis had landed it in. That, I think Krugman 2002 would have said, would have been enough to boost nominal spending back to our above its pre-crisis trend even given all the credibility problems of monetary policy. I did not hear any of the other panelists give a self-struggle session. So may I ask them to do so? May I ask Carlo, briefly, in four minutes? COTTARELLI: After all the noise that my friend Olivier Blanchard made about how we at the IMF have changed our views on the size of the fiscal multiplier, I didn’t think that there is any need. But let me say a few words. The paper presented by Olivier Blanchard and Daniel Leigh yesterday said that we have realized that the multipliers we were using in 2010 were ex post too low. The question is to try to understand why this happened. The multiplier we know very well is not a universal constant that is fixed: it depends on a number of circumstances. It is a reduced form. One of the things it depends on is the state of the banking system. That directly affects the number of households that are liquidity constrained. We thought that reforms would be implemented to strengthen the banking system, particularly in Europe, and that this would allow the private sector to recover more rapidly and to offset the effects of a fiscal tightening. It is clear that ex post this was wrong. The indication of this is that our growth projections turned out to be too optimistic in countries that undertook larger than projected programs of fiscal tightening. However, it is a very different question to ask if we had known this, would our policy advice have changed? That is a much tougher question because the value of the multiplier is not the only thing that matters in deciding what is the right policy course. The fiscal policy course depends first on how bad your fiscal policy situation is; second, what is the amount of financing that can be done at a reasonable interest rate; and third, what is the state of the economy and thus the impact of the multiplier on GDP. Another thing to keep in mind is the counterfactual. When we talk about the multiplier being high, we need to keep in mind what the counterfactual is. When we say that the multiplier is higher than one it is with respect to a situation in which we do not tighten fiscal policy and nothing much else happens. Now it is possible, and this is the main reason that you sometimes have to go ahead with fiscal tightening even if you know that it will reduce GDP, that if you do not tighten fiscal policy something even worse is going to happen because of the loss of confidence in the system due to the fiscal accounts. And that is the main reason that gradual fiscal adjustment—or even no fiscal adjustment as long as you believe that if you do not tighten there is not going to be a collapse in confidence—is preferable. The extent to which this is true depends on the condition of the countries we are considering: not all countries are in the same position. One last point: Having said all this, we need to remember that if multipliers are high, then we should not kid ourselves and pretend that if you tighten fiscal policy nothing bad will happen to the economy. There is going to be some deceleration of economic activity. You may have to go ahead anyway because the counterfactual will be even worse. This is something we have learned. You need to have realistic growth projections and use all other policy tools that you have available. That is why we have argued in Europe that it may be necessary to go ahead with fiscal contraction but you do need to do something to fix banks and do something to make sure the credit channel recovers. Of course, ex post if the credit channel does not sustain aggregate demand the cost will be higher in reduced aggregate economic activity. DELONG: Valerie? RAMEY: I was not making any policy recommendations five years ago, so I do not have to go back on anything. The first thing is that have really become aware of how important the zero lower bound stuff is. I would look at research by Paul Krugman and Mike Woodford and others on the zero lower bound, and I would say: “That’s interesting research. Maybe I will read it one day.” But I thought of it more as a curiosity and did not imagine that it would become so relevant for the U.S. From now on, I am going to pay more attention to that sort of research. The second has to do with the multiplier. I started working on the effects of government spending in the 1990s because southern California was hit so hard by the fall of the Berlin Wall. There was a serious recession in southern California when all the defense companies went under. I did a lot of research on that and began looking at the effects of government spending then. But back then researching government spending was a backwater: Federal Reserves have much more money than do Treasuries. There would be a few of us that debated this, and most people did not realize what a lack of consensus there was on the government spending multiplier. Suddenly by chance it became a hot topic. That was useful. I also figured out how complicated the idea of the multiplier is—periods of slack versus other periods. But something else that I did not mention was the possibility of asymmetry. One thing we saw in the defense wind down of the early 1990s was that the decreases in government spending can have larger multipliers than increases because they engender these sectoral shifts. One reason the IMF might find that it was underestimating the multiplier is that its previous estimates were estimated on average while when it is exclusively contractions, especially public employment contractions, it can have really costly impacts on the economy. The third thing is that what you don’t know can really hurt you. Housing prices went up first in areas like San Diego. And they started going down first here as well. My colleague Ross Starr is sitting in the front row. I am trying to remember in what year it was that we told our junior colleagues that this is not a good time to buy a house. 2004? 2005? Our junior colleagues thought we were a little bit kooky. I said that I was going to go out on a limb because housing prices had gone down in San Diego in the early 1990s. I said that I thought that housing prices in San Diego could go down by as much as 10%. Now I never thought it would be a drag on the rest of the economy, I didn’t know what was going on in the rest of the nation. And I didn’t know, what I did not pay attention to, along with not paying attention to all that zero lower bound stuff and Japan was what all my finance colleagues were talking about in terms of all those new exotic financial instruments. And it was because I did not know that I did not understand how what was going on in my little corner of San Diego would amplify to the rest of the economy. That is what I have learned in the past five years. DELONG: OK. Harald? UHLIG: I change my mind all the time. That is the exciting part of being in economic research and studying the economy. You always see new people coming up with new ideas. It would be boring—frustrating—if there were all this good new work that was coming up and you did not change your mind and did not learn anything. For me it is mostly the questions that have changed: the issues that people had not thought much about ten years ago: fiscal multipliers, the interaction between fiscal and monetary policy, the zero lower bound, what’s the impact of price stickiness—if you change the degree of price stickiness, what is the impact on the fiscal multiplier. I would have made a lot of wild guesses. I would not have had an informed view. There is lots and lots of research that has come out. All this research on identifying the fiscal policy shocks. There was little. Now there is a lot more. All this work on the sticky-price model—it is very interesting. Even despite my misgivings about sticky-price models I think we ought to look at them—from Woodford and Eggertsson and Krugman and from all the others. And we learn