Christina D Romer

Policy Responses to the Great Recession: Interaction of Leadership and Economic Ideas - Dec. 1, 2011

Christina D Romer
December 01, 2011— Ames, Iowa
Mary Louise Smith Chair in Women and Politics
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Romer spoke at Iowa State University as the Fall 2011 Mary Louise Smith Chair in Women and Politics.

Thank you, it is indeed an honor and a pleasure to be here this evening. It’s particularly nice to be here as the Mary Louise Smith Chair on the Thursday night before the first Friday of the month. Now you ask me, why is that? The first Friday of the month is actually a very big deal if you’re the chair of the council of economic advisors because that’s the day when the employment and unemployment numbers come out. So tomorrow morning we’ll get the unemployment numbers for November. And one of the jobs of the CEA chair is to actually get all of the numbers that are going to be released to the public on the economy the night before, and so one of my jobs was to let say the secretary of treasury or the chairmen of the Fed know if it might be something that would cause a market reaction, and of course my job was to brief the president as well. So we were inevitably working late on a night like tonight.

Now, as you might imagine, when the economy is in the grip of a terrible recession, the employment report is of particular interest, and this actually gave rise to a couple of awkward situations. Now one, I was only authorized, obviously, to tell a very small number of people what was in the report, but that didn’t stop Rahm Emanuel, who was the president’s first chief of staff, from starting to call me at about 4:00 on the day before the employment report was going to come out. And Rahm would pretend to make small talk, now believe me that is not something he normally did. So I would pick up the phone, and I’d hear, “So how are things?” And he was just going to see if I would accidently let something drop. Another time I got a an email message from the president’s body man, Reggie Love, who was, the president was traveling, and he was emailing me to say the president was in his limo and would I call him and give him the employment report. So I dialed the number and I hear a very familiar “Hello”, but you can’t really say, “Are you the President?” So I proceed to, you know, give him the employment numbers, and I hang up the phone and I suddenly said oh my heavens have I just played into the biggest scam ever and given someone on Wall Street the employment numbers? So I quickly emailed Reggie who said no that really was the president that I had been talking to. So the bottom line is, I would be delighted to be at Iowa State any night of the year, but I am particularly happy to be here on this particular one and to be the Mary Louise Smith Chair and not the CEA chair.

The Carrie Chapman Catt Center’s focus, and the focus of this lecture, is on women and leadership, and this lecture’s actually been a chance for me to branch out a little bit and to think about the role of leadership in successful economic policy. And the place I found myself starting is what do we even mean by leadership? And I think many people tend to think of leadership in pretty narrow terms, the ability to get people to follow you. To get people to do what you want them to do, and that’s of course a part of leadership, but it occurs to me that a much more fundamental issue is not can you get people to follow you, but where do you lead them? Do you convince people to do good and sensible things? And for this, what matters is much less the leader’s dynamism or their powers of persuasion, but rather the quality of his or her ideas. I think in the case of economic policy what matters is, does the leader have a good understanding of how the economy works and policy prescriptions that are based on strong economic evidence? Let me give you an example of what I think is the central importance of ideas in economic leadership. If you go back to the 1930s, I think almost everyone would agree that Herbert Hoover was not a very successful leader on the economy in the early 1930s. I think it’s tempting to think that that’s because he lacked personal dynamism or the ability to rally people to his policies, but the truth is President Hoover was actually quite effective in that narrow form of leadership. He actually got congress to pass a number of significant pieces of legislation in response to the Great Depression. I think the problem is that President Hoover’s ideas just weren’t very good. That in the midst of the worst depression in American history, he believed that two things were the most important: one was to stay on the gold standard, and the second was to balance the budget. Now most economic research, as we were discussing at dinner actually, identifies the gold standard as one of the key sources of the worldwide depression of the 1930s, and it shows that countries that abandoned it sooner, like Great Britain, actually recovered much more rapidly. And almost any macroeconomics textbook will tell you that balancing the budget when the unemployment rate is 25 percent, as it was back in the early 1930s, is virtually impossible and almost surely counterproductive. And yet one of President Hoover’s signature accomplishments was the Revenue Act of 1932, which was at that time the biggest peace time tax increase ever. So I would argue that his failure of economic leadership was fundamentally a failure of his economic ideas.

