Published for Economics One, September 13, 2011

Congress was busy working on fiscal policy today. This morning, over on the House side, it held its first hearing on President Obama’s fiscal stimulus proposal. As one of the witnesses, I argued that the fiscal policy responses thus far to the unemployment problem have not been effective. Consisting mainly of short-term temporary and targeted interventions, the policy has not had a sustainable impact on economic growth and unemployment. Instead, the policy has increased the federal debt and raised uncertainty, which is an impediment to economic growth. Unfortunately, the proposals made by President Obama on September 8 consist largely of the same type of temporary and targeted interventions that have been tried for the past several years. Recent experience and past experiences show that this type of fiscal policy will not increase economic growth, certainly not on a sustained basis. It will not therefore bring the unemployment rate down to pre-recession levels which should now be the goal of policy. Over on the Senate side this afternoon, there was a hearing on more comprehensive tax and budget reform. I testified there too, along with Alan Greenspan and Martin Feldstein.  I briefly laid out a more permanent and predictable alternative to the President’s temporary and targetted proposal—a budget strategy to raise economic growth with revenue-neutral tax reform. It builds on the Budget Control Act and brings spending to the level of 2007 as a share of GDP.

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Published for The Wall Street Journal, August 17th, 2011:

The GOP plan is more effective byt may work better if the spending limits are set the way the president proposed.

As the fallout over the Standard & Poor’s downgrade makes clear, getting the country’s future finances under control will require going beyond the spending-growth reductions in the Budget Control Act of 2011 and making fundamental changes to our entitlement programs, especially Medicare. To make the Medicare program fiscally sustainable, reform must: (1) place limits on spending growth and (2) change the program to hold actual spending growth to these limits.

There are two major approaches to achieve these ends. On April 6, House Budget Committee Chairman Paul Ryan put forth a plan that transforms Medicare into a marketplace of regulated, private-insurance policies with government-provided support for insurance premiums. On April 13, President Barack Obama proposed an alternative that retains the program’s current structure with the overlay of a new, centralized bureaucracy.

Both plans place limits on spending growth that are far below that projected under the current Medicare law. The most important difference between the plans is their approach to containing spending within these limits.

The Ryan plan builds on the approach of the Medicare Part D prescription drug benefit, which has been widely recognized as a success. It encourages competition among private insurance plans and provides incentives for cost-conscious choices among plans by beneficiaries. The Obama plan would empower a new Independent Payment Advisory Board (IPAB) to analyze the drivers of excessive and unnecessary Medicare spending and recommend policies to Congress to limit it.

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Published for The Wall Street Journal, July 21st, 2011:

America added 44 million jobs in the 1980s and ’90s, when both parties showed they had learned from past mistakes. The lessons have been forgotten.

This month marks the two-year anniversary of the official start of the recovery from the 2007-09 recession. But it’s a recovery in name only: Real gross domestic product growth has averaged only 2.8% per year compared with 7.1% after the most recent deep recession in 1981-82. The growth slowdown this year—to about 1.5% in the second quarter—is not only disappointing, it’s a reminder that the recovery has been stalled from the start. As shown in the nearby chart, the percentage of the working-age population that is actually working has declined since the start of the recovery in sharp contrast to 1983-84. With unemployment still over 9%, there is an urgent need to change course.

Some blame the weak recovery on special factors such as high personal saving rates as households repair their balance sheets. But people are consuming a larger fraction of their income now than they were in the 1983-84 recovery: The personal savings rate is 5.6% now compared with 9.4% then. Others blame certain sectors such as weak housing. But the weak housing sector is much less of a negative factor today than declining net exports were in the 1983-84 recovery, and the problem isn’t confined to any particular sector. The broad categories of investment and consumption are both contributing less to growth. Real GDP growth is 60%-70% less than in the early-’80s recovery, as is growth in consumption and investment.

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Published for The Wall Street Journal, April 22nd, 2011:

If government got by with 20% of GDP in 2007, why not in 2021, when GDP will be substantially higher?

Palo Alto, Calif.