about the zero lower bound. I think there are lots and lots of puzzles still out there. Let me mention something on which I have shifted my views. Johannes Wieland is from Berkeley. In his job market paper he says that in new Keynesian models at the zero lower bound there is, theoretically, a perverse reaction to supply shocks. An adverse supply shock which reduces potential output rises expected inflation and so reduces real interest rates and boosts output. this topsy-turvy effect enables an adverse supply shock to actually increase output at the zero lower bound. He goes out and tries to see if this is actually true. He finds the opposite is true: if you raise oil prices it is actually bad for Japanese output and not good at the zero lower bound. The world seems to have a more conventional reaction. He comes to the conclusion that this tells us something about the model—if you have a model in which everything is determined by sticky prices, in crisis times you can see that a better fit is attained by models that say that you really ought to look at balance sheets. Other research has recently emphasized balance sheets as very important in what has been happening in the past several years. There are lots and lots of open questions out there that I wish we just understood more. You see that there is inflation and it has been very very stable over the past three years. All the Federal Reserve action didn’t really change that very much. All the government spending didn’t change that very much. Remember: that is a key feature of many of these new Keynesian models: clearly we need to understand more what is going on there. We still have—we have financial constraints, and they amplify shocks, that is true, but somehow I still have to think that somewhere there was a bit of leverage and from a small seed a big catastrophe can grow. There are papers on leverage cycles. There is a guy on the market from MIT this year who has a model in which they build up and then collapse afterwards. People have been trying to work on these things. There is a lot more work to be done. And once it gets done I change my view once again. KRUGMAN: Brad? DELONG: Yes? KRUGMAN: Since I already criticized myself can I spend a couple of minutes criticizing other people? DELONG: Two minutes. Only two minutes. KRUGMAN: OK. I disagreed with everything Harald said. With respect to Valerie, there are two points I want to make—more that I want to make, only two that I can make in the time I have. I am baffled by the discussion of things like the increase in labor participation during World War II as affecting the multiplier. A lot of people, including people I respect a lot, say that. But that seems to me to be a confusion between supply and demand. Government purchases increase and that increases spending through the multiplier. The increase in labor force participation makes it possible for that increase in spending to show up as an increase in output rather than inflation. But I don’t see that as changing the multiplier, which is a demand story. And I do not see any way to tell the story of World War II in such a way that government command-and-control would lead us to overestimate the multiplier using World War II data. And we are not here talking here about anything that might remotely push us up to the bounds of capacity. Structural reform—we are all for structural reform, we are always for structural reform. But when it is advanced as the answer to a cyclical downturn, I and some of my economic-doctrine friends get exasperated. I think the best statement came from Kevin O’Rourke of Oxford, back in 2010, when Ireland was really hitting the skids. He said that there were two views being expressed by the “structuralists”: one was that Ireland could get out of this through structural reforms; the other was that Ireland was going to be OK because it had already done all its structural reforms and had such a great and flexible economy. He said that those cannot both be true. Some of the rest of us then said that if you believe that story then you should not undertake structural reforms in normal times in order to preserve inefficiency so you can deliver some structural reform the next time you hit a recession. At some point you have to stop saying that structural reform is the answer. You have to say that if bad things happen to a perfectly flexible economy there has to be some way of dealing with the cyclical demand problem through cyclical problems? DELONG: There doesn’t have to be some way… KRUGMAN: Well, if you want to say something useful... DELONG: Well… KRUGMAN: Let me say just one more thing. There is this wise saying that we need to think about the long run and not the short run. But (a) in the long run we are all dead, and (b) there is a lot of reason—I am surprised that Brad of all people has not mentioned it—that a failure to deal with the short run is inflicting very large long run costs. I believe that we are deeply in DeLong-Summers territory where we are crippling our future as well as our present by falling to do what is needed to deal with the short run. DELONG: Well I am the moderator. I am not supposed to take over the panel. But I think there was a view—ten years ago you would have said that for Japan at least that even if everything else—increasing the balance sheet, driving short-term nominal interest rates to zero—did not work, the last resort of monetary policy would be to adopt an exchange rate target and depreciate the yen at 5%/year until nominal spending is back on track because that is guaranteed to boost expectations of inflation and the money stock. For we know that governments can credibly promise to peg exchange rates wherever they want. KRUGMAN: That was Lars Svensson, not me. I was less confident that you could actually do it. DELONG: So I am confusing my Princeton Japan-worriers of the 1990s. It seemed to me then to be a smart thing for Lars to say. But I think now I certainly would, you would, I don’t know what Lars would, say that we have grave doubts over whether monetary policy can in fact do the job. It may indeed be the case that some demand management problems cannot be resolved with the tools governments have at their disposal. It may be that all we can do then is recommend structural reforms to boost potential output. I don’t want to be there. Valerie does not want to be in a world where the policy-relevant multiplier is 0.5 rather than 2.5. But there is little enough time left. So let me open up this panel to questions. QUESTION: Valerie, in your slide where you were looking at different alternatives for improving the efficiency of health care in the United States, you were looking at government-funded health care. I believe you had a statistic there of 25% inefficiency. How does that compare to the inefficiencies of our private health insurance system? Does that inefficiency come from bureaucratic inefficiency or politically-imposed constraints like the prohibition against Medicare negotiating the prices it pays for pharmaceuticals? RAMEY: What I was saying was that the U.S. government spends the same share of GDP on health care as the Canadian government but that the Canadian government covers 100% of its population while the U.S. government covers only 25% of its. There is a suggestion that we could cut the percent of GDP devoted to health care without much loss if we could somehow get incentives right. All the micro studies suggest that there are lots of inefficiencies in the system, and I would direct you to people like David Cutler. One answer to Paul. On health care, if you could change the tax structure so you could immediately decouple health care from the employment relationship, I think that the employment-to-population ratio would be much higher by the end of this year. QUESTION: A question for Dr. Krugman. You said that the amount of stimulus was insufficient. I take it you were talking about the 2009 Recovery Act. What would you call$1 trillion/year deficits if not sufficient stimulus?