Tonight what I want to do is to talk about the policies taken in response to our most recent recession, which unfortunately I think is appropriately named The Great Recession, because the United States’, and indeed the entire world, economy has been through just a horrific downturn. The financial panics surrounding the collapse Lehman Brothers in the fall of 2008 sent the American economy into free fall. The unemployment rate as we all know, though I understand it’s not nearly as bad here in Iowa, but it has risen dramatically from less than 5 percent for the country as a whole before the recession, to over 10 percent at its highest. And this rise in unemployment has hit every demographic group including the college educated, a segment of the population that traditionally weathered recessions more easily. But of course some parts of our society have been particularly devastated. So young people, for example especially those without a college education, have just been severely affected. The unemployment rate for young people is 25 percent, and for African-Americans it’s 16 percent. Perhaps even more distressing than the severity of the downturn, has in fact been the weakness of the recovery. Though we started to grow in the fall of 2009, hard to believe that was two years ago now, growth has been painfully anemic, and as a result the unemployment rate has just barely inched down from maybe 10.1 percent, to now nationally 9 percent, and as I said we’ll get a new number on that tomorrow morning.

The United States and other countries tried numerous policy responses to stop the free fall and to try to accelerate that rate of recovery. Everything from monetary policy to housing policy to fiscal policy, and I thought what I’d do this evening is to talk about the role of ideas behind those various policy responses. And what I’m going to try to argue is that the key determinant of the actions that we’re taken was not the politics or the personal dynamism of our leaders, but rather their ideas about how the economy worked. And perhaps even more important, I’m going to suggest that whether policies were successful or not fundamentally depended on the quality of the ideas behind them. That I think sensible, empirically accurate ideas generally lead to useful policies, whereas less accurate ideas I think have led to policy shortfalls.

Let me start this discussion of economic policy and leadership, in the most recent recession, with monetary policy because I think this is an area where we’ve had some of the earliest and most important actions, where we’re even having big actions yesterday as we’ve been discussing. And it’s an area where I think economic ideas have played just a fundamental role in determining what has been done and what hasn’t been done. Alright so first, what has the Fed done to deal with the recession and how well has it worked? First, as the economy actually started to slowdown now way back in 2007 and early in 2008, the Fed did the conventional thing, they lowered interest rates. And in fact by December of 2008 they’d pushed the Federal funds rate, that main interest rate that they control, basically down to zero. In addition to lowering interest rates, the Fed took all sorts of extraordinary actions to try to keep credit flowing. So, for example, when nobody was buying commercial paper, the bonds that corporations used to kind of cover working capital and some short-term borrowing needs, the Feds said, “Fine, we’ll create a special purpose vehicle and buy the commercial paper ourselves to try to keep credit flowing in the economy.” And I think, by almost all accounts, the early monetary policy actions were incredibly important and effective. I think there’s actually a good reason why Ben Bernanke, the chairman of the Fed, was named Time Magazine’s “person of the year” back in January of 2009. What he did through lowering interest rates and flooding the financial system with liquidity, helped to stop the panic, which believe it or not could have been far worse than it actually was.

