The Severity of the Economic Crisis and the Direction of America’s Recovery

Editor’s Note: Below are the opening notes for Martin Baily’s July 1 testimony before the United States House Committee on the Budget. The full testimony for the hearing, entitled “Perspectives on the Economy,” can be downloaded at the link above.

Key Points in this Testimony

• There were early signs of financial crisis even in 2006 and early 2007, and then financial markets seized up in the summer of 2007. Initially, the decline in GDP and jobs was mild, but the economy fell like a stone in the last quarter of 2008 and the first quarter of 2009. The situation in the spring of 2009 was extremely dire with the risk of continuing deep declines and collapse of the financial sector.
• There were many contributors to this crisis, market failures, regulatory failures and policy failures. Regardless, given the severity of the recession and the financial turmoil and the global reach of both elements, no policies could have restored full employment quickly or healed the problems in the financial sector rapidly. Financial crises and the ensuing recessions result in prolonged losses.
• The Treasury and the Federal Reserve were slow to react to the financial crisis, but once its enormity became clear they moved aggressively to fight it. Secretary Geithner was part of the team at the Federal Reserve dealing with the crisis from the outset and he provided continuity as the Obama team took over. The TARP was essential to restoring the financial sector and the FDIC played a vital role in resolving small and medium-sized banks. The stress tests in the spring of 2009 were a turning point in financial recovery in large part because the Treasury was able to promise bank capital if the private sector could not provide it.
• The fiscal stimulus had to be deployed quickly and the money had to reach households and businesses as soon as possible. The states were facing large budget deficits that would trigger sharp cutbacks unless federal funds could provide emergency relief. The stimulus package was messy, but it did what it was supposed to do as evidenced by the recovery of growth in the fall of 2009.
• The fact that GDP growth was solid by the end of 2009 and that employment started to grow in 2010 is a miracle, given how bad the situation became.
• Despite the gains achieved, the jobs picture remains extremely bleak and the problems in Europe could result in a double dip recession here at home. Our ability to respond is weakened by the fact that there were federal budget deficits every year from 2002 on, and because the deficit ballooned in this crisis.
• The European crisis has forced some countries to curtail their stimulus packages and move towards fiscal consolidation. With the backing of the IMF, they are making a virtue of necessity and arguing that fiscal discipline will encourage growth even in the short run. I agree they should start down a well-marked path to lower deficits, but they should avoid acting too quickly. An aborted economic recovery will result in even worse budget deficits.
• The U.S. situation is somewhat similar in that we also need to weigh the need for stronger demand growth against the limits on Treasury borrowing. The U.S. economy is less constrained and markets are not flashing warnings about Treasury borrowing, given that interest rates are at historic lows. That could change, however, and we do not want to get too close to the edge of the cliff. If the economic recovery peters out, I would support a further fiscal stimulus, but only if accompanied by a clear and credible path towards lower deficits in the out years.