Working in Congress: Barking at the ref

Working in Congress: Barking at the ref

Congressional Budget Office Director Doug Elmendorf is doing a great job informing the economic policy debate in a rigorous and unbiased matter. Dr. Elmendorf’s background suggests a different perspective on economic policy from my own. This is unsurprising, given that he was chosen by the chairmen of the House and Senate Budget Committees, Rep. John Spratt (D-SC) and Sen. Kent Conrad (D-ND). He worked at the Fed (a strong signal of first-quality), and in the Clinton Council of Economic Advisers and Treasury Department. Before coming to CBO as director, he was a scholar at the Brookings Institution and worked with the left-side Hamilton Project founded by Robert Rubin.

Dr. Elmendorf is serving admirably as an impartial referee, and is contributing substantially to the economic policy debate.When CBO is at the top of its game, they don’t just produce tables. They explain without bias what the tables of numbers mean.

CBO works for Congress. If you’re writing a bill, you need a “score” from CBO. Working with their sister tax organization, the Joint Tax Committee staff, they will tell you how much spending and taxes will increase or decrease based on your legislative language. If the budget effects of your bill make it inconsistent with the budget resolution passed each year by the Congress, then your bill faces difficult procedural hurdles, and its chance of legislative success declines significantly.

Most CBO staff have advanced degrees, often in economics, public policy, or some specific policy specialty like health or taxes. Theirs is a world of spreadsheets, legislative language, and angry Members of Congress and Congressional staff. Often the CBO staff understand a bill better than the author. CBO staff get barked at a lot by Members of Congress and their staff.

As a government institution, it’s not surprising that CBO staff on average lean a little left. The best evidence of this is that when CBO staff leave, they are far more likely to work for a Democratic member of Congress, or for a liberal think tank like Brookings, the Urban Institute, or the Center on Budget and Policy Priorities.

At the same time, CBO’s reputation as an institution is predicated on its nonpartisanship, lack of institutional bias, and intellectual rigor. I think that, on the whole, they do as good a job as any of setting aside their personal policy preferences and fulfilling this critical role of an unbiased referee.

CBO is at its best when it is nonpartisan: they say what the evidence demonstrates, no matter who it upsets. This is most difficult for the Director when it upsets the Congressional majority that gave him his job, especially since he is usually of the same political party as they.

Sometimes CBO strays and tries to be bipartisan, rather than nonpartisan. That’s like a referee who tries to even out the game by balancing a bad call he made earlier for one team, by making a bad call now to benefit the other team. I believe the referee should call the play as he sees it, no matter who it upsets, and no matter what the score or history. If the ref makes 5 calls in a row that upset one team, that may not be bias. It may just be that the other team is fouling a lot, or that they have a coach that likes to hector the ref. Some past CBO directors have tried to balance the politics so they get equal heat from both sides. They do this by taking arguments they know are weak and including them to please (or mitigate the anger of) the Member of Congress to whom they’re delivering other bad news. I believe this kind of behavior reflects poorly on the institution. It seems largely absent now.

One of the most effective and best-known CBO directors was Dr. Robert Reischauer in the mid-90s. Put in place by Democrats, he made some hard (and, in my view, correct) budget scoring calls that infuriated the Clinton Administration as it tried to enact the Clinton Health Plan. Dr. Reischauer was publicly savaged by Congressional Democratic Leaders. I imagine the private pressure was even more intense.

Dr. Elmendorf faces a similar situation this year as health care has risen to the top of the Administration’s and the Congressional majority’s agenda. CBO’s rulings are critical to their chances of success, and the pressure already being brought to bear is intense. I have heard reports of specific meetings within the past few weeks in which senior Members of Congress have been directly pressuring Dr. Elmendorf to cut them some slack on scoring. He has withstood that pressure, and the public work CBO is providing is first-rate.

I say this even though I don’t agree with everything they’re producing on this topic. I disagree with some of the judgment calls they are making, in particular, on some of the details of whether “health exchanges” should be counted in the budget. But I think they’re being fair about it. In my first job as a Congressional staffer, I was the health and retirement analyst for the Senate Budget Committee staff under Chairman Pete Domenici (R-NM). I have worked on health budget policy for 15 years, and think I’ve got a pretty good nose for sniffing out biased estimates and analysis. It is now remarkably and admirably absent.

Over the past few weeks, I have been getting a lot of new readers among Congressional staff (from both sides of the aisle). Welcome. For those of you without a lot of experience dealing with CBO, I’d like to suggest some tips for how to work well with the CBO and maximize your chances of getting a score that doesn’t destroy your chances of legislative success:

  • Give them a bill to score, or at a minimum a highly detailed policy spec. The more precise you are, the better your score will be. CBO takes a skeptic’s eye to ambiguity and will often not give you the benefit of the doubt when you’re unclear.
  • Read what they have written on your bill’s topic before you talk with them. You’ll be smarter, and you’ll get more respect from the analyst for having done your homework.
  • Plan ahead. Way ahead. Each analyst and branch has a queue of work. If you’re not on the staff of the committee of jurisdiction, the Budget Committee staff, or in leadership, you will start pretty far back in that queue. Live with it, and plan for it.
  • Ask your friendly neighborhood Budget Committee staffer for help.
  • Talk with the analyst who is scoring your bill before, during, and after they have worked on it. Ask them if there are parts of your bill that are unclear. See if you can get a discussion going, so you know early if their estimate is headed in a direction that is devastating for you. If it is, ask them to stop so you can fix your bill. See if you can save them time by not making them estimate something, and then starting from scratch.
  • Do your homework, and share with the analysts working on your bill. If you have a good study, data or information, share it with CBO, especially if this is a new issue. If you have an expert, set up a meeting with CBO. They will talk to anyone with data and good arguments.
  • CBO staff are paid not to care about whether your bill is good policy or bad policy. Don’t be offended. They are paid only to figure out its effects on the federal budget.
  • Don’t try to shoot the messenger. It’s usually counterproductive.
  • I always had more success asking CBO analysts questions, than trying to change their minds. I would try to figure out how they approach a score, and why they thought my bill would produce the budget effect that it did. Sometimes you get scored with a big budgetary effect for something that is tangential to your core purpose. The better you understand this, the more you can adapt to get your score down. CBO analysts generally react much better to incisive questions than they do to screaming.
  • I always found I had much better success by being respectful and polite than a jerk. I don’t think it directly affected the analysis they produced for me, but it did get me better response times, and more useful information that wasn’t in the formal written estimate. Besides, if you act like a jerk, then you are a jerk. Who wants that?

Dr. Elmendorf and the CBO staff face a test similar to that faced by CBO under Dr. Reischauer during debate on the Clinton Health Plan. They have so far withstood the pressure with aplomb, but the real pressure is just beginning.

(photo credit: z04b_57 Growling Gizmo Dog, Vancouver 2005 by CanadaGood)

Government Motors discussion on Fox News Sunday (continued)

In an earlier post I attempted to correct Dr. Austan Goolsbee’s incorrect and inflammatory statements about President Bush.I would like here to add my views to one additional question on the auto industry discussion on this morning’s edition of Fox News Sunday.

Host Chris Wallace moderated a discussion this morning with:

  • Dr. Austan Goolsbee, Member of President Obama’s Council of Economic Advisers and chief economist on the President’s Economic Recovery Advisory Board;
  • Senator Richard Shelby (R-AL), ranking Republican on the Senate Banking Committee;
  • Thayer Capital Chairman Fred Malek; and
  • Google CEO Eric Schmidt.

I offer kudos to Mr. Schmitt for his thoughtful responses throughout. And the hero of the discussion was Mr. Wallace, who in his questions demonstrated a deep understanding of the actual options faced by policymakers, the choices they made, and the serious consequences of those choices. I thank him for trying to elevate the policy discussion this morning.