Now since the extraordinary actions of late 2008 and early 2009, frankly I think the Fed’s been much less aggressive. They’ve taken a couple of rounds of quantitative easing. In case you’re not up on the lingo, quantitative easing just means that the Fed buys a large amount of kind of unusual assets, things they wouldn’t normally buy like mortgage backed securities or long-term government bonds. And the idea is to try to push down any interest rates that aren’t already to zero, like mortgage rates or long-term borrowing rates. And the evidence is that those actions have been at least somewhat helpful. But I think in terms of the Feds own guideposts, monetary policy today is clearly not succeeding. You know, the Federal Reserve Act says that the Fed’s supposed to care about both inflation and unemployment, and the Fed’s so called dual mandate. And the Fed has, for years, said that it thinks inflation of two percent, or a little bit less, is reasonable and unemployment should be at its normal sustainable level, which the Fed itself estimates is about 5 ½ percent today. By those criteria, the Fed is pretty clearly not doing very well. Inflation, the main measure they look at, is actually somewhat below their target and their forecasts are that it’s going to remain there, and unemployment is obviously about twice what the Fed thinks is its normal sustainable level. And it, too, is expected to stay very high for a long time. So how do we make sense of this? What explains the Fed’s behavior? Why was the Fed so much more aggressive and successful early in the crisis than perhaps it’s been in the past year-and-a-half or so?

Let me tell you what I don’t think it is, right. I don’t think it’s that the members of the Federal Reserve care more about banks than they do about ordinary people, right, so they took extraordinary actions when the financial system was on the line, but not when unemployment was high. If you read the speeches of Chairman Bernanke and other members of the Federal Reserve, they seem to care passionately about unemployment, and I do believe they’re deeply concerned about their failure to meet their dual mandate. Likewise, I don’t think the answer has to do with a failure of that narrow type of leadership that I talked about earlier, the ability to get people to follow you. I don’t think that the problem is that somehow Chairman Bernanke was a forceful leader in 2008 and somehow has lost his leadership mojo. I think that the key difference, I think, has to do with the quality of the ideas guiding policy. I’d say early in the crisis, two ideas were paramount: one, financial crisis are destructive and preventable and two, credit availability is essential to economic activity. These two ideas are about as fundamental as you can get in macroeconomics and the research behind them, I think, is well regarded and rigorous. So Milton Friedman and Anna Schwartz’s classic book, A Monetary History of the United States, showed that unchecked banking panics in the 1930s had been a central cause of the Great Depression and that better monetary policy could have stemmed the panics and prevented the worst economic crisis in our history. Likewise, a large modern literature, much of it written, that are inspired by Chairman Bernanke’s own research on the depression, showed that credit absolutely is essential to the normal spending of households and the operation of businesses. And if you read the speeches of Fed officials, or descriptions of their policy deliberations, it’s just clear that these basic ideas drove their response to the crisis and, in my view, the policies were largely successful because the ideas behind them were strong and sensible.

But I’d say, more recently, ideas are still determining Fed policy, but they’re unfortunately somewhat less sensible. So a substantial number of Fed members appear to believe that much of the unemployment that we’re facing is due to a mismatch between workers skills and the jobs available. That is, that the unemployment of nine percent is largely structural. In fact, there’s a very colorful statement by the head of the Philadelphia Fed, Charlie Plosser, who said “You can’t change a carpenter into a nurse easily, and you can’t change the mortgage broker into a computer expert very easily. Monetary policy can’t fix those problems.” And this reasoning has been repeated by many other Fed members, and I think this view is clearly leading at least some Fed policy makers to oppose any additional actions to help the economy. But I’d argue that it’s not very well founded, those ideas aren’t well founded in economic research. Of course there’s always a degree of skills mismatch in a dynamic economy. We’re always coming up with new things, and new ways of producing them, and that makes some jobs obsolete and others growing. But, the evidence does not suggest that there’s substantially more mismatch today then there was back when, say, the unemployment was five percent or lower. That most of the unemployment, the research says, that we are currently experiencing is still due to cyclical factors, particularly just way too little aggregate demand, which is something that monetary policy absolutely can help to fix.

