What Have We Learned from the Crisis and What Remains to be Done?

Martin Baily delivered this speech in a slightly modified version at the Economic Policy Institute’s Conference on Lessons Learned from the Transatlantic Economic Recovery.

Obama is getting a lot of criticism at present and it is clear that he has not been able to make the case for his policies strongly enough to gain the support of the American people. At the same time, I would argue that Obama, who came into office at the worst of the crisis, has been one of the most consequential presidents of recent times. I am not sure how strong Obama’s own views were on how to deal with the crisis but it did not matter because he put in place, or kept in place, the right people to deal with the situation. The financial system was kept from collapse. The economy was in free fall at the end of 2008 and into early 2009 but it was growing quite strongly by the end of 2009. This is an enormous achievement and a lesson to remember from the crisis.

A second major contribution is that financial reform legislation was put in place, the Dodd-Frank Act. The Act is not perfect but the financial system is now much safer than it was. The financial reform effort was for a while a bipartisan one and the bill could have been a bipartisan bill. It was not, and both sides blame the other. My understanding is that the Republican leadership decided to withdraw support for any Obama initiatives. That is too bad.

Third, a hugely consequential Obama policy has been the Affordable Care Act. When Obama decided to propose the ACA while the economy was still extremely weak, I thought he was crazy to do it at that time. In the event, he has made it happen. The United States has been one of the few advanced countries lacking universal healthcare and that has been a disgrace. The ACA is now here to stay and has been embraced by many of the largest states in the Union. It will take many years before all states expand health care coverage under the ACA, just as other similar programs have spread slowly, but eventually it will be a national program. Never mind the difficult timing and the lousy roll-out problems, Obama has given America a chance at universal coverage despite the Great Recession. Another lesson of the crisis is that such a disaster was not enough to stop this enormously important step towards improved healthcare for all and elevating the living standards of lower income Americans.

There are some negatives on the Obama ledger but these carry me into remarks about economics. The post-crisis economic difficulties reflect a failure of economics at least as much as a failure of Obama’s policies.

Let me warm Tom Palley’s heart by saying that we have learned from this crisis that Keynes is not dead;[1] indeed his ideas have proven highly relevant in the Great Recession. Keynes did not provide an analysis of the links from the financial sector to the real economy of production and employment. But he argued correctly that, with wages and prices sticky, a sharp decline in aggregate demand will fall on the level of output and employment, creating unemployment, and perhaps massive unemployment. He highlighted the unstable dynamic that can grip an economy as declining employment and production result in falling incomes and hence further declines in demand and production. Keynes argued that when this dynamic plays out, the economy can end up stuck in a low-income equilibrium and it will not get itself out of this trap in reasonable time without policy help. He also argued that monetary policy could fail in its efforts to revive the economy because of the zero lower bound on interest rates. Keynes’ analysis of the liquidity trap published nearly 80 years ago is extraordinarily prescient in seeing the problem faced by central bankers today and hence ultimately by all of us.

Keynes’ liquidity trap used to be standard fare in intermediate macroeconomic textbooks in the 1950s and 60s but I think you would have been hard pressed to find any discussion of it in textbooks or in classrooms or in seminar rooms in the years leading up to the crisis. Another lesson of this crisis is that we must not forget the wisdoms that were acquired in the past even if they do not seem to be relevant any more. Monetary policy has done all it can to revive the economy over the past few years and its efforts have not achieved very much. Keynes explained why.

Alvin Hansen Paul Samuelson and others brought Keynes’ ideas to America after the war and the big policy lesson was that fiscal policy was necessary to ensure a stable economy. The counterargument came from Milton Friedman who asserted the primacy of the money supply in explaining economic fluctuations, even in the Great Depression. As it turned out, active fiscal policy was difficult to use for macro stability in normal times because Congress and the budget process are ill-suited to this task. The most successful fiscal stabilization policy in the recent past was probably Ronald Reagan’s tax cuts, which helped the economy move out of the 1981-82 recession. That was a rather accidental victory, however, since the tax cuts were initiated not as a boost to demand, but on the erroneous assumption that they would spur work effort and productivity—boost supply. Despite the problems with active fiscal policy, the automatic stabilizers have been enormously important in reducing the amplitude of cycles.