Here’s Chris Wallace asking Fred Malek whether the Bush Administration have provided loans before a Chapter 11 filing:

WALLACE: Let me bring in Fred Malek, though. The President says that he has no interest in running businesses, he’s just trying to save them from collapse and get out. [plays clip of President Obama's press conference] Fred Malek, in the middle of a financial crisis, in the middle of a terrible recession, could the President really let General Motors and Chrysler, AIG and Citibank go under?

MALEK: … I think what you have here, is you have two different situations. I would label the injection of capital into the financial institutions, stabilizing the financial systems, that’s a war of necessity. You had to do that. But, getting into General Motors, saving General Motors and then taking them into bankruptcy, that’s a war of choice, it’s the wrong choice.

Senator Shelby later commented on this same question, as did Mr. Malek again:

SHELBY: First of all, I advocated last fall that General Motors and Chrysler’s best bet would have go to Chapter 11 then, it would have saved a lot of money, not a political restructuring like what’s happened, where the bondholders have been sacrificed, the unions have carried the day.

MALEK: I agree with Senator Shelby. Look, we’ve had for decades we’ve had a bankruptcy system in this country that has worked well, and has fueled the free enterprise system in a positive way. It is impervious to politics because it’s run by federal courts. Now, what have you done? You have taken it out of the judicial and you’ve turned it over to the executive, and I think you’ve injected politics into it. Senator Shelby is right, there was no sense in putting billions of dollars in and then declaring Chapter 11 afterwards. They should have let them go into bankruptcy and let the courts work it through. …

Mr. Wallace then asks the critical follow-up question:

WALLACE: Let me just ask. Mr. Goolsbee, if at some point, either the Bush Administration back in the fall, or you guys when you took over, had just said, go into Chapter 11, we’re not going to take an ownership stake, we’re not going to give you 50 billion dollars, what would have happened?

The answer is that GM and Chrysler would have liquidated. Neither GM nor Chrysler was ready for a complex Chapter 11 filing. Had the entered the Chapter 11 process in December or January, the firms and every outside expert told us that the restructuring would have failed and the firms would have liquidated. We estimated this would have resulted in about 1.1 million lost jobs.

Mr. Malek was right, the loans to GM and Chrysler were a choice, but they were not the choice that he and Senator Shelby thought we faced. The choice was loan or liquidate. There was no feasible Chapter 11 option available at the time. (GM may fail even now, after they have had five months to prepare for Chapter 11.) Mr. Schmitt frames it correctly:

SCHMITT: It seems to me that what choice did we have except try to save General Motors, given the roughly million jobs that were related at a time of incredible pain and job loss. So if you think about it , the choice was bankruptcy, the supply chain goes away, the loss of the American automobile industry, or a band-aid. It needs to be a band-aid, and it needs to be something we get out of.

Dr. Goolsbee gets it wrong on the auto loans

This morning on Fox News Sunday, host Chris Wallace moderated a discussion about the auto industry. One of his guests was Dr. Austan Goolsbee, who is a Member of President Obama’s Council of Economic Advisers and chief economist on the President’s Economic Recovery Advisory Board.

I want to focus on some incorrect and inflammatory statements by Dr. Goolsbee this morning:

Chris Wallace: I also want you to talk about the clash between policy and profits. The governments wants General Motors to make small cars, fuel-efficient cars, while all the indications are, that according to the market, the cars they make most profit on are SUVs and pickup trucks. So which takes preference? Profits for the taxpayer shareholders, or environmental policy?

Dr. Goolsbee: The President made totally clear in his remarks, and he specifically said we are not going to be in the business of telling General Motors or anybody else what kind of cars to make, where they should open their plants, or anything of the sort. The President made clear we want to get out of this as quickly as possible. We are only in this situation because somebody else kicked the can down the road, and that’s really an understatement. They shook up the can, they opened the can, and handed to us in our laps.Senator Shelby knows that to be true. When George Bush put money in to General Motors, almost explicitly with the purpose, how many dollars do they need to stay alive until January 20th, 2009? There was no commitment to restructuring, to making these viable enterprises of any kind. They made none of the serious sacrifices. And Republicans in the Senate attached a list of conditions, they opposed George Bush’s intervention, because they said the unions had not made the following sacrifices. In the Obama plan, it asked more and received more from the unions and from the other stakeholders than the people that objected to the bailout last November asked for. So we have finally put them on that path.

This is incorrect. I will bite my lip, refrain from commenting on the tone, and focus on the facts.


At 3:30 pm on Sunday, November 30, 2008, a quiet meeting occurred at the Treasury Department in Secretary Hank Paulson’s office. Present for the Bush Administration were Treasury Secretary Paulson and Commerce Secretary Carlos Gutierrez, White House Chief of Staff Josh Bolten, Deputy COS Joel Kaplan, White House Legislative Affairs chief Dan Meyer, Treasury Legislative Affairs head Kevin Fromer, and me. Present for the incoming Obama Administration were Deputy COS-designate Mona Sutphen, NEC-designate Dr. Larry Summers, Dan Turullo (now a Fed Governor), and WH Legislative Affairs-designate Phil Schiliro. We had requested the meeting. They agreed and asked that it be held outside the White House. It appeared to us that they were quite concerned about leaks, and about the risk of creating a public impression that they were working closely with us.

At that meeting, we (the Bush team) floated a proposal to establish an auto czar. President Bush would create a new position called a Financial Viability Advisor (FVA) through an executive order. The President would instruct the FVA, for any auto manufacturer that sought a “bridge loan,” to evaluate that firm’s restructuring plan for viability. If after 60 days (which the FVA could unilaterally extend for another 30) the firm did not have a plan to achieve viability, then the FVA would produce his own plan to make that firm viable. The draft executive order was explicit that the FVA could include a Chapter 11 bankruptcy in his plan. We invited the Obama team to suggest names for the Financial Viability Advisor, so that it would be someone with whom the new President would be comfortable.

Under the Bush team’s proposal to the Obama team, the current Secretary of the Treasury (Paulson) would provide bridge funding from the TARP, and he would state that, as a matter of policy, no further TARP funding would be made available except in support of (1) a plan certified as viable by the FVA, or (2) the FVA’s own plan.

The key to success of this plan was that the Obama team would publicly link arms with us and agree that they would continue the Paulson policy statement when they took over after January 20th. Thus, the auto company’s stakeholders would know that they had no wiggle room, and that they had no chance of getting additional funding from the next Administration. The Obama team would voluntarily commit itself to be bound by the restriction self-imposed by the Bush team.

Remember that this was one of two huge issues going on at the time. The bigger issue was the financial crisis, and we were nearing the limit on the $350 B of available TARP funds. We were concerned that another too-big-to-fail institution might fail before January 20th without Treasury having the funds available to prevent a systemic collapse. So our proposal to the Obama team was a package deal: we will announce the above process for autos, and we will ask Congress for the second $350 B of TARP funding, if the President-elect publicly supports us on both. They would join with us in convincing Congress to approve the last tranche of TARP funding, since we would need help with Congressional Democrats.

We saw two huge economic issues that posed grave risks to the economy and to a smooth transition. We proposed to work together with the incoming Administration in a way that we thought minimized these risks and would have positioned the new President as well as possible on January 20th. GM and Chrysler would not be in liquidation, and there would be a strict, tight, and enforceable deadline (of about March 1) and process for GM and Chrysler to become viable or to have time to prepare for an orderly Chapter 11 process. We would have a cushion in case another major financial institution failed in the last eight weeks, and the next President would not have to be bothered with having to ask Congress for the last $350 B from the TARP.

The Obama team were polite and professional. They listened carefully and gave little reaction in the meeting. We concluded based on their questions in that meeting that they were leaning against the proposal, because they did not want to be bound by the judgment of a Financial Viability Advisor – they wanted the ability to make decisions in the White House. They also appeared to want to avoid being bound by our strict definition of viability. (We defined a viable firm as one that would, under reasonable assumptions, have a positive net present value without additional taxpayer assistance.)