Even Fed members who don’t agree that the current unemployment is due to structural factors, have expressed, I think, some questionable ideas about the usefulness of additional action. So if you watched, by any chance, Chairman Bernanke’s recent press conference he said of additional actions, “Are those tools likely to be sufficiently effective or do they bear costs and risks that would make them less effective and not worth using?” I think, reading between the lines, they’re worried that what they can do just won’t be very helpful. I think, from my tone you can probably sense, that I don’t think that idea, that economic idea, is correct. And, in fact, it goes against what I learned from studying the Great Depression, because in that episode, much like today, interest rates were down at zero and yet aggressive monetary action absolutely helped. It seemed to have made people feel more optimistic, and they started buying things again. They started buying cars and trucks and industrial machinery, and that this helped to foster the recovery. So I’d say the Fed’s tools may not be powerful enough to return the economy quickly to full employment while keeping inflation close to two percent, but I do think the evidence from economic history, and that much of economic theory, it’s clear that the Fed could be doing much more at achieving its stated goals. So the bottom line from this discussion is that monetary policy is absolutely determined in large part by economic ideas, and the success of those policies, I think, depends on the very quality of the ideas behind them.

Okay, so that’s one area of policy. The second one I want to think about is housing policy. Alright, because obviously house price movements, and housing in general, have played a big role in this recession. The rapid rise of house prices just led to an incredible boom in home building and a huge increase in household debt. Then when house prices started to fall in 2007, that put pressure on both homeowners and lenders who were holding lots of this mortgage debt. Defaults rose, home building ground to a halt, and eventually all those defaults led to a loss in confidence in our financial system, that was holding so many of the bad loans, and we had the first genuine financial crisis that we’ve had in this country for a good two generations. But, you know, the story of how important housing is doesn’t end with the collapse of Lehman Brothers back in 2008, because since the beginning of 2008 there have now been more than 3 million foreclosures, which is obviously devastating families, but it’s also devastating the economy and further depressing home prices. Today, another at least 11 million homeowners are what we would say are “underwater” on their mortgages, which means they owe more on their mortgage than their house is currently worth. And those underwater homeowners are, obviously at a bigger risk of defaulting on their mortgage, but we also think they seem to be hesitant to spend until they dig out from underneath this mountain of debt. And finally, we built so darn many houses in the early 2000s, during the boom, that we have a significant oversupply right now. So we’re not going to be needing to build houses in many areas for, unfortunately, quite some time. So the bottom line is that housing has been, and continues to be, I think, a big source of our economic troubles.

So what housing policies have we pursued and how well have they worked? And here, I’d say, the administration absolutely implemented a number of programs, but I think it’s fair to say they’ve worked less well than people had hoped, and I think this has certainly been a source of frustration to everyone in the government, including the president. The main program was the Home Affordable Modification Program or HAMP. I think one thing we can all agree on, these programs could not have had worse names. But, I think, what the program did was to try to encourage a servicer, or a bank holding a mortgage, to modify it to make the payments lower for a troubled homeowner. And the treasury department would help them do that by giving them an incentive payment and covering part of the cost. And of about the 4 million homeowners that we thought were at risk of foreclosure and could benefit from this program, only about a million have moved on to get a permanent modification. So it’s absolutely helped some, but not as many as one would have hoped. The other big housing program is one that allows those underwater homeowners that I talked about, to refinance at lower rates. One of the problems was even as mortgage rates came way down, if your house wasn’t worth as much as your mortgage, you couldn’t get a new loan. And so the administration has tried to make it easier and change the program so that people who were underwater could still refinance at a lower interest rate. And, again, about a million people have refinancing through this program, which is a big improvement, but again I think we’ve been hoping that more like 4 or 5 million people would be helped.

Now, importantly, essentially none of these existing programs do much of anything to get rid of that negative equity. What we don’t have is any kind of a widespread program where we actually write down the principle on a mortgage that’s underwater. And that’s kind of very different than what we had, say, back in the Great Depression where we did have a program that did that. And, as a result, one of the things that’s going on is there is just a whole lot of negative equity out there. If you want to put a number on it, American homeowners, you know as a group, owe about $750 billion more on their mortgages than their homes are currently worth. So that’s a lot of negative equity. Alright, so what it counts for, the housing programs that we pursued and what, I think we’d agree, was their somewhat limited success. Why was this path taken and not others? And here too, I can tell you from firsthand experience that ideas were just incredibly important.