KRUGMAN: What we have is automatic stabilizers at work. Relative to a world in which we only had lump-sum taxes and social insurance programs were not responsive to economic conditions, this would be a large stimulus. But we do not have a large policy stimulus right now. The deficit right now is overwhelmingly the result of the collapse in revenue from the recession plus secondarily the increase in spending on social insurance from the recession—unemployment insurance, food stamps, and a few other things that are cyclically sensitive. On the PPE basis—the proof of the pudding is in the eating—we have a large output gap, spending is insufficient, and it’s very hard to come up with stories that could fill that gap other than some rise in government spending. We should not be talking about hiring people to dig holes and fill them in. The truth is that we have had a dramatic fall in public investment, have laid off hundreds of thousands of school teachers, and all we want is to restore some of that public investment and rehire those schoolteachers. We are not talking about doing new and dubious projects. We are talking about reversing the large austerity that has already taken place. [1:45:00]

DELONG: Let me abuse moderatorial privilege by adding two historical footnotes. John Maynard Keynes wrote so damned well and was so clever that he does not fit well with our world of soundbites. The Keynes quote “in the long run we are all dead”: In context that is not a claim that we should worry only about the short run and ignore the long run. In context that is an attack on comparative statics—a plea for economists to do dynamics, and not be satisfied with saying nothing more than the quantity theory of money doctrine that when the money stock increases the equilibrium is a proportional increase in the price level. The Keynes quote about how it would be effective to dig holes in the ground and put bottles of money in them: In context that is a critique of gold-bugs saying that recovery had to come of itself and that the money stock should be increased simply by an increase in gold mining. Keynes was pointing out that an increase in monetary gold via mining was the equivalent of (a) printing currency, (b) burying the currency in the ground in bottles, and (c ) having people then dig the currency up. The point was that that would be effective, yes, but more effective would be simply (a) and then spending the government money in (b) employing people to do things that were useful. It is an attack on goldbugs, not a serious claim that the government should hire people to dig holes in the ground to fight recession.

