Latest Brookings Panel on Economic Activity

September 21, 2010

Justin Wolfers, visiting fellow and co-editor of the Brookings Papers on Economic Policy, explains the interesting findings from the latest Brookings Panel on Economic Activity: recessions hit the rich as much as the poor; the new Dodd-Frank financial reform bill has gaping holes in it; no approach to economic forecasting has been successful; and the social safety net has held up surprisingly well even in the Great Recession.

Recession Hit the Top and Bottom
“For a long time, labor economists have believed that recessions have been especially bad for the poorest in society. Recessions definitely are worse for the poorest in society but the new result that comes out of research by Jonathan Parker and Vissing-Jorgensen is if you look at the rich (and particularly the very, very rich), they’re bearing an enormous part of the brunt of economic downturns. So it turns out we have learned that recession hit the poor – a fairly large group particularly – and the very rich, and it is actually the middle class who don’t quite go up and down as much with the business cycle. This turns out to be quantitatively a really big effect. If you look at how much income is lost during the course of a recession, a big chunk (maybe a quarter of it actually) is lost by the very richest of the rich. So that is new. It is exciting. It is something we did not understand before, and I think it is going to start a lot more research.”

Shadow Banking Still a Problem

“Sometimes the most interesting part of research is actually the part we all agree on. The paper by Gary Gorton and Andrew Metrick puts together a specific proposal for how to regulate the shadow banking system, and they do a beautiful job of explaining just what that creature is. It is not backroom deals, but it’s a way for lending to occur without being under the formal regulatory structures we are all used to. We have just been through financial reform, so all of us would think that the shadow banking system – which was almost certainly a big part of the financial crisis – got fixed by that regulatory reform. The interesting thing the authors did at the end is they said to the audience ‘so it looks like we all agree Dodd-Frank, the recent reform, did very little about this.’ Everyone agreed on that, so the real question is ‘what is it we should do to fix the shadow banking system?’ The authors have a specific proposal. One of their discussants, Governor Tarullo from the Fed, also commented at length, and it looks very much like this is going to be a live policy issue.”

No Macro Crystal Ball

“We had two young economists, Rochelle Edge, who works at the Fed, and Refet Gurkaynak, who used to work at the Fed, talking about forecasting the economy. They thought what they were going to do was run a horse race to see which models for predicting the economy did better. It turns out this is a horse race with no winner. When they took a step back it turned out that, basically, over the last 10 to 15 years no approach to forecasting the path of the economy has had any success whatsoever. So they looked, in particular, at what are called ‘dynamic stochastic general equilibrium theories.’ Now that is a mouthful, but it is also code for basically ‘trendy state-of-the-art macro.’ It turns out the trendy state-of-the-art macro did as bad of a job of forecasting the economy as if you had trained a parrot to simply say ‘GDP will grow at 3.5% and inflation will grow at 2.5% to 3%.’ The parrot, the modern model, and also then the statistical models all failed to pick any of the ups and downs over the last 15 years. Then you might think ‘Well, I don’t like models and I don’t like computers, what about asking real economists?’ So they compared the Fed staff’s forecasts (called the ‘Green Book forecast) and they also compared the consensus forecast (that comes from surveying a bunch of private sector economists). It turns out those people were just as bad as the models, and none of them were any better than that parrot. So it turns out the last 15 years have been a dismal failure for any approach to forecasting the macroeconomy.”

Welfare Net Intact

“The big debate among labor economists and social policy types going back a decade was welfare reform. If we reformed welfare by making it harder for non-working single mothers to get government assistance, what would happen? A lot of people at the time predicted ‘gloom and doom’- that without the safety net, families would suffer. We then saw the 2001 recession, and none of those predictions were born out. But to be fair, the 2001 recession was a pretty weak recession, so maybe that wasn’t the right test of the social safety net. Well we have just had the Great Recession, and the Great Recession surely tried the safety net. So Marianne Bitler and Hilary Hoynes have gone back to see how well the safety net held up when we gave it a real test. Now it is the case that, since welfare reform, it looks like poverty rights and things like that have become somewhat more cyclical. So the safety net maybe has a few more holes. That is one part of their answer, but actually the big picture is also really worth bearing in mind. During the previous large recession – the most comparable recession in 1981 – the unemployment rate rose by about as much as it has today, but the measured poverty rate rose by 5.5 percentage points. Today, the measured poverty only has risen by about 1.8 percentage points, suggesting that with the same-sized shock, the safety net is holding up really pretty well. What is even more amazing about this fact is that our measures of poverty are measures that don’t take account of many of the ways in which we have expanded the safety net through things like food stamps and the earned-income tax credit. So the big picture looks to be coming out of the current recession, it is surprising how well we have managed to protect those at the bottom.”