So my colleague at the Council of Economic Advisors, Austin Goolsby, played just a tremendous role during the transition in formulating our housing policy. And at that time, what the best academic evidence showed, was that very few underwater homeowners actually defaulted. Most people, even if they owe more on their house than the house was worth, keep making their payments, they stay in the house. And what you find is that what pushes people over the edge, what actually ends up pushing them into default, is usually something bad happening in their life. They lose their job. Somebody gets sick. There is a divorce. And so what this analysis suggested was that if we wanted to reduce foreclosures, the important thing to do was to reduce mortgage payments for these people that get into trouble, to help them get though these rough patches. And so that was the logic behind that beautifully named HAMP program, that lowered people’s payments if they got into trouble.

One of the things that we ran into, that actually went into where we had trouble, was in the implementation. It turns out it was good idea, but we had very few carrots and even very few sticks, by which we could make financial institutions actually modify people’s mortgages. A more fundamental limitation is, I think, we designed a program that only focused on part of the problem. So we were focused on preventing foreclosures, and that’s absolutely very important, but I think new research shows that household indebtedness matters even separate from the risk of foreclosure. In fact, here I’d tell you about some great new research by my colleague, Atif Mian and his co-author, Amir Sufi, who look at household debt, and household spending, across all the counties in the United States. And what they find is that consumers in counties that had a big run up in household debt before the crisis, have been much more hesitant to spend, to buy cars, to do home repairs, all those things, than people living in counties, probably like a lot of the counties in Iowa, that didn’t run up those big amounts of debt. And what appears to be the case is that heavy debt loads and negative equity really do seem to be a bigger problem, I think, than economists had realized. And it suggests that policies need to be more focused on reducing principal on troubled mortgages and less on just reducing payments.

Now, I don’t actually think it’s the government who should absorb this negative equity, so that as we described, would be really expensive, we’re talking 750 billion dollars, and as we discussed in the meeting with some of the students this afternoon, I’d be nervous about spending a whole bunch of government money on people who are at least rich enough to own houses, right, so they’re already at the upper part of the income distribution. But I think there are some very sensible ways that we could encourage or even force financial institutions to do the write-downs on their own dime. For example, we could modify the bankruptcy law to allow judges to modify mortgages. Right now they can write down the principal on a car loan or other loans, but not on mortgages. It seems to me, housing is a case where policy was driven by sensible ideas, but implementation problems reduced its effectiveness, and it’s a place where new research suggests that the driving ideas may have been too limited. And certainly, what I hope is that policy response to this new research and the emerging consensus that principal write downs are desperately needed.

That’s housing; we’ve done monetary policy. I’ve saved kind of the biggest one for last, that’s the ever popular fiscal policy. Because fiscal policy refers to anything having to do with the government budget, whether it’s tax changes, spending changes, anything that affects the budget deficit. It includes these measures that are aimed to help to reduce the unemployment rate, the so called “fiscal stimulus,” but it also covers spending and tax changes to deal with our long run budget problems. So let’s start with what we’ve done with fiscal policy since the Great Recession started and how well has it worked? And here I’m going to branch out a little bit and talk not just about the United States, but also some other countries, because as we know from what’s going on in Europe, fiscal policy is a huge issue not just in our country, but obviously in the troubled countries of Europe and even in a number of emerging economies, such as China and Brazil. Fiscal stimulus was an absolutely essential part of the policy response to the Great Recession, and here I think it’s important for people to realize it actually started in the Bush administration. The Economic Stimulus Act of 2008 was signed way back in February of 2008. Actually just two months after what we know date as the start of the recession, and it provided a tax cut for about $1200 for a typical family. Much of which came in the form of a rebate check mailed to families that year. Now President Obama obviously continued the fiscal response, the American Recovery and Investment Act of 2009 was passed just one month after his inauguration. And at $787 billion, it was the largest counter-cyclical fiscal stimulus in American history. The one thing that people may not realize is it actually took various forms, roughly about a third of it was more tax cuts, about a third of it was spending increases on things like infrastructure and renewable energy, and about a third of it was payments to either state and local governments to help them through the crisis or to people who’ve been directly hurt like through unemployment insurance or supplemental nutrition.