In the Great Moderation of the economy prior to the recent crisis, monetary and not fiscal policy won the race to be the main active stabilizer, at times slowing the economy to curb inflation and at times boosting growth to aid recovery. This could be seen as a victory for Friedman, but I hesitate to award him even this prize because he had issued a very clear warning that the FED should not try to stabilize the economy by adjusting short term nominal interest rates. He laid out the instability that he argued would result from such a policy. In practice, adjusting short term nominal rates is exactly what the FED did with great success for thirty years or more. In fact, this approach to stabilization policy was enshrined in John Taylor’s famous Taylor rule. In short, monetary policy in the form of changes in the Federal Funds rate proved very good at stabilizing the economy in normal times when it is subject to small shocks to demand or to inflation.

Unfortunately, the Great Recession came from a big shock, the housing price collapse and the financial sector swoon. As I emphasized earlier, monetary policy turned out to be powerless to help very much in the Great Recession because of the liquidity trap. Just as unfortunately, fiscal policy, as practiced so far, has not succeeded either. Why not? Was it tried but failed or was it not tried?

Making the case that fiscal policy was tried and failed is a pretty easy one. Budget deficits of well over a trillion dollars a year were incurred for several years (the automatic stabilizers were allowed to work, more so than in the Great Depression). Obama proposed an $800 billion stimulus package that was passed by Congress (as well as a TARP program of about the same size to bail out the banks and the auto industry). There was also the Cash for Clunkers program and, by the way, there was a modest fiscal stimulus effort in the George Bush Administration in 2008. None of these sources of fiscal stimulus have done the trick.

Compounding the problem was that the Obama Administration made a forceful case that its policies were sufficient to restore full employment in a couple of years. They claimed that they had done enough in the fiscal policy area.

The argument of the fiscal policy advocates is that the fiscal stimulus was not nearly large enough. Larry Summers, I think, had that concern at the time the fiscal stimulus was passed[2], even though his public speeches were constrained by his position at NEC. Paul Krugman has used his Times’ columns as well as other writings to make the fiscal policy case over and over. Krugman points to the experience of Europe following the euro crisis to support his position, making the case that Greece, Spain and indeed the whole euro area have suffered from its decision to try and balance budgets with expenditures cuts and tax increases while in recession. He also points to the fiscal policy contraction that has taken place here as a result of tax increases and spending cuts in the last couple of years.

Another advocate of the view that fiscal policy was not tried enough is macro modeler and bipartisan policy advisor Mark Zandi, who said in 2008 that his empirical analysis showed the original stimulus would be too small. He also joined forces with Alan Blinder to make the case for a larger stimulus or an additional stimulus.[3]

My own record on this issue is suspect. I was less optimistic than the Administration about the speed of recovery after 2009, but much more optimistic than was justified by the reality we have faced. I thought the US economy was more resilient than it has turned out to be. Our economy is innovative, dynamic and risk taking and Americans have been spending nearly all of their income for many years now. I thought this would be enough, when combined with zero interest rates and some fiscal stimulus. I was reluctant to support a big new stimulus because of its impact on a debt and deficit already exploding. I never dreamed that in 2014 we would be looking at growth of less than one percent in the first half of the year. Unemployment has come down gradually but almost all of that has been because of a decline in the labor force.

Why has the economy stayed so sluggish? First, I hark back to a concept used by Keynes and his Cambridge colleagues in the 1930s; companies both large and small have had their animal spirits severely dented. In the great boom of the 1990s no one wanted to be left behind, the risk premium was low and investment was booming. Investment has been sluggish since 2000 and terrible in this recovery because no one wants to lay out a lot of money on facilities they fear may never be used profitably. When many companies all reach the same conclusion it becomes a self-fulfilling prophecy.