Americans are clamoring for a fact-based debate about the budget, but the numbers they’re hearing from Washington are terribly confusing. Here’s an example: Speaking at a Facebook town hall meeting here on Wednesday, President Obama sometimes talked about saving $4 trillion, at other times $2 trillion, and he varied whether it was over 10 years or 12 years, never mentioning any one year.

A simple chart, like the one nearby, would greatly clarify the debate. It shows total federal government spending year-by-year for the two decades starting in the year 2000. Spending is shown as a percentage of GDP, which is a sensible and quite common way to assess trends: When the percentage rises, government spending rises relative to total income or total goods and services produced in our economy.

For the past decade, the chart shows the recent history of government spending. For the next decade—the window for the current budget—it shows three different spending visions for the future.

The uppermost line shows outlays under the official budget submitted by Mr. Obama to Congress on Feb. 14. The lowest line shows the House Budget Resolution submitted by House Budget Committee Chairman Paul Ryan on April 5, while the third line shows year-by-year outlays I estimated from the 12-year totals in the new budget proposed by the president on April 13.

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Published for The Wall Street Journal, April 4th, 2011:

Assurance that current tax levels will remain in place would provide an immediate stimulus. House Republican budget planners are on the right track.

By Gary S. Becker, George P. Shultz and John B. Taylor

Wanted: A strategy for economic growth, full employment, and deficit reduction—all without inflation. Experience shows how to get there. Credible actions that reduce the rapid growth of federal spending and debt will raise economic growth and lower the unemployment rate. Higher private investment, not more government purchases, is the surest way to increase prosperity.

When private investment is high, unemployment is low. In 2006, investment—business fixed investment plus residential investment—as a share of GDP was high, at 17%, and unemployment was low, at 5%. By 2010 private investment as a share of GDP was down to 12%, and unemployment was up to more than 9%. In the year 2000, investment as a share of GDP was 17% while unemployment averaged around 4%. This is a regular pattern.

In contrast, higher government spending is not associated with lower unemployment. For example, when government purchases of goods and services came down as a share of GDP in the 1990s, unemployment didn’t rise. In fact it fell, and the higher level of government purchases as a share of GDP since 2000 has clearly not been associated with lower unemployment.

To the extent that government spending crowds out job-creating private investment, it can actually worsen unemployment. Indeed, extensive government efforts to stimulate the economy and reduce joblessness by spending more have failed to reduce joblessness.

Above all, the federal government needs a credible and transparent budget strategy. It’s time for a game-changer—a budget action that will stop the recent discretionary spending binge before it gets entrenched in government agencies.

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Published for The Wall Street Journal, January 28th, 2011:

Our economic wounds are self-inflicted.  Changing fiscal and monetary policies could make a difference fast.

It’s been three years since the financial crisis flared up and the recession began. Yet the unemployment rate is still over 9%—double what it was before the recession—and it’s been stuck above 9% for 20 consecutive months. Why the extraordinarily high and prolonged unemployment? My research shows that discretionary government interventions—deviations from sound economic principles and policies—have been largely responsible.

Many government interventions occurred before the panic in the fall of 2008, but in the past two years the government doubled down. We have seen an $862 billion stimulus, an increase in federal spending to 25% from 21% of GDP, and a corresponding explosion of federal debt. We have the Fed’s unconventional “quantitative easings”: purchases of $1.25 trillion of mortgage backed securities and $900 billion of longer-term Treasury bonds. And we have seen hundreds of new regulations in the health and financial sectors.

The one-time stimulus payments to people did not jump-start consumption. The stimulus grants to states did not increase infrastructure spending. Cash for clunkers merely shifted consumption a few months forward. The Fed’s purchases did not have a material impact on mortgage interest rates once changes in risks are taken into account. At best these actions had a small temporary effect that dissipated quickly, leaving a legacy of higher debt, a bloated Fed balance sheet and uncertainty—all of which slow growth and job creation.

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Published for The Wall Street Journal, September 16th, 2010:

Our prosperity has faded because policies have moved away from those that have proven to work. Here are the priorities that should guide policy makers as they seek to restore more rapid growth.

America’s financial crisis, deep recession and anemic recovery have largely been driven by economic policies that have deviated from proven fact-based principles. To return to prosperity we must get back to these principles.