Importantly, many other countries also took aggressive fiscal action. So Germany, for example, had a very aggressive program of paying employers to keep workers working, but the government would carry the bill. China spent about $600 billion on infrastructure, which may not sound so big until you realize they’re only about a third as big an economy as we are, so that’s really a huge number. And I think the best available research points strongly to the conclusion that, all that rapid fiscal stimulus worldwide played an important role in stopping the free fall. In fact, a really interesting study that we did at the Council of Economic Advisors looked at the outcome across countries, and what we found is that countries that did more fiscal stimulus like China, Korea, Japan actually did better relative to what people had been predicting before the stimulus, than countries that did a lot less like Italy and Switzerland. And in that study the U.S. was kind of in the middle. We did a moderate amount of stimulus given our size, and we did moderately better than expected.

Now the notion that the Economic Stimulus Act of 2008 and the Recovery Act of 2009 were helpful in the United States has actually been backed up by a number of recent studies. One of the few silver linings to this terrible cloud that we’ve been living under is that there’s been a blossoming of new research on macroeconomic policy and especially on the effects of fiscal policy. And almost all of it finds that expansionary fiscal policy does increase demand and increase employment relative to what it otherwise would have been. For example, a really nice new study that that Economic Stimulus Act of 2008, a nice new study found that people actually absolutely did spend it, and in fact many of them behave like my father, who I remember was waiting for his check to come in the mail and then immediately went to the Honda dealer and bought a new car. Believe me, the check did not did not begin to cover it.

Likewise, there’s several studies that show the Recovery Act had an impact. So for example I’ll just give you one, but a study by Daniel Wilson, who’s at the Federal Reserve Bank of San Francisco, looked at the variation in Recovery Act spending across states, and what he concluded is that the Recovery Act raised employment relative to what it otherwise would have been by about 3 million as of mid-2010. That, not surprisingly, is music to my ears since I predicted it would raise employment by roughly 3 million, but it’s nice to see it confirmed by a very different kind of study. Now, since the Recovery Act the United States has taken a handful of additional actions, but so far we haven’t done another big round of fiscal stimulus. And, indeed both here and in the United States and especially in Europe, much of the focus of fiscal policy has really changed from stimulus and reducing unemployment to concern about the budget deficit. You know that the Greek debt crisis, which, again, hard to believe we’ve been living with this nightmare for now almost a year-and-a-half, it began back in the spring of 2010, I think that helped to wake everybody up to the fact that many countries, including our own, are not on a sustainable fiscal path. So many advanced countries both here, in Europe, Japan are looking at just enormous budget deficits going out as sort that dual problem of the baby boom generation retiring and rising healthcare cost continue, come together.

The response in many European countries to the Greek debt crisis and concern about the deficit was to move immediately from fighting the recession to dealing with the deficit, and country after country cut government spending and raised taxes. Now some countries, like Greece and Spain and Portugal, basically had no choice, right, if they wanted help with their debt crises places like the IMF and other European countries said they had to cut their budget deficits. But, others like the United Kingdom and Germany chose to do this because they thought it was the best policy. And I think the outcome in countries adopting what we’d call a strong fiscal austerity, that immediate aggressive deficit reduction, I think frankly has not been very good. If you look at the true problem children of Europe, they find themselves caught in just a terrible circle. So a country, like Spain, where fiscal austerity causes unemployment, when unemployment goes up, tax revenues go down, so their budget deficit doesn’t actually fall, so then they have another round of fiscal austerity. And what we see happening in a country like Spain, but you could put in Greece, you could put in Italy, you could put in Ireland, is that what you see is their unemployment rates have gone up, and hard as it is to believe, the unemployment rate now in Spain is some 22.6 percent, and their deficit, you won’t be surprised, is a disaster precisely because of it.

