Lessons from the (Ongoing) Global Financial Crisis & Recession Robert J. Barro Harvard University.

Lessons from the (Ongoing) Global Financial Crisis &

Recession

Robert J. BarroHarvard University

Topics to be Covered

• Sources of financial crisis, from a U.S. (and, therefore, global) perspective.

• Role of fiscal-stimulus packages, based mostly on U.S. historical evidence.

• What should a developing country like Peru do?

Fall in Housing Prices by over 30%since mid 2007 is Key for U.S.

40

80

120

160

200

240

88 90 92 94 96 98 00 02 04 06 08 10

COMP10 COMP20

Case-Shiller Composites (seas. adj.)

U.S. Recession Officially Started inDecember 2007, but Main Downturn

began in mid 2008

-.08

-.06

-.04

-.02

.00

.02

.04

.06

2005 2006 2007 2008 2009

GDP Growth Rate, 2005-09 (annual rate)

• House-price decline would likely have caused recession with earlier financial structure. But would have appeared as failures of many banks & other financial institutions. Failures of insured institutions not key to current crisis.

• With “modern” financial structure (high leverage of large investment banks & lots of assets based on mortgage-based securities), failures concentrated in small number of large institutions.

0

100

200

300

400

500

600

1940 1950 1960 1970 1980 1990 2000

Failures of Financial Institutions

.00

.04

.08

.12

.16

.20

1925 1950 1975 2000

Ratio of Deposits at Failed/Assisted FinancialInstitutions to Total Deposits, 1913-2009

(Data 1913-34 from Federal Reserve, 1935- from FDIC)

• Deposit insurance helpful especially with traditional financial structure. In current crisis, substitute was bail-outs and capital infusions for large financial institutions, especially following failure of Lehman Brothers in September 2008.

• Bailouts reasonable policy under the circumstances; may have avoided depression. Some other policies—fiscal-stimulus packages, bailout of General motors—wasteful.

Response of Federal Reserve Dramatic(conventional & unconventional)

0

1

2

3

4

5

6

7

8

9

1990 1995 2000 2005 2010

Federal Funds Rate (%)

I have been particularly studying fiscal-stimulus packages (government spending increases and tax cuts), one of main issues for U.S. and other countries.

Have new empirical results from long-term U.S. macroeconomic data.

Spending multipliers identified primarily from variations in defense spending, especially changes associated with buildups and aftermaths of wars.

Ramey’s defense-news variable allows us to assess changes in expected future defense outlays; thereby distinguishing temporary from permanent spending.

Tax effects estimated mainly from changes in newly constructed time series on average marginal income-tax rates (AMTR) from federal and state income taxes and social-security payroll tax.

Defense and Non-Defense Purchases

-.3

-.2

-.1

.0

.1

.2

.3

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

change in defense purchaseschange in non-defense purchases

Defense-News Variable

-0.4

0.0

0.4

0.8

1.2

1.6

1920 1930 1940 1950 1960 1970 1980 1990 2000

Average Marginal Income-Tax Rates

Next figure shows time series 1912 to 2006 for overall U.S. AMTR and 3 components: federal individual income tax, social-security payroll tax, state income taxes. 2006: overall AMTR 35.3%, breaking down into 21.7% for federal individual income tax, 9.3% for social-security levy, 4.3% for state income taxes.

Average Marginal Income-Tax Rates

.0

.1

.2

.3

.4

.5

20 30 40 50 60 70 80 90 00

TotalFederal Income TaxSocial-Security Tax (FICA)State Income Taxes

Estimated equations for GDP Growth(1) (2) (3) (4) (5)

Starting 1950 1939 1930 1917 1954

Δg: defense 0.68*(0.27)

0.44**(0.06)

0.46**(0.08)

0.47**(0.08)

0.98(0.65)

Δg: defense (-1)

0.01(0.28)

0.20**(0.06)

0.21*(0.09)

0.16(0.08)

-0.54(0.56)

Δg*: def news

0.026(0.016)

0.039**(0.011)

0.034*(0.015)

0.034*(0.017)

-0.120(0.112)

U(-1) 0.50**(0.17)

0.58**(0.14)

0.61**(0.10)

0.47**(0.10)

0.51**(0.18)

Δτ(-1) -0.54**(0.21)

-0.16(0.16)

-0.26(0.22)

-0.19(0.25)

-0.48*(0.22)

Yield spread

-43.9*(20.7)

-37.8(22.0)

-101.5**(12.8)

-73.6**(12.2)

-43.1*(21.8)

p-value: defense

0.030 0.000 0.000 0.000 0.47

R2 0.48 0.82 0.75 0.66 0.45

σ 0.017 0.019 0.027 0.030 0.018

• Samples with WWII; multiplier for temporary defense spending 0.4-0.5 contemporaneously, 0.6-0.7 over 2 years.

• If change in defense spending “permanent” (gauged by Ramey defense-news variable), multipliers higher by 0.1-0.2.