Dr. Goolsbee was not in this meeting. I do not know if he was aware of it, either back in November or this morning.

Despite multiple efforts to get the Obama team on board, they did not take up our proposal, nor did they suggest any modifications. At the end of that week we gave up on that approach and began to negotiate a bill with Speaker Pelosi, Chairman Barney Frank, and Chairman Chris Dodd that would provide bridge loans from previously appropriated non-TARP funds.Senate Republicans blocked that bill. Congress adjourned for the year and went home. In the last week of December, GM and Chrysler told us they would file under Chapter 11 in early January if they did not get loans from the TARP. They also told us, as did countless outside experts, that they were not ready for such a filing, and that Chapter 11 would lead to near-immediate liquidation. We estimated that about 1.1 million jobs would be lost if this happened.

Confronted with a choice between loaning TARP funds to GM and Chrysler, and allowing both to liquidate in the weeks before his successor took office, President Bush authorized loans from the TARP to GM and Chrysler. We had warned Senate Republicans earlier that month that the President would face this choice if legislation failed. This was (and still is) a politically unpopular decision, and was the least worst of two bad options. Based both on his public comments and what I saw privately, President Bush wanted to give the firms a limited amount of time and a hard back end to prepare for and, if necessary, to force an orderly Chapter 11 process. He also knew that President-elect Obama would be facing tremendous challenges in his first days in office.Despite their different political parties and policy perspectives, President Bush stressed that we needed to provide his successor with the time and space he would need in the opening weeks of his Presidency.

Structure of the December loans to GM and Chrysler

In the last few days of December, Treasury loaned $24.9 B from TARP to GM, Chrysler, and their financing companies.

According to the terms of the loan (see pages 5-6 of the GM term sheet), by February 17th GM and Chrysler would have to submit restructuring plans to the President’s designee (and they did).

Each plan had to “achieve and sustain the long-term viability, international competitiveness and energy efficiency of the Company and its subsidiaries.” Each plan also had to “include specific actions intended” to achieve five goals. These goals came from the legislation we negotiated with Frank, Pelosi, and Dodd:

  1. repay the loan and any other government financing;
  2. comply with fuel efficiency and emissions requirements and commence domestic manufacturing of advanced technology vehicles;
  3. achieve a positive net present value, using reasonable assumptions and taking into account all existing and projected future costs, including repayment of the Loan Amount and any other financing extended by the Government;
  4. rationalize costs, capitalization, and capacity with respect to the manufacturing workforce, suppliers and dealerships; and
  5. have a product mix and cost structure that is competitive in the U.S.

The Bush-era loans also set non-binding targets for the companies. There was no penalty if the companies developing plans missed these targets, but if they did, they had to explain why they thought they could still be viable. We took the targets from Senator Corker’s floor amendment earlier in the month:

  1. reduce your outstanding unsecured public debt by at least 2/3 through conversion into equity;
  2. reduce total compensation paid to U.S. workers so that by 12/31/09 the average per hour per person amount is competitive with workers in the transplant factories;
  3. eliminate the jobs bank;
  4. develop work rules that are competitive with the transplants by 12/31/09; and
  5. convert at least half of GM’s obliged payments to the VEBA to equity.

If, by March 31, the firm did not have a viability plan approved by the President’s designee, then the loan would be automatically called. Presumably the firm would then run out of cash within a few weeks and would enter a Chapter 11 process. We gave the President’s designee the authority to extend this process for 30 days.

In another error this morning, Dr. Goolsbee claimed the “Obama plan, it asked more and received more from the unions and from the other stakeholders than the people that objected to the bailout last November asked for.” As I wrote last Monday (Understanding the GM bankruptcy), I have seen no convincing evidence that GM workers will now be paid competitive compensation with transplant workers, nor that the work rules are competitive with the transplants. The negotiations led by the Obama team did meet the Corker targets for the unsecured debt holders and the retiree benefits, but current workers still look to have received a relatively good deal.


November 30: Bush team proposes joint solution to Obama team.

The following week: Obama team declines to respond. Bush team begins negotiations with House and Senate Democrats.

Mid-December: Bush team negotiates compromise legislation with House and Senate Democrats. Senate Republicans block the legislation. Congress goes home.

Late December: President Bush authorizes the above-described three month loans to GM and Chrysler.

January 20: President Obama takes office.

Mid-February: GM and Chrysler submit their first viability plans, per the terms of the Bush-era loans.

End of March: President Obama says GM and Chrysler have failed to develop viable plans, as required by the Bush-era loans. He gives Chrysler 30 more days, and GM about 60 until the end of May.

End of April: Chrysler files Chapter 11 with a pre-packaged plan negotiated largely by the Obama Administration.

June 1: GM does the same. Chrysler emerges from Chapter 11.

Responding to Dr. Goolsbee

Let’s again examine Dr. Goolsbee’s claim:

We are only in this situation because somebody else kicked the can down the road, and that’s really an understatement. They shook up the can, they opened the can, and handed to us in our laps. Senator Shelby knows that to be true. When George Bush put money in to General Motors, almost explicitly with the purpose, how many dollars do they need to stay alive until January 20th, 2009? There was no commitment to restructuring, to making these viable enterprises of any kind. They made none of the serious sacrifices.

Even if Dr. Goolsbee was not privy to the quiet discussion we had with the senior Obama team last November, the public record refutes his claim:

  1. The Obama team declined to respond to the Bush team’s offer to work together to create a joint process that would have resulted in a resolution by March 1st or April 1st, rather than by June 1st for Chrysler and maybe September 1st for GM.
  2. We then worked with the Democratic majority to enact legislation that would have limited funds to be available only to firms that would become viable.
  3. After Congress left town for the holidays without having addressed the issue, President Bush was faced with a choice between providing loans and allowing these firms to liquidate in early January, which would have further exacerbated the economic situation for the incoming President. President Bush chose to provide the loans.
  4. We provided GM and Chrysler with sufficient funds to get to March 31st, not January 20th, and in those loans we gave the incoming Administration the ability to extend them for 30 more days.
  5. The loans were conditioned on restructuring to become viable, with a precise definition of viability, specific restructuring goals, and quantitative targets.
  6. The Obama Administration followed the restructuring process laid out in the Bush-era loans. They are now measuring that deal against the targets established in the Bush-era loans. The only changes the Obama team made were that they extended GM for 60 days rather than 30, and the Obama Administration directly inserted themselves into the negotiations as the pre-packager.

Dr. Goolsbee’s comments this morning were both inflammatory and incorrect.

Intro to TARP: Banks have two problems

The big banks (and some large non-banks like AIG, Fannie Mae, and Freddie Mac) have two problems, not one:

  1. They don’t have enough capital.
  2. They have on their balance sheet downside risk that is creating uncertainty about how much the firm is worth and is scaring away investors.

I will use a simple example constructed by former Council of Economic Advisers member Donald Marron.

Imagine that you run Large Bank. You collect deposits and you borrow on the debt market, and you use both sources of funds to make loans. Here is what your balance sheet looked like three years ago when you made these loans.

Assets Liabilities and Equity
Loans 1,000 Deposits 600
Debt 300
Equity 100
Preferred 0
Total 1,000 . . . . . . . Total 1,000

To keep it simple, let us assume that all 1,000 of loans were for home mortgages.

We measure the health of your bank in three ways:

  1. You have 100 of capital — the equity from the shareholders who invested in your bank.
  2. Your leverage ratio is 10 to 1 — you are supporting 1,000 of loans with 100 of capital.
  3. Can you roll over your debt and issue new debt when you need/want to? Do creditors have enough confidence in your bank that they are willing to loan you money?

A healthy bank is one with a lot of capital, with a leverage ratio that is not too high, and that can borrow when it needs to at reasonable interest rates. Of course, the higher the leverage ratio, the more profit you make on each dollar of capital.