Now here in the United States, we’re talking a lot about the deficit, and heavens knows we’re fighting a lot about the deficit. We’re not actually doing all that much. You know this summer, the president and congress eventually agreed we were going to reduce our deficit over the next 10 years by about $2 trillion. And then we learned just before Thanksgiving that the Super Committee that was set up by the legislation to actually figure out how we were going to reduce it by $2 trillion, couldn’t come to agreement, so our long run fiscal situation is still very unsettled.

Once again we can talk about where these various fiscal policies came from, and once again I think the evidence points very strongly to a central role for economic ideas. So take those first two big fiscal stimulus actions: the tax rebate under President Bush and the Recovery Act under President Obama. Now, in both cases, the president’s leadership was important. So having watched the process up close, I know it takes a lot to shepherd even a pretty popular bill to completion, so I don’t want to sell short the persuasion and the personal leadership that both presidents provided. Likewise, in the case of the Recovery Act the two women centers from Maine, Susan Collins and Olympia Snow, I think both also showed extraordinary personal leadership. They made a very tough decision to support the Recovery Act, despite the opposition from their party’s leadership, because they thought it was the right thing to do.

But I think a far more important source of these actions, were, in fact, the prevailing economic ideas. Again, it may feel hard to believe this now, given how acrimonious the discussion of stimulus has become, but one of the most widely accepted principals of economics is that tax cuts and increases in government spending can help to heal a troubled economy. Indeed, one of the things that the economics team did when we first came to Washington in December of 2008, was to just call a large number of respected macroeconomists of both parties to ask them what we should do, we figured we could use all the help we could get. And what we found is that Republicans and Democrats differed some in the form of stimulus that they recommended, so Republican macroeconomists tended to like tax cuts more and Democratic economists tended to prefer increases in government spending. But, there was incredibly widespread support for aggressive fiscal expansion. Likewise, ideas played a key role in why the rest of the world passed aggressive fiscal stimulus, as well. But, importantly, ideas have also played a huge role in why it’s been stopped. You know here in the United States, if you are listening to any of the discussion, it’s clear that many policymakers have become convinced that fiscal policy, fiscal stimulus, doesn’t work to create jobs. And believe me, I understand the temptation. Right? You say we spent $787 billion and the economy is still weak so obviously the stimulus didn’t work. But, where that reasoning fails is that it doesn’t take into account the fact that the economy was headed into a tailspin when the act was passed, so it could still have been very helpful even if we still have a long way to go before we’re fully recovered. And as I described, a number of careful studies have, in fact, concluded that the stimulus did work.

Now in Europe, ideas have changed even more radically. A key idea that took hold there is the notion that a fiscal contraction can actually be expansionary. Right, that is, that getting the budget deficit down could actually raise output. And the mechanism is supposed to be a confidence effect; that people would be so reassured by the improvement in the deficit that the private sector would take off. And you can see why this idea is very appealing to policymakers. They could deal with both their problems at one time, right, high unemployment, the budget deficit, all we have to do is get the deficit down, both problems will be solved. And it caught on very strongly, particularly in the United Kingdom and in Germany. I think the main problem with the idea is it just doesn’t seem to be right. Now, one study thought they’d found this in the data, but a much more careful study, done by the IMF, actually showed, pretty convincingly, that fiscal contractions were in fact contractionary. And what they did, they used budget documents to identify every time, they went through 15 countries over 30 years, identified every time the countries were actually trying to do a fiscal contraction. And what they found is not surprising to most macroeconomists, that output typically fell and unemployment rose after such fiscal contractions.