 A second answer is that the global economy is weak. It is hard for the United States to go it alone in the recovery. Europe, Japan and even China have had weak growth.

A third answer is that the financial sector is not providing the funding needed to those companies and individuals that are willing to spend and invest. Banks are not assessing the risks of consumer and business loans as they used to, rather they are figuring out what the regulators will say, regulators who are looking over their shoulders at every move. We do not want a return to the pre-crisis bubble, but we do want funds to be available for economic growth.

Fourth, reluctantly, I give credence to the conservative argument that the Obama Administration has increased policy uncertainty. Some of this may be real and some of it imagined, stoked by a parade of TV talking heads. Still, this administration seems to have a tin ear when it comes to business. Large companies are sitting on tons of cash and they are making very high profits, much of it coming from overseas. In order to strengthen growth, companies have to be induced to spend some of that money here in America and they have to see such investment as an opportunity to make even more money.

Fifth, there were trends emerging in the economy before the Great Recession that seem to be holding back recovery. Most importantly, skill-biased technical change, a name only economists could love, is real and powerful. The changing composition of the economy with many fewer workers in manufacturing and industrial jobs, the power of computers and automation and the expansion of trade have combined to undercut the opportunities and wages of workers without higher education. Many US companies, whether retail stores or banks, now have a business model based on low wages, little or no formal training and very high turnover–hence little on-the-job training. At the same time, young people themselves are making bad choices about how to prepare themselves for the workforce, avoiding hard subjects when in school, dropping out of school, and using alcohol and drugs.

What is to be done? I am now a convert to the cause of infrastructure spending. I am not certain whether or not an infrastructure spending initiative will get the economy back to full employment, but it should be tried. Interest rates are low, the budget deficit is coming down. Much of the existing infrastructure needs repair and there are good projects to be built. The Administration should prepare an infrastructure plan that is concrete, literally and figuratively, and well designed to improve people’s lives and make the economy work better. Actually I think they already have such a plan and the hard step is to sell it to the American people.

My next proposal is likely to be greeted with some skepticism at this conference. I would cut the corporate tax rate and perhaps even eliminate it. I would also eliminate or reduce the US taxation of extraterritorial income. I need cover for this view and I will mention Laura Tyson, someone with impeccable liberal and economic credentials. She has suggested reforming the corporate tax or even abolishing it.[4] Investing in America has to be made attractive relative to investing in other countries.

In return for cutting or eliminating the corporate income tax, I would impose increases in the federal tax on gasoline starting in 2015 and rising steadily into the indefinite future, or at least until there is a balanced budget. A carbon tax would be even better but a gas tax would be good enough.

Next, something needs to be done about improving education and skills training. Since others in this conference know much more about that than I do, I will say no more on the topic.

Finally, a word about economics itself. Economics and economists are important. The revolution begun by Keynes provided the intellectual foundation for stabilization policies that made the postwar period much more stable than prior years. Hansen, Samuelson, Tobin and others made a big difference to America and to the world but the profession has dissipated that legacy by trying to fit an economy characterized by volatile and often irrational actions and expectations back into the box of rational neoclassical equilibria; the Polyanna economy, as it has been described.

Keynes did not solve all the problems and he did not get everything right. Economists need to build on what he did with true scientific research to illuminate an unstable and sometimes irrational global economy.

[1] See Thomas I. Palley, Post Keynesian Economics: Debt, Distribution, and the Macro-Economy, St Martin’s Press, 1996.

[2] Summers spoke at a Brookings event for trustees in 2008 shortly before entering the Administration and argued for a fiscal stimulus that was as large as possible.

[3] Blinder and Zandi do argue that the recession was brought to an end in part by the fiscal stimulus even if it did not restore full employment. See

[4] See