The most fundamental starting point is that people respond to incentives and disincentives. Tax rates are a great example because the data are so clear and the results so powerful. A wealth of evidence shows that high tax rates reduce work effort, retard investment and lower productivity growth. Raise taxes, and living standards stagnate.

Nobel Prize-winning economist Edward Prescott examined international labor market data and showed that changes in tax rates on labor are associated with changes in employment and hours worked. From the 1970s to the 1990s, the effective tax rate on work increased by an average of 28% in Germany, France and Italy. Over that same period, work hours fell by an average of 22% in those three countries. When higher taxes reduce the reward for work, you get less of it.

Long-lasting economic policies based on a long-term strategy work; temporary policies don’t. The difference between the effect of permanent tax rate cuts and one-time temporary tax rebates is also well-documented. The former creates a sustainable increase in economic output, the latter at best only a transitory blip. Temporary policies create uncertainty that dampen economic output as market participants, unsure about whether and how policies might change, delay their decisions.

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Published for The Wall Street Journal, September 9th, 2010:

Return to Rule-Based Policy Making

By John B. Taylor

To establish Fed policy going forward, the best place to start is to consider what has worked in the past. During the two decades before the recent financial crisis, the Fed employed a reasonably rule-based strategy for adjusting the money supply and the interest rate. The interest rate rose by predictable amounts when inflation increased, and it fell by predictable amounts during recessions.

Economists cite the Taylor rule—which says that the Fed’s target interest rate should be one-and-a-half times the inflation rate, plus one-half times the shortfall of GDP from potential plus one—as evidence that this approach worked. Performance was good during the 1980s and 1990s when policy was close to the rule. And it was poor when policy was far away from the rule, as it was during the 1970s and the Great Depression.

Unfortunately, leading up to and during the recent crisis, the Fed deviated from this framework. It held interest rates too low for too long from 2002 to 2005, and after the crisis began to flare up in 2007 it engaged in massive discretionary credit operations. While some actions helped halt the panic in the fall of 2008, others, like the unpredictable on-again off-again bailouts, brought it on and left a legacy of uncertainty that’s holding back recovery now.

So the answer to the question is simple: Get back to the rule-based policy that was working before the crisis. To get there without causing more market disruption, announce and follow a clear exit rule, in which the Fed’s bloated balance sheet is gradually pared back by predictable amounts as the economic recovery picks up.

Such a policy would be a much better stimulus than another large dose of quantitative easing in which the Fed’s balance sheet explodes even further, raising more uncertainty about how it will ever be unwound. A rules-based monetary policy could also serve as a model for fiscal policy—an area where increased predictability and certainty are sorely needed.

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Jackson Hole, Wyoming

August 28, 2010

Charles Bean and his colleagues at the Bank of England take the right approach to evaluating proposals for monetary policy going forward. They empirically examine policy leading up to and during the crisis and then draw several important policy conclusions. I agree with some of the conclusions, but not others.

I agree that low policy rates played a role in the housing boom and the search for yield and thereby the crisis, but I disagree that it was only a modest role without implications for future policy. I agree that the unorthodox policies have no role in normal times, but I disagree that these policies were always successful in the crisis. I agree that inflation targets should not be raised, but I disagree that we need new policy instruments, such as discretionary counter- cyclical capital buffers, to ward off financial crises in the future.

In this commentary I will focus on the disagreements because understanding them is crucial for deciding where monetary policy should be going in the decade ahead.

A Framework that Worked

Let me begin with my views on what monetary policy should be in the decade ahead. I start from the position that we had a good monetary framework that worked well for many years before the crisis. Let’s call in the “framework that worked.” The theory underlying this framework is embodied in models now sitting at many central banks. Volker Wieland (2009) and his colleagues at the University of Frankfurt are performing a valuable public service by assembling these models in an on-line database to encourage transparency, model comparisons, and policy robustness research. An earlier representative list of models is found in Taylor (1999). While the models differ in some ways, they are all dynamic and stochastic, and the impact of monetary policy is surprisingly similar in the different models, as shown in Taylor and Wieland (2009).

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