• Spending multipliers significantly less than 1.

• Positive and negative values for change in g have similar magnitudes of effects.

• Interaction between g and unemployment rate has coefficient close to zero.

Post-1950 sample: coefficient of -0.54 on lagged change in AMTR.

Accords with microeconomic estimates of labor-supply elasticities. Result corresponds to “tax multiplier” around -1.1.

Results in Table 2 provide reliable estimates of multipliers for defense spending: around 0.4-0.6 for temporary, 0.15 higher for permanent.

To evaluate typical fiscal-stimulus packages, more interested in multipliers for non-defense G. Hard to estimate because observed movements likely endogenous with respect to GDP.

Hence, important to know whether defense-spending multiplier provides upper or lower bound for non-defense G.

Implications from Theory,Defense versus Non-Defense G

• Temporary versus permanent changes in G.• Command & control and rationing.• Patriotic boost to labor supply (but threat to

future property rights?).• Command & control and patriotism stressed by

Mulligan (1998). We think these forces strong enough so that defense multiplier is upper bound for non-defense multiplier.

More on Government PurchasesStart date 1950 1939 1930 1917 1950 1950

Δg: defense 0.89**(0.27)

0.44**(0.06)

0.46**(0.08)

0.46**(0.08)

0.84**(0.24)

0.46(0.26)

Δg: defense (-1)

-0.13(0.27)

0.21**(0.06)

0.21*(0.09)

0.19*(0.09)

-0.36(0.25)

0.02(0.26)

Δg*: def news

0.040**(0.016)

0.041**(0.013)

0.036*(0.016)

0.040*(0.018)

0.014(0.013)

0.016(0.014)

U(-1) 0.64**(0.17)

0.58**(0.15)

0.60**(0.11)

0.45**(0.11)

0.26*(0.16)

0.55**(0.16)

Δτ(-1) -0.45*(0.20)

-0.13(0.18)

-0.25(0.23)

-0.15(0.25)

-0.26(0.19)

-0.38(0.20)

Yield spread

-31.2(20.0)

-35.6(22.3)

-100.9**(13.3)

-71.2**(12.2)

-38.9*(18.1)

-21.6(20.5)

Δg: non-defense

2.65**(0.93)

0.25(0.72)

0.12(0.63)

0.51(0.51)

-- --

Δ(GM sales)

-- -- -- -- 3.66**(0.86)

--

Δ(GE sales) -- -- -- -- -- 17.6**(4.7)

R2 0.54 0.82 0.75 0.67 0.63 0.57σ 0.017 0.019 0.027 0.030 0.015 0.016

• Short run: extra spending deficit financed. Multiplier less than one means that GDP rises but parts of GDP aside from government spending (private investment & consumption) decline.

• Longer run: higher public debt and higher taxes. Combination of estimated spending & tax multipliers means that longer-run effect negative for GDP.

• Bottom line: Fiscal-Stimulus packages are a bad idea unless government programs are highly productive.

• Better approach to stimulating economy in short run would be temporary cuts in marginal income-tax rates.

• A few other countries promising for extending U.S. study. Need large variations in defense outlays without massive destruction of physical capital & people.

• Promising cases: Canada, Australia, New Zealand, South Africa. Enter world wars in 1914, 1939.

Canada: Change in DefensePurchases (relative to GDP)

-.25

-.20

-.15

-.10

-.05

.00

.05

.10

.15

1920 1930 1940 1950 1960 1970 1980 1990 2000

Australia: Change in DefensePurchases (relative to GDP)

-.15

-.10

-.05

.00

.05

.10

.15

1920 1930 1940 1950 1960 1970 1980 1990 2000

Future Fiscal Problems

Most likely future crisis will involve governments. Related to cumulated public debts—partly responses to financial crisis and partly longer-run structural problems (e.g. growing social-insurance spending). Broad movement toward weaker fiscal discipline. Greece and California are prominent examples.

Monetary & Inflation Threats

Likely return to global inflation. Idea of independent central banks committed to price stability weakened. U.S. Federal Reserve prime example. Operating like development bank, over $1 trillion in private claims, mostly related to residential mortgages. How will this unwind without inflation, once unusual demand for low-risk reserves goes down?

Provident Funds

Great idea for developing country government to amass large provident fund in good times—IF government can avoid political temptation to spend the funds. Chile has done well with saving when copper prices high. Has reserves to help with financial crisis & earthquake. Similar behavior by, at least, Norway, Singapore. Mexico & Trinidad to some extent (related to petroleum sectors).

Old Lessons on Economic GrowthStill Valid

• Empirical research on determinants of economic growth identifies factors that help poor countries to converge toward rich ones.

• Well-functioning institutions; property rights & rule of law.

• Free markets with reasonable regulations.

• Openness to international trade.

• Fostering of human-capital investment: schooling and health.

• Avoidance of large government sector; reliance on private sector for transportation, aspects of education and health, etc.

• Sound macroeconomic and tax policies.