Now let us assume that you screwed up three years ago. 200 of the 1,000 of loans you made were “no documentation” loans.Some (many? most?) of those 200 of loans are going to default, or at least be late with some of their payments. They are clearly not worth the 200 of face value. First let’s separate out the good and bad loans.

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 200 Debt 300
Equity 100
Preferred 0
Total 1,000 . . . . . . . Total 1,000

Now in present day, you estimate that 80% of those bad loans will default, with a 50% recovery rate, so they are worth only 120 (60% of 200). You write down the value of the bad loans to 120, losing 80 on the assets side. This means the value of your equity has dropped from 100 to 20.

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 120 Debt 300
Equity 20
Preferred 0
Total 920 . . . . . . . Total 920

Writing down these loans has wiped out 80% of your capital. Problem #1 is that you only have 20 left of capital. This also leaves you with a very high leverage ratio of 46:1 (920 of loans divided by 20 of capital). Large Bank is clearly not in good shape.Creditors will start charging you higher interest rates for new debt (or to roll over existing debt), and any uninsured depositors may get nervous and pull their money out.

If you can raise more capital by selling more equity, you can give yourself more protection against insolvency and reduce your leverage ratio. Your existing shareholders will be upset, because before they owned 100% of the profits, and after raising more capital they will own a much smaller share. If you raise new private capital, you will be “diluting” your existing shareholders. This is one possible explanation why some banks have not raised capital so far.

You have a second problem, however. As you try to raise more capital and sell equity to new private investors, they are questioning the value of those bad loans. Sure they might be worth 120, but they might be worth only 100, or 80, or even 60.A private investor thinking of putting 60 of his own capital into Large Bank could see that get wiped out if the bad loans are only worth 40 rather than 120. The downside risk associated with those bad loans may deter private investors from putting in their own capital.

So Large Bank has two problems. You don’t have enough capital, either to satisfy your regulator or to reassure yourself that you won’t soon go insolvent if things get even worse.

You also have downside risk which makes the health of your bank even shakier than the above balance sheet suggests, and which scares away private investors.

Tomorrow we will look at three different ways to address your problems, aka TARP I, II, and III.

What caused this financial mess?

What caused this financial mess?

President Bush spoke today about the financial crisis to the U.S. Chamber of Commerce.

I’m going to use the President’s speech as an opportunity to explain to a non-financial audience what the Federal government did this week and why. I will oversimplify in many cases, and will gloss over many details. I don’t claim that the description below is comprehensive. But it is, we think, a good starting point for discussion.

This is a story that evolves over time as we learn more, and will be debated by economists and historians long after we’re gone.

  • We begin with a global credit boom. A dramatic increase in worldwide saving outside the United States, and especially in Asia and the Middle East, meant there was a lot of money to lend. Fed Chairman Ben Bernanke referred to this as a “global savings glut.” The U.S. has a productive economy and a strong legal framework that protects investors, so a lot of this capital was attracted to the U.S. This lowered interest rates here, creating abundant and inexpensive credit. This was particularly true for riskier borrowers – as the supply of loanable funds increased, the interest rates charged to these borrowers came down a lot, making it easier for them to get loans. In many cases this was a good thing – many low-income people who had previously been unable to buy a home were able to do so. At the same time, an economist would say that “credit spreads narrowed dramatically,” and many would say this led to an underpricing of risk. Lots of lenders seeking higher yields made increasingly risky investments.While most of the focus has been on housing, and I’ll use housing to explain the rest of the story, the underpricing of risk existed in other markets as well (e.g., commercial real estate). Also note that the credit boom was not confined to the U.S. – Australia, the U.K., France, and Spain also experienced housing or credit booms.
  • We then look at a domestic housing boom. Cheap credit and low interest rates contributed to a building boom, soaring housing prices, and ultimately an excess supply of housing. Normally you’d expect about 1.6 million homes to be built each year. At the peak of this boom, about 2 1/2 million houses were being built each year. At a normal time, there’s about a 5 1/2 month supply of unsold inventory of homes; now there’s about a 10 month supply. When there’s excess supply, prices drop and construction of new homes plummets. This last factor meant that the “residential construction” component of GDP was shrinking, and caused an overall drag to economic growth beginning in early 2006.
  • Risky mortgages proliferated. Low interest rates combined with relaxed lending standards, a new model of mortgage origination, and innovations in mortgage products to dramatically expand the number of Americans who could get mortgages and buy homes. At the same time, these factors also expanded the universe of people who purchased mortgages and homes they could not afford.In an imperfect lending system, you’re always trading off between helping too few deserving people, and too many really bad risks who will never be able to pay off their loans. The expansion of credit and innovation in mortgage markets moved the pendulum toward a lot more people being able to borrow and buy homes than had previously occurred. Many of these people who previously would not have been offered credit are now living in their homes, paying their mortgage every month. This is a good thing. At the same time, these changes allowed others to purchase mortgages and homes that they could not afford.
  • You can try to minimize this tradeoff by doing things like fixing the lending disclosure rules, and changing requirements on lenders to make sure that a borrower will be able to afford the highest interest rate of the mortgage, and not just the teaser rate. But even after you’ve made these kinds of fixes (which the Fed did late in 2007), there will still always be a tradeoff and a value choice to make: do you want to help more higher-risk low income people own homes, at the cost of having more defaults and more bad lenders and borrowers abusing the system? Or do you want fewer abuses of the system, at the cost of fewer responsible low-income and high-risk people owning homes?
  • We then move to the secondary market for mortgages. Mortgages were bundled, guaranteed, securitized, and sold to financial institutions (especially banks). DETOUR: What is a mortgage-backed security?You get a mortgage from Bob’s Bank. You will make monthly mortgage payments to Bob’s Bank for the next 30 years. 99 of your neighbors get similar mortgages from Bob. Bob then sells the 100 mortgages to the company Fannie Mae (or Freddie Mac, or a fully private securitization firm). Fannie collects a fee from Bob and slaps a guarantee onto each mortgage – if you default, Fannie will pay the rest of the mortgage due to Bob’s Bank, or whoever owns it.Now imagine that each of your monthly mortgage payments is a pancake, and so your mortgage is a big vertical stack of 360 payments/pancakes (30 year mortgage X 12 monthly payments per year). Fannie Mae lines up the 100 stacks of pancakes/payments side-by-side, and then takes a slice of the pancake/payments stacks (e.g., the bottom pancake/payment from each stack, or in the usual case with Fannie Mae, a vertical slice of each stack). That slice is a mortgage-backed security (MBS) that consists of a portion of the payments from all 100 mortgages. Fannie Mae then sells the MBS slices back to Bob, after charging him a fee for the service. Bob then sells those mortgage-backed securities to investors for cash, which he can turn around and use to offer new mortgages to other homebuyers.Fannie Mae and Freddie Mac did the bulk of this guarantee and securitization business, while other firms securitized lower quality subprime and Alt-A loans. A deeper analysis could explain how this securitization contributed to problems in these secondary markets. Creative financial engineers further sliced and diced these mortgage-backed securities, breaking risk apart into little pieces and combining them in interesting, creative, and almost completely incomprehensible ways. (Imagine flipping and swapping some pancakes around before slicing them and you’ll have a feel for it).
  • Many banks and other large financial institutions, including some insurance companies, and Fannie Mae and Freddie Mac themselves, bought and held these mortgage-backed and other complex securities. These investors all made the same incorrect assumption: they assumed that anything mortgage-related would be safe and yield a good return. While most mortgages are safe investments, investors did not correctly understand that some of these assets were quite risky. They didn’t really know what they were buying for two reasons: (1) the underlying information about some of the mortgages was bad, because some of the loans were based on poor information (e.g. “no documentation loans”) or were made to people who were higher credit risks; and (2) many buyers of complex securities did not understand how the sophisticated financial engineering affected the risks built into these securities. In some cases, investors relied on the Fannie/Freddie brand name and didn’t do their own homework. Others relied solely on credit rating agencies that later turned out to be wrong in their risk assessments.
  • Banks and other financial institutions that bought mortgage-backed securities (and other mortgage-related investments) lost a lot of money when these securities later declined in value. Because many of these institutions (especially large investment banks) were highly leveraged, they faced a greater risk of failure from a bad bet, and the consequences of that failure were much greater. Many of those banks that did not fail still lost a lot of their capital. Some of these large financial institutions were so big and so interconnected with other institutions, that their failure would create a domino effect. This is what we call “too big to fail,” which should more precisely be called “too big and interconnected to fail suddenly.”