Now, actually, back in May of 2010 the administration was actually pretty concerned about this spread of this notion of expansionary fiscal contractions and the move to fiscal austerity in Europe, and we were afraid it could derail the recovery. And so actually, Secretary of the Treasury Geithner and I went to Europe to try to convey the message that maybe countries should, you know, take turns or a more varied approach rather than everybody moving immediately to austerity. Now, as an aside, I will tell you that the flight itself was a bit of an adventure. So we were flying in a military plane with, unfortunately, had one lovely cabin. And though we were both cabinet members, believe me the Secretary of Treasury outranks the Chair of the Council of Economic Advisors because his position was created in 1789 and mine wasn’t created until 1946. And that meant that he got the bed. At one point on this flight, we actually hit terrible turbulence, and I saw Tim’s security detail rush to his cabin. Now being a nervous flier I kind of, when they came out, I stopped them and said what’s wrong, is the plane going down? And they said no, we were afraid the secretary might have fallen out of bed. So, I figured it was justice. When we got to Europe, what we tried to explain was that fiscal austerity might absolutely be necessary for some countries, particularly those with the largest deficit or under attack by financial markets, but that other countries, like the United States and France and Germany, could wait until the recovery was more formally established before they got their budget deficits down. We clearly weren’t very successful because austerity has continued to be the main policy prescription in Europe and frankly, I think it’s not working.

To my mind what’s desperately needed, both in Europe and here in the United States, is a much more comprehensive fiscal policy based, frankly, on better, more accurate ideas. Because fiscal stimulus does help an economy grow in the near term, I think there is a strong case to be made for doing another significant round as the president has suggested. At the same time, I feel strongly we can’t just ignore the deficit. The budgets for the United States, and frankly, for lots of other countries, are on a completely terrible and unsustainable path, and you just have to look from some of the projections coming out of the congressional budget office to know that this is a problem that absolutely has to be solved. But, I think a sensible way to deal with both the fact we have high unemployment now and a terrible budget deficit over the longer term, is to pass a comprehensive plan that has more stimulus now, but also a plan to get the deficit down gradually over time, and we should make that decision right now. What spending are we going to cut? Whose taxes are we going to raise? But then we should phase in the actual contraction only gradually as the economy actually recovers. That way we’ll be able to do what we need to do for the economy today, but will reassure everyone, I think including ourselves, that we’ll be solvent over the long haul.

The key message of my talk this evening is that when it comes to economic policy, I think ideas about how the economy works are just a key determinant of policy actions, and the success of the policy depends on the soundness of the ideas. And that has certainly been true of the policy response to the Great Recession. Monetary policy, housing policy, and fiscal policy actions have all had their roots in the prevailing economic ideas, and the policy responses that have been most successful when the ideas behind them are based on strong empirical evidence and careful economic theory. So what does the key link between ideas and policy tell us about leadership? To my mind, what it suggests is that true leadership is indeed much less about personal dynamism and the ability to motivate others. It’s about the strength of one’s ideas. It’s about where you lead people, not just whether you can get them to follow you. And I think this view of leadership has implications for universities such as Iowa State or Berkeley, where I teach, and that trains so many of our future leaders. I feel we need to instill in our students a passion for ideas and a deep respect for evidence. I think we can do the most to train them to lead by training them to think and to never stop learning. Because I think the ability to critically evaluate ideas and empirical evidence is a skill future leaders need most to acquire. I think this view of leadership also has implications for all of us as voters. Each one of us needs to learn to look past the superficial attributes, such as charm and charisma, and we need to focus on a candidate’s ideas. I think in realm of economic policy, we need to demand that our potential leaders explain their views of how the economy works and ask them to defend the soundness of their ideas. Early on I somehow got pegged as the optimistic member of the economics team, and I still haven’t forgiven The San Francisco Chronicle, who wrote an otherwise very lovely profile, but then put the headline “Obama’s Sunny Economic Forecaster.” Personally, I just think anybody looks cheerful next to Larry Summers. It’s not that I don’t see the difficulties facing our economy, of course I do. Our economic challenges, as I’ve described, are larger than they have probably ever been since our parents, or even our grandparents, were born. But, my optimism comes from a belief that sensible policies can indeed help to solve our economic problems, as long as they’re based on sound ideas and rigorous evidence. More fundamentally, I think my optimism is born, actually, of a very deep respect for American voters, who I think are hungry for a serious discussion of our economic challenges and an honest debate about economic ideas. And for all our sakes, I hope that candidates from both parties will give voters the straight talk and the substantive discussion of economic ideas that they so desperately need and deserve.

Thank you.