QUESTION: We have seen government come very close to the fiscal cliff. The bigger cliff is going to be the debt ceiling. Obama says he is not going to negotiate over it. What in fact do you think will happen if there is no negotiation over it and we do in fact go past the debt ceiling?

DELONG: Carlo should probably not answer that as an international civil servant… Let’s get one answer… OK, Carlo can answer that…

COTTARELLI: Hitting the debt ceiling not for one day but for longer means that you have to have a balanced budget. It means a fiscal tightening of 8% of GDP. This is twice as much as the fiscal cliff. That must be avoided. Hitting it for even one day does show that there is considerable dysfunction in American governance. You should not get into a situation in which it is only at the very last moment that the crisis is avoided. We have argued that there is a pronounced need to find a solution to the debt ceiling as soon as possible. The economic consequences of a fiscal tightening of 8% of GDP are too grim to contemplate.

KRUGMAN: The real answer is that I hope that everybody in this room has plenty of bottled water and ammunition…

DELONG: Sewing needles. In the long run sewing needles are more important…

QUESTION: Professor Uhlig, you are the only one on the panel who does not think that aggregate demand for goods and services is not a crucial concept for understanding how we go into a recession and how we come out of one. Could you explain why you make no reference whatsoever to aggregate demand?

UHLIG: Economics is always demand and supply. More seriously, aggregate demand is—there was a shock to aggregate demand. That is really hard for me to think about. There are all kinds of sectors of the economy. And then there is aggregate demand where people go out and spend is a reaction. People think about the future—whether they will have a job in the future, what taxes they will pay in the future, does this happen, what is happening, and therefore demand is a reaction to this. I don’t think it is constructive to say that aggregate demand has fallen for reasons we do not understand and that we should now step up and have government fill that spending gap. We should look at the underlying causes that made the economy move and look at the underlying fundamental shocks that move the economy. People do that. There are these models where people try to disentangle where these shocks come from. We had the financial system going down. We had the balance sheets, and so forth. Then we should address the causes of what caused the recession. If it is about entrepreneurs and not spending let’s address why entrepreneurs are doing that rather than thinking directly about aggregate demand. Demand for me is what happens as a result of all these other things. It is not the point at which you want to start. That was the whole point of Hall and Lucas and all these other things. Consumption is a lot smoother than output and people are really forward looking and trying to figure what is going to happen in the future and people react to that and that is where aggregate demand comes from.