Example of low leverage

If an investment bank has $10 of capital and makes $50 of loans, it is leveraged 5 to 1. (The other $40 to lend comes from deposits or borrowing.) If that $50 of loans loses 10% of its value and pays back only $45, then the bank has lost $5, which is half of its $10 of capital.

Example of high leverage

The same bank with $10 of capital makes $200 of loans, and is leveraged 20 to 1. If that $200 of loans loses 10% of its value and pays only $180, then the bank has lost $20. All of its capital is gone (the bank is bankrupt), and the bank is $10 in the hole. Because this bank was highly leveraged, it took on greater risk of failure.

The major investment banks were levered 25 to 1. That’s like buying a house with only 4% down – if your home price declines by 5%, you’re “underwater.” And since many of these large financial firms relied on short-term financing to run their operations, when lenders started to get nervous and pull back from their short-term loans to these large firms, things rapidly spiraled downward.

That story gets us up to the point of a large bank (we’ll call it Big Bank) ending up in a bad position in two ways:

  1. Big Bank lost a lot of capital because the mortgage-backed securities (MBS) it bought have declined tremendously in value.
  2. Big Bank is still holding the MBS on their balance sheet. Nobody wants to buy these MBS. And if housing prices or market conditions get even worse than expected, those MBS will decline in value even more. So Big Bank has a security that is illiquid and contains the downside risk of further losses.

Big Bank’s problems show up in any combination of three different ways:

  • Capital – Because Big Bank has too little capital, they can’t lend as much. This hurts everyone in the economy who needs to borrow – students who want student loans, drivers who want car loans, small business owners who need credit to operate and to expand, farmers who borrow for seed and fertilizer, and others.
  • Liquidity – Banks normally loan money to each other for short periods of time. But now Large Bank doesn’t want to lend to Big Bank, because Large Bank fears Big Bank might be insolvent and not be around to pay them back. So Large Bank charges Big Bank more (a higher interest rate) for this short-term borrowing. We have seen this in dramatic fashion as the interest rate that banks charge either, called the London Interbank Offerer Rate (LIBOR) has spiked up. Large Bank may shorten the term of their lending – being willing to loan to Big Bank overnight, but not for 30 days. In an extreme case, Large Bank may not lend at all to Big Bank. To oversimplify, banks don’t trust each other enough to lend. This breakdown in trust/confidence among large financial institutions is a core problem in our financial system.
  • Solvency - At the extreme, a bank could lose so much capital that it is clearly insolvent. In less severe cases, either depositors or lenders to that bank might lose confidence that the bank was viable. Depositors might withdraw their funds from the bank, or lenders to that bank might stop lending. Either one of these could cause a “run on the bank” that could ultimately force the bank to shut down.


Many banks and other financial institutions, and especially big ones, lost a lot of money on bad mortgage-related investments. This caused them to lose a lot of their capital, and in many cases some of their assets are illiquid and pose additional downside risk to their balance sheets. This hurts those banks’ ability to lend, it hurts their ability to remain liquid and borrow short-term cash from other banks, and in extreme cases it can lead to a run on the bank (of depositors, lenders, or both) and insolvency.

I am indebted to Eddie Lazear and Donald Marron of our Council of Economic Advisers for their help with this note. All mistakes are my own.

A "second stimulus?"

We are frequently asked whether there should be a “second stimulus” bill. Unfortunately, what is being considered on Capitol Hill is a very different animal from what we did earlier this year.

10-second macroeconomic review

GDP = Consumption + Investment + Government spending + Exports – Imports

= C + I + G + X – M

In January the President proposed, and in February Congress enacted, a bill that was short-term macroeconomic stimulus. We wanted that stimulus policy to be big, fast-acting, an efficient use of taxpayer dollars, and an effective stimulus to broad-based economic growth. We let taxpayers keep more of their wages, assuming that they would spend some of those refunds, thereby increasing consumption (C). We also temporarily cut taxes on business investment in an attempt to increase investment (I). The idea is that these two actions would quickly increase GDP. Millions of American workers and families and thousands of firms can react quickly to a change in their financial status.

This strategy appears to be working. We’ve got evidence from multiple sources suggesting that people are spending some of their stimulus checks, and that this is helping to support increased consumption. It’s harder to tell how much firms are taking advantage of the investment incentives, because it’s hard to measure that in real time.

In yesterday’s Wall Street Journal, Professor Martin Feldstein writes that the stimulus was a “flop.” Specifically, he argues that the recent GDP data show that the boost to consumer spending from the rebates was small relative to the overall size of the rebates. He estimates that $12 billion was spent out of a total of $78 billion in rebates paid out by the end of June. The core of his argument is that we didn’t get a lot of bang for the buck – only a small bump to GDP for a large loss of revenue for the government.

We disagree with this analysis. First, we think the stimulus bang is bigger than $12 B. Prof. Feldstein assumes that the growth in consumer outlays would have been flat had there been no stimulus. He then observes that consumer outlays actually grew by $12 billion more from Q1 to Q2 than they did in the prior quarter, and attributes that to the stimulus. Many observers think that, without the stimulus, consumer outlays would have grown more slowly in Q2 than in Q1. If this is the case (and we believe it is), then the effect of the stimulus is bigger than $12 billion.

In addition, we have felt only part of the bang so far. The stimulus enacted in February will have ongoing impacts in the upcoming months. Almost all the cash to consumers is out the door, but the resulting boost in consumer spending has not yet reached its full effect. We anticipate that the past stimulus law is continuing to increase GDP in the 3rd quarter, with a diminishing amount in the 4th quarter of this year. Monetary policy works with an even “longer lag” – the evidence suggests that when the Fed cuts interest rates, it takes about a year for half of the economic effect to take hold. So there’s more bang left in the remainder of this year from past actions on both the fiscal and monetary sides.

Allowing people to keep more of their money for one year is better than not doing so at all, so the loss of government revenue is actually a good thing if that money stays in the hands of the taxpayers who earned it, even if we can only get Congress to agree to do that for one year. We agree with Marty that the stimulus would be more effective if we had been able to enact a permanent tax cut, rather than a temporary one. Legislative realities forced it to be temporary. Permanent is better than temporary, and temporary is better than nothing.

On the second stimulus question, the following interchange from May 19th is instructive. Our deputy press secretary Scott Stanzel talked with a White House reporter at the “daily gaggle”:

Q: Scott, is the administration looking any more closely at a second economic stimulus package? The Commerce Secretary was on Late Edition over the weekend, and didn’t directly and definitively shoot that idea down.

MR. STANZEL: Well, what’s in the second stimulus package that you’re talking about?

Q: Well, just — I’m saying that many in Congress say we need a second economic stimulus package.

MR. STANZEL: Right, but what’s in that? That’s the thing. The idea of the second stimulus has become sort of this catch-all phrase for adding a lot of additional government spending, or doing things that Democratic leaders in Congress may have wanted to do previously, but are now — would want to sort of put under the umbrella of a stimulus package.

Before last Thursday, there was no second stimulus proposal. Now there’s a proposal from the Chairman of the Senate Appropriations Committee, Senator Byrd (D-WV), but we have seen no indications that House or Senate Democratic leaders have signaled support for that proposal.

For more than two months we were asked to comment on something that did not exist. What does exist is pent-up demand in Congress to spend more money, and then to label that spending as a “second stimulus.” We anticipate that demand will only increase as we get closer to an election.

Congressional advocates for increased government spending this Fall have been arguing, in effect, that we should expand (G) in the equation above, and that doing so will increase economic growth.

But trying to stimulate short-term economic growth through increased government spending has a few problems:

  1. It’s slow. – Construction projects take years to plan and build. History shows that only about 27 cents of each dollar is spent in the first year.
  2. It’s often funneled through States. – Infrastructure spending and increased federal funds for programs like Medicaid result in transfers from the Federal government to State governments. This transfer doesn’t actually increase GDP, it just shifts money from one level of government to another. It’s more like putting in motion 50 potential stimulus packages, each of uncertain efficacy and speed. Some States might try to spend the funds quickly. Others might shift money around and use the Federal dollars to pay down debt, or wait until their State legislature convenes next year to allocate the funds. There’s also a danger that providing States with aid during challenging economic times will encourage states to spend irresponsibly during boom years, counting on Federal bailouts when times are tough.

You can make other arguments for spending more taxpayer funds on roads and bridges, but it’s a highly inefficient tool to stimulate immediate economic growth. Many of the advocates for a so-called “second stimulus” know that spending taxpayer funds on roads and bridges is popular with voting constituents.

There’s an important philosophical difference between the first stimulus (which was overwhelmingly bipartisan) and current Congressional attempts to increase government spending. The first stimulus proposed by the President looked at the economy as a whole, and tried to design a package that would help spur growth across the entire economy. Ideas being bandied about for a so-called “second stimulus” tend instead to take a constituency-based approach: they try to identify who is hurting, or who is politically powerful, and funnel government funding to them. Advocates then claim that these funds will stimulate broad-based economic growth.

We think that the first stimulus was both more fair and more effective by providing taxpayer rebates to more than 100 million Americans and broad-based business investment incentives to thousands of firms. And we think that there’s more economic bang still left from those recently implemented policies.

In summary:

  • We think the stimulus is working and increased Q2 consumption and GDP.
  • The effects of the first stimulus are not yet complete. Most of the cash is out the door, but we think there will be increased consumption effects this quarter, and a diminishing amount in Q4.
  • For many, “second stimulus” is code for “allow Congress to increase politically popular government spending shortly before Election Day, and call it macroeconomic stimulus.”
  • Increased government spending is slow and ineffective macroeconomic stimulus.

Thanks to Donald Marron, the newest Member of the Council of Economic Advisers, and to the CEA team for their help with his note.

The Economic Report of the President

On Monday Dr. Edward Lazear, Chairman of the President’s Council of Economic Advisers, released the Economic Report of the President for 2008.

This traditionally is released a week after the President’s Budget. It describes the state of the U.S. economy, and also discusses in more detail a range of economic policy issues. As the ERP is written by professional economists on the CEA staff, it’s quite substantive. Topics covered this year include the U.S. macroeconomic picture, credit and housing markets, export growth, health care, tax policy, the Nation’s infrastructure, alternative energy, and improving economic statistics.

In addition, Dr. Lazear spoke to reporters yesterday about the ERP, and about the Administration’s economic forecast. Here are some of the most significant quotes from that press briefing. While normally I try to explain our policies, I can’t do better than Eddie has done for himself, so I present his quotes without further ado.

On the economy

CHAIRMAN LAZEAR: Going forward, most forecasters expect the first half of 2008 to have slow, but positive, growth, followed by a pick-up in the latter half of the year. The stimulus package just passed by Congress that will be signed by the President shortly should help ensure against risks in the economy.

This year’s most significant economic events revolved around housing and credit markets. An apparent under-pricing of risk was revealed first in mortgage markets, and later in a variety of credit markets. The President was quick to respond to these issues by focusing on borrowers through programs like FHA Secure, suspension of the tax liability on mortgage write-downs, and HOPE NOW programs. Additionally, the Federal Reserve acted to pump liquidity into the market. Some credit markets have become more stable since the acute tightening that occurred in the summer.

Are we in a recession?

Q: [D]o you think we’re going to go into a recession or are in a recession right now?

CHAIRMAN LAZEAR: The answer is, I don’t think we are in a recession right now, and we are not forecasting a recession. We are forecasting slower growth. There’s no denying that the growth that we had in the fourth quarter of last year was significantly lower than the growth that we had in the third quarter. Now I just remind you that we had similar growth rates in the first quarter of last year, and those similar growth rates were followed by two very strong quarters. So these things are somewhat volatile.

I am not suggesting that we expect that in this quarter we’ll see the same kind of growth that we saw, say, in the third quarter of last year — we’ve had some issues, obviously, in terms of credit tightening, in terms of the housing markets. And that’s the reason why the President was very active in pushing through the stimulus package, which we’re very pleased about. I think we got that in record time. We think that’s insurance against risks on lower economic growth, and we think that will help a good bit. We think it should help immediately, because businesses will build those expectations into their plans, and we expect that will help the economy even in the very near term.

Should people be worried even if we’re not in a recession?

Q: I know you’re not forecasting a recession, but a lot of Americans look at the fourth quarter figures, they look at the stock market, they look at the shrinkage in the job figures in the fourth quarter, and they say, well, I’m worried about it. Are they wrong to be worried about it?

CHAIRMAN LAZEAR: Well, we look at those numbers too, and that was the motivation, of course, behind the stimulus package, because of the concerns out there — and it wasn’t just the public’s concerns, it was our concern that there are some factors that suggest some potential weakness in the economy. We were worried about lower growth, and as a result of that, we decided that it was the right time to act.

We believe that the stimulus package that was voted on last week will be quite effective in ensuring against these downside risks, and we think that they will keep the economy from slipping into lower levels of growth. And again I think that our forecasts are realistic, they’re consistent with what you’re seeing out on the street, as well. I think this is — we’re moving in the right direction.

I should also mention, by the way, that the Federal Reserve has also acted to change their monetary policy stature over the last few weeks, and in a pretty aggressive way, and that will also contribute, we think, to the economic picture.

Is the Administration willing to consider a second stimulus bill?

Q: Congress is planning to advance a second stimulus package in a few weeks. First of all, given the timing, would you even agree that it would be a stimulus package? And whether or not it has a stimulative effect, is the administration willing to consider additional measures?

CHAIRMAN LAZEAR: We think the proposal that we put out a few weeks ago, and it was acted on last week, is the right thing to do. We think 1 percent of GDP is about the right number — it’s slightly higher than 1 percent, but we think that’s an effective stimulus. We think it will have the desired effect. And that was the policy that we thought was appropriate. We still think that policy is appropriate and we’ll stick with that.

Does your forecast assume spillover from the housing problems into other financial markets or economic sectors?

Q: Back in March, the great debate was, will this housing crisis spill over into any other sector, and economists were divided, and of course by August we knew it was spilling into the financial sector. Now, if you pick up the papers you’re reading about corporate debt market seems to be under pressure. Is your forecast assuming no more spillover, or have you actually taken into effect possible spillover into corporate debt and other marketplaces?

CHAIRMAN LAZEAR: Well, when you say “spillover,” I guess I would say that’s still a debatable point. The fact that we saw some distress in other credit markets does not necessarily mean that it was a spillover from the housing market. It could have been, but it could also be a reflection of the same underlying phenomenon. I think most market observers believe that most of what we’ve seen in terms of credit markets reflects the under-pricing of risk that occurred over the past couple of years, that happen to have shown up first in mortgages.

Okay, so it showed up first in subprime. That doesn’t mean that subprime necessarily was the cause of what we saw in other markets. It’s just a reflection of the same forces perhaps showing up there first. And my guess is that will be something that will be debated by academics for the next 10 years to come.