QUESTION: I have heard very little discussion of the relation between the multiplier and the debt. There is some sort of case that when your debt is 25% of GDP you are going to get a different multiplier than when your debt is 125% of GDP. You would expect the effects of fiscal policies would be different depending on the burden of the debt. But I didn’t hear any discussion of that.

COTTARELLI: A number of studies show that the level of the multiplier depends on the state of public finances, of which the debt-to-GDP ratio is one important indicator. What is critical is the relationship between the multiplier and the confidence people have in public finances.

UHLIG: I have seen papers—I am trying to remember the names—by people who have looked at these issues. You can have negative impacts. If you are close to fiscal sustainability, and if you try to do more spending, that raises more doubts in financial markets about whether the debt is going to be repaid, and has a very negative effect. As a case in point say Spain right now. If Spain started to issue more debt it might be disastrous because it would raise yields even more and have the opposite effect. I am not saying Spain shouldn’t. But we have to be very careful in this respect.

DELONG: Well, I will say that Spain should not issue more debt and run bigger budget deficits right now unless somebody credit-worthy backstops its debt. If you look not at the national income but at the savings-investment identity, you can see that investors’ willingness to hold bonds rather than cash depends on (a) the nominal interest rate and (b) the average riskiness of bonds. Raise the average riskiness of bonds and the resulting desire to deleverage puts downward pressure on spending, employment, and output. From this perspective expansionary fiscal policy works when it does work is that it boosts the economy because by adding safe Treasury bonds to the market it changes the mix and makes the average bond less risky. That is not the case for government spending when you are up at a debt-to-GDP ratio of 125%. Adding more government bonds makes the existing stock of government bonds more risky. And that is not the case in Spain right now. Adding more Spanish government bonds to the mix does not increase but decreases the safety of your average bonds. If more spending in Spain could be financed by an entity whose bonds were regarded as safe, however…

KRUGMAN: This point that Gauti Eggertsson has made that if you are worried about having a credible commitment to inflation, in that case a public debt large enough that people know you will have to monetize it may be the best way to credibly commit to inflation and so reduce real interest rates and boost the economy. We are in a really weird Alice-through-the-Looking-Glass world here. Obviously for Spain which doesn’t have its own currency…

DELONG: Right.

KRUGMAN: But for Japan, if the deflation ever breaks it might be because people start saying: hey, they have so much debt they will have to monetize some of it.

DELONG: And if I were channeling Greg Mankiw, I would say that is exactly how monetary policy should be used in place of fiscal policy—that if we were to have a lot more quantitative easing right now, that would convince people that the debt will be monetized at some point, and that would decrease people’s willingness to hold outside nominal assets and increase their desire to spend on currently-produced goods and services and so get themselves unleveraged.

QUESTION: Valerie Ramey’s compelling evidence about how we need to reform our health-care system. She said that the Affordable Care Act. I am curious, Paul, whether you agree or disagree.

DELONG: Is David Cutler in the audience? Is John Gruber in the audience? Is Mark McClellan in the audience?

KRUGMAN: I can channel David Cutler for a second. He says that basically every idea that everyone has ever had for controlling health-care costs is in the ACA, at least as a pilot project. It is not as though they are not trying. To some extent by locking in the commitment to universal coverage you have eliminated the political escape hatch of dealing with rising health care costs by casting people into the outer darkness where there is weeping and wailing and gnashing of teeth. You create the political incentive that you must deal with it. On health care Stein’s Law applies: if something cannot go on forever, it must stop. The ACA brings that moment closer even if you do not think the reforms specifically embodied in it are the right ones. [2:00:00]