Is it over? You know, who knows whether it’s over. I think the good thing that has happened in credit markets is that many firms have recognized their losses and, in addition to that, they’ve been able to raise capital. I think that’s the most encouraging sign — that firms have suffered some distress and financial markets, no question about it, but after they’ve declared those losses they’ve been able to go out and raise capital and to start again. And that’s what’s most important, I think, going forward.

Extending unemployment insurance

Extending unemployment insurance

Some have been arguing that the growth package should extend the availability of unemployment insurance (UI) benefits.

I’d like to cover three points in response:

  1. Unemployment benefits have never before been extended when the unemployment rate is as low as it is now, or before the economy has been in a recession.
  2. Extending unemployment benefits will not have a quicker positive effect on GDP growth than tax rebates.
  3. Extending unemployment insurance benefits encourages some workers to remain unemployed. This could hurt job growth and undo much or all of the near-term positive effects of the House-passed growth package.

Special thanks go to Dr. Edward Lazear and his team at the Council of Economic Advisers for the first and third points. p.s. Eddie is a labor economist.

Unemployment benefits have been extended seven times since the 1950s. Only twice have extended benefits started when the unemployment rate was below 7.0 percent. In both cases, the unemployment rate was above 5.7 percent. The current unemployment rate is 5.0 percent.

Unemployment benefits have never been extended before a recession. Almost all periods of extended benefits occurred after the conclusion of a recession. Twice extensions were initiated 12 months into a recession (1975 and 1982). And of course, our economy is now growing, albeit slowly.

Special Extended Benefit Programs

Date Unemployment rate
June 1958 7.3%
April 1961 7.0%
January 1972 5.8%
January 1975 8.1%
September 1982 10.1%
November 1991 7.0%
March 2002 5.7%

Some (including, unfortunately, the Congressional Budget Office) have blurred the distinction between when UI and rebates begin, and when the actual increase in GDP would occur. The press has repeated the incorrect assertion that “unemployment benefits would affect the economy more rapidly than tax rebates.”

While UI checks would start sooner than rebate checks, the vast majority of the cash out the door, and therefore the GDP effect, would occur much earlier from rebate checks than from extending unemployment insurance.

The logic is quite simple.

  • Remember that this is an extension of unemployment insurance, from 26 weeks to 52 weeks. That means you only see the financial effects of the policy change in your 27th week of unemployment.
  • The first UI help is felt very quickly, within a few weeks — but it only affects people who are about to exhaust their unemployment benefits. For people who aren’t at 26 weeks yet, they won’t feel the effects till later.
  • Hence, the stimulus effect of UI relief begins rapidly for a few, but it grows quite gradually — it gets drawn out over a longer time frame, as more people approach week 27.
  • Sending people tax refund checks would start later but would peak quickly instead of being spread out over a longer time. We estimate checks would start about 60 days after enactment, and would be delivered over roughly a 7-week period.

This graph shows the cumulative cash out the door, comparing rebate checks and unemployment insurance. The first thing to notice is the difference in magnitude — UI benefits affect fewer people than broad-based tax rebates, so the total amount of dollars going out the door is much smaller, and therefore the economic benefit is smaller.

But the main point is that, while UI benefits would begin in late March and rebate checks not until about mid-May, the checks are concentrated into about a 7-week window. Once that’s done (say, by the end of June), the whole $100B of rebate checks are out the door and into the economy. The UI benefits grow much more slowly, as people “age into” their extended benefits by hitting the 26-week threshold.

timing of fiscal stimulus

Under current law you’re eligible for 26 weeks of unemployment insurance. The most frequently discussed proposal is to extend that for another 26 weeks, to a full year.

Some find it implausible to suggest that some people would choose to remain unemployed because they don’t want to lose their unemployment insurance. But the numbers don’t lie. Look at the dramatic increase in the percentage of workers who find a job in week 26, right before their UI benefits run out.

graph - reemployment rate by weeks employed

In fact, according to two economists from the Clinton Administration, extending UI benefits by 13 weeks increases the duration of the typical spell of unemployment by one to two weeks. (Card and Levine, 2000; Katz and Meyer 1990)

So if you extend UI benefits, you will increase the duration of the typical spell of unemployment. Fewer people will have jobs, and economic growth will be slower. While we’re reticent to put an exact number on this effect, the numbers are significant enough that it could counteract much of the benefits of the House-passed growth package.

A bipartisan economic booster shot

Last Friday the President spoke about the need for additional Congressional action on the economy. Outsiders are referring to this as fiscal stimulus. We’ve been calling it a growth package.

There’s a lot to say, so I’m going to break this up into three big parts.

  1. what the President proposed;
  2. why the President proposed it; and
  3. today’s bipartisan agreement, and why we support it.

1. What the President proposed last Friday

Here are the President’s remarks from last Friday. They’re short and well worth reading, and they contain a lot of substantive content.

To put it simply, the President proposed that Congress pull the fiscal policy lever to increase economic growth (GDP) this year. You’ll remember (or not) from your macroeconomics course that there are two basic governmental tools for addressing the short-term economic picture. The Federal Reserve has a monetary policy lever, and the Congress has a fiscal policy lever. The Federal Open Market Committee pulled their lever on Tuesday, by cutting both the federal funds rate and the discount rate by 0.75 percentage points (experts say “75 basis points”). We studiously refrain from commenting on the Fed and its tools.

Last Friday the President described the shape of an effective growth proposal. He did this instead of laying out a detailed proposal, in part at the request of Congressional leaders on both sides of the aisle, to allow them some flexibility in their negotiations. It appears to have worked.

To actually increase GDP in the near term, an effective growth package must be:

  • Big enough to move the needle on a $14.5 trillion economy. The President proposed a package that’s 1% of GDP, or about 145 billion dollars in 2008. That’s 50% — 100% bigger than what Congress has been discussing for the past two weeks.
  • Immediate. This means (i) Congress should pass legislation immediately. (ii) Policies with immediate macro effects are better than those with lagged effects.
  • Based on tax relief. Individuals, families, and businesses will react quickly (and more effectively) if they are deciding how to spend more of their own money. Government bureaucracies react slowly.
  • Broad-based. Many were emphasizing “targeted.” In contrast, we think policies should be neutral and distort decisions as little as possible. We have a macroeconomic focus on sectors of the economy, like increasing consumption and business investment. This is in contrast to those who implicitly have a microeconomic focus on particular constituencies in American society. There’s also a difference in philosophical approach, between helping the American economy as a whole, to benefit everyone, and helping those parts/members of the American economy that someone deems to be “most in need of assistance.” (In retrospect, some were also using “targeted” to refer to the income distribution of tax relief. In this respect, we think that the compromise announced today addresses their concerns.)
  • And temporary. As a general matter, we prefer long-term policy changes, especially on the tax side. In this case, our policy focus is insuring against drops in GDP growth without significantly raising the national debt. That necessitates short-term and temporary policy changes. (It also dramatically increases the chances of a bipartisan legislative success.)

The President also described a couple of things that move in the wrong direction. To be effective, a growth package must not:

  • Raise taxes.
  • Waste money on federal spending without an immediate positive effect on GDP growth.

In addition to these principals, the President suggested that a growth package should try to increase consumption (70% of our economy) and business investment (11%). The President said that to be effective, a growth package must:

  • Include tax incentives for American businesses to invest (especially small businesses).
  • Include “direct and rapid income tax relief” to increase consumer spending.

2. Why our economy needs a booster shot

Here is a memo from the Chairman of the President’s Council of Economic Advisers, Dr. Edward Lazear. It goes into more substantive depth than I will do here.

Our view of where the economy is now

booster shot [boo-ster shot] (n) An additional dose of a vaccine needed to “boost” the immune system.

You don’t get a booster shot when you’re sick. You get it when you’re well, but you’re concerned you might get sick. It’s a preventive measure to reduce the chance that you get sick.

Let’s start with three simple but critically important facts:

  1. The single most important indicator of a healthy economy is how many people are working. The unemployment rate is now 5.0%. While that’s up quite a bit from 4.7% in the prior month, 5.0% unemployment is still a very good number. Lots of Americans are working, and that’s good. Today’s unemployment rate is below where it was (on average) in each of the last three decades.
  2. The U.S. economy is growing, albeit slowly. We had a strong 3rd quarter last year (GDP +4.9%). But private sector projections for both Q4 of last year and Q1 of this year fluctuate around +1% (with a big error margin). That’s a significant slowdown, and it’s slower than we would like. (Silly but important reminder: “slowdown” does not equal “recession.” Slowdown means slow growth. Recession means negative growth. Rule of thumb: a “recession” is two successive quarters of negative GDP growth. And for the technicians, yes, the NBER’s definition is actually more complex than this.)
  3. The President’s economic advisors and most private sector forecasts expect the economy to continue to grow this year, albeit slowly. The most likely scenario is slow GDP growth through the first half of 2008. Most also predict that growth will accelerate somewhat in the second half of the year.

It’s easy to miss these three facts, because much of the press coverage has glossed over them and instead covered the possibility of worse economic scenarios.

Future downside risks provoke economists inside and outside the Administration to recommend an economic booster shot. Most economists raise housing problems and financial markets issues as the greatest near-term threats to continued economic growth. Many also point to the economic drag of expensive oil.

While much of the policy and legislative discussion in the Fall was about housing finance (mortgages), the principal macroeconomic issue is the actual houses themselves. Fast-rising house prices created an incentive for builders to keep putting up new houses beginning in 2003, and inventories built up. When a manufacturer has lots of products in its inventory, it slows down the manufacture of new goods. The same has happened, quite dramatically, in the housing sector. Builders aren’t building because there’s a big supply of unsold houses on the market (with significant regional differences).

As long as housing inventories remain high:

  • since supply exceeds demand, prices of new and existing houses will decline (by how much is highly uncertain); and
  • builders won’t build many new houses; so
  • the residential construction component of GDP will shrink; and therefore
  • a shrinking housing sector will cause slower overall economic growth.

These adjustments in the housing sector will take some time. We need to make sure that policy in Washington doesn’t make this problem worse. We are also watching carefully to see whether problems in the housing sector bleed over into consumer spending. This could happen in one of two ways:

  1. If your home is worth less, you have less overall wealth. The evidence shows that you then spend less (maybe 1 or 2% of the decline in your wealth). This is the “wealth effect.”
  2. If your home is worth less, you might be less confidence about the economy as a whole, and this might cause you to spend less.

It’s important to understand that the President’s proposal from last Friday was about the U.S. economy as a whole, and his proposal focused on consumer spending (70% of the economy) and business investment (11%). The housing sector needs to adjust, and we can have a greater effect with fiscal policy on consumption and business investment, through the policy direction outlined by the President last Friday.

To summarize:

  • Our economy is growing, albeit slowly.
  • We think the economy will continue to grow, albeit slowly. We are not predicting a downturn.
  • There are risks to that growth projection, especially from housing, the financial markets, and high oil prices.
  • The President proposed that Congress quickly enact legislation to address these risks.

3. Today’s bipartisan agreement, and why we support it.

A short while ago House Speaker Nancy Pelosi (D-CA), House Republican Leader John Boehner (R-OH), and Treasury Secretary Hank Paulson announced their agreement on a growth package. The Speaker said she intends rapid legislative action in the House.

Here’s a useful summary, followed by our evaluation of how this agreement fits with the principles the President offered last Friday.

House Bipartisan Leadership Growth Plan Agreement

What it does:

  • Part I: Personal Tax Relief ($103 B)
    • Cut the 10% tax rate in 2008 to 0% for the first $6,000 (individuals)/$12,000 (couples) of taxable income
    • Maximum rebate: $600 (individuals)/$1200 (couples)
    • Minimum (refundable) rebate check: $300 (individuals)/$600 (couples)
    • Eligible if earned income > $3,000 (subject to income limits below)
    • Rebate phases up from $300 to $600 for those with taxable incomes ranging from $3,000 to $6,000
    • Additional refundable tax credit of $300 per child for those who otherwise receive a rebate
    • Full rebates/credits are available to those with adjusted gross income (AGI) < $75 K (individuals)/$150 K (couples)
    • Total rebate (including child credit) phases out above $75K/$150K (by 5% of AGI above those levels, until eliminated)
    • Relief provided via rebate checks sent ASAP after enactment (estimated starting date = 60 days later)
    • Examples:
      • Single parent with two children, earned income of $4,000 (has no current income tax liability).
        • Individual rebate = $300
        • Child tax credit = $600
      • Single parent with two children, AGI = $38,000, taking standard deduction.
        • Individual rebate = $450
        • Child tax credit = $600
      • Married couple with two children, AGI = $48,000, taking standard deduction.
        • Individual rebate = $800
        • Child tax credit = $600
      • Married couple with two children, AGI = $80,000 (assuming tax liability greater than $1,200).
        • Individual rebate = $1,200
        • Child tax credit = $600
  • Part II: Business Investment incentives (~$50 B)
    • Accelerated bonus depreciation of 50% in 2008
    • Increased expensing for small business (Section 179 limit raised from $125 K to $250K)

The agreement would also increase the conforming loan limits for Freddie Mac, Fannie Mae, and the Federal Housing Administration.

Why it is good:

  • Effective: The package addresses the two major components identified by the President as essential to promoting near-term growth: boosting consumer spending and business investment.
  • Timely: The personal tax relief will begin to stimulate consumer spending and additional economic growth within about 60 days of enactment. The business incentives will spur investment throughout 2008.
  • Temporary: The package will provide immediate relief to the economy without turning away from policies to promote long-term growth and to balance the Federal budget.
  • Rewards Work: Individuals must have earned income to receive the $300 rebate check.
  • Broad-based: Rebates will reach 117 million households.
  • Neutral: The package allows individuals and businesses to decide how best to use the relief provided.

What it does not do:

  • The package does not raise taxes.
  • The package is not a collection of spending programs; it does not include any government outlays beyond the minimum rebate check and refundable child tax credit.
  • The package does not contain wasteful provisions that would spend money slowly, failing to meet near-term economic objectives.
  • The package does not contain lender bailout provisions that would interfere with ongoing and necessary corrections in the housing sector.

I want to return to the criteria the President laid out last Friday, to see how the bipartisan agreement matches up.

  1. Big The President proposed 1% of GDP, or about $145 B. This package is about $153 B. 
  2. Immediate We got a bipartisan agreement in the House even faster than we expected, thanks to the excellent work and leadership of Secretary Paulson, Speaker Pelosi, and Leader Boehner. We hope for quick legislative action, and similar bipartisan support in the Senate. TBDWe anticipate advance refund checks could start being delivered about 60 days after the President signs the bill into law. TBD
  3. Based on tax relief The entire package is done through tax relief, excepting one mortgage-related provision (that does not affect spending). The refundable aspects of the tax relief technically count as spending. But the other spending items (which we opposed) are all excluded from this agreement. 
  4. Broad-based It is very important to us that the government not pick particular constituencies as more “deserving” of tax relief. The agreement largely meets that test. 
  5. Temporary Every provision in this bill is effective only for 2008.
  6. Don’t raise taxes. 
  7. Don’t waste money on federal spending without an immediate positive effect on GDP growth. 

You can see why the President is strongly supporting this bipartisan agreement. He said a short while ago, “Because the country needs this boost to the economy now, I urge the House, and the Senate, to enact this economic growth agreement into law as soon as possible.” We have an opportunity to come together, and take the swift, decisive action our economy urgently needs.


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