DELONG: There are lots of specific reforms in the ACA that fit at least what was the Republican health-care policy agenda, at least as of 2007. For example, the end of the tax preference for employer-sponsored health coverage is in the ACA in a gradual, back-door way in the form of the “Cadillac Tax” on high-cost health care plans. Whenever you try to evaluate the ACA you have to figure out first what is in it and second what pieces of it are going to survive the legislative process. And last Thursday we got bad news on that from the House Republicans. They stated that they are not going to follow the ACA and give the Secretary of HHS’s recommendations on how to cut Medicare cost fast-track consideration and a rapid up-or-down vote, with the recommendations going into effect if the vote is not held. They are not going to follow what is written in the ACA. That nullification of the IPAB provisions of the ACA is very bad news for federal health-care spending growth.

QUESTION: The share of debt to GDP influences fiscal policies. The capability of government to collect taxes is an important factor and that is better than in Ukraine and even more in Spain. Another factor is that a country needs to have a currency it fully controls. Japan has so much leverage and leeway because it has such a currency. One reason that so many EU countries suffer is that they do not. As concerns the United States, it is still on the side of Japan.

QUESTION: Blinder and Zandi two years ago showed that the fiscal multiplier of the TARP was much higher than for ordinary spending. Recapitalizing banks was a high-value thing to do. I asked a question of Olivier yesterday, and he made the same point about recapitalizing European banks. Is it possible that you could reengineer fiscal spending in times of buying shares when investment is low and therefor reengineer the fiscal multiplier.

KRUGMAN: You want to distinguish between things you do to deal with an acute financial crisis and things you do to deal with a depressed economy that is not at the edge of collapse. Most people would agree that QE I—keeping the banks and commercial paper market functioning—was effective. When the Fed stepped in and acted as lender of last resort that was effective. That is very different from QE II and QE III. Similarly, stepping in and recapitalizing the banks when there was a collapse of confidence in the financial system is probably a pretty effective tool. But taking a system that is not on the edge of collapse and stuffing more capital into the banks is unlikely to have big positive effects.

DELONG: We have people who study the macroeconomics of monetary policy and people who study the macroeconomics of fiscal policy. We need to have a third set of people who study the macroeconomics of financial policy, especially to the extent that what is going on is Bagehot-Minsky-Kindleberger-Koo “something terrible has happened to cause almost everybody to think their portfolio is too risky and thinks that cutting their spending below their income to build up their safe asset holdings is what I most need to do right now”.

QUESTION: [Inaudible]

DELONG: The question is directly about the prudential regulation of banks, and indirectly about the belief of the Clinton Treasury in the late 1990s that banks understood risk management and no longer needed the New Deal regulatory straitjacket and that opening up finance to competition via deregulation was the best way to improve competition, diminish oligopoly profits, and improve the functioning of the financial sector—turns out to have been the worst idea ever. Anyone want to talk about prudential regulation of banks?

QUESTION: I am guessing that most of you on the panel applauded the Bernanke Fed and the Treasury in TARP for doing politically difficult and messy things to save the financial system. Would any of you have second thoughts five years later? Might we be better off if we had allowed massive foreclosures and a complete collapse of the financial system to strip the bandaid off and accept the 20% unemployment?

COTTARELLI: No.

DELONG: I think the answer is: “probably not, but counterfactuals are hard”. Four more minutes, so one more question?

QUESTION: What is the effect of the distribution of income on the calculation of the multiplier?

COTTARELLI: We definitely have the idea that money given to lower-income people has a higher multiplier. Those were the sort of stimulus measures we were recommending in 2008-9: transferring money to the poor.

KRUGMAN: But we do not know how rising inequality interacts. There are more poor people who are liquidity constrained but they have less spending power, so we are not sure how it goes.

DELONG: Let me thank all four of my panelists for coming to this windowless room and say what they think about hard issues. Let me second Harald and say that Johannes Wieland is an absolutely crackerjack and superb young economist. And let me second what somebody said and say that, from my perspective at least, DeLong and Summers in Brookings is an absolutely superb paper not because it gets coefficient estimates right but because it does a good job of laying out how your beliefs about reduced-form parameter values map onto the policy conclusions that they entail. Thank you.