United States Senate Republican Policy Committee on February 2, 2009

Testimony of Douglas Holtz-Eakin

“The Economic Outlook and its Implications for Policy”

United States Senate Republican Policy Committee

February 2, 2009

Mr. Chairman and members of the Committee, I thank you for the privilege of appearing today to discuss the important issues facing our economy and the Senate.  I would like to make the following main points:

• The difficulties facing the U.S. economy stem from three different forces: (1) a dramatic and financial crisis, (2) a severe recession, and (3) a dramatic need to build household wealth.

• Near term fiscal policy should be tailored to reflect the need to support the weak real economy in light of both the likely budgetary demands from the financial crisis and the need to move expeditiously to addressing the dire outlook for the federal budget.  A premium should be placed on avoiding new, permanent spending programs. 

• The recent sharp rise in federal debt – and the likely further increase due to fiscal policies under consideration – is far from costless. This rise:

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  • Reduces federal budgetary flexibility in the future,

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  • Imposes lower standards of living on future workers and hinders U.S. competitiveness, and

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  • Will likely prove an impediment to fundamental reforms of the tax code and entitlement spending programs.

• Any necessary sharp, near-term rise in federal debt should be paired with an explicit strategy to address the underlying forces driving up federal spending, thereby stabilizing and reducing the debt outstanding.

• Congress should be cognizant that the recent pattern of fiscal policy responses to economic conditions raises the risk of a return to systematic  attempts at fiscal fine-tuning of business cycles.  The lessons of the 1960s and 1970s are that such a strategy is self-defeating and engenders sub-par economic performance.

The Economic Situation

The U.S. economy is suffering the effects of three inter-related phenomena.  The first is a dramatic financial crisis that has threatened the viability of flagship financial market institutions, dramatically shrunk the value of equity investments and has left households, students, businesses and sub-federal government constrained in their ability to borrow.  Historical banking crises around the globe suggest that restoring the liquidity, solvency, and functioning of financial markets will likely take considerable time and enormous resources – perhaps as much as 15 to 20 percent of Gross Domestic Product (GDP).

These financial pressures are a substantial downward pressure on the real economy, which is in the midst of a recession that appears comparable in depth to those experienced in the mid-1970s and early 1980s.  Final demand fell at a roughly 5 percent pace in the fourth quarter of 2008, and most forecasts do not anticipate a return to growth until the latter half of 2009.  One would anticipate the labor market recovery will lag growth in GDP, with unemployment likely to rise into 2010.

The recovery will take place in the aftermath of an era that saw a rough tripling of the household debt-to-income ratio since 2000, and is facing sharp declines in housing and equity wealth.  As a result of the need to build household wealth, the recovery will likely be characterized by relatively slow growth in consumption.

In sum, the United States faces tremendous economic challenges that will persist for several years. 

Policy Issues

The dramatic weakness in overall demand suggests that a substantial fiscal stimulus and serve to soften the recession and accelerate recovery.  Even more important, steps continue to be required to stabilize financial markets in the United States.  My view is that that latter is likely to require substantial additional taxpayer resources.

In typical circumstances, a financially-troubled firm enters bankruptcy.  Equity investors lose the value of their investments, assets are sold to satisfy other creditors to the greatest extent possible, and the re-organized firm exits bankruptcy.  In the process, the valuation of assets is established by their sale during bankruptcy and the firm begins operations with uncertainty over their balance sheet valuations fully resolved.

U.S. attempts to address troubled financial institutions should follow this template to the greatest extent possible.  In particular, there is great merit to the discipline of bankruptcy (or bankruptcy-like operations) and the use of private market sales to establish valuations.  In the case of “troubled assets”, it may be the case that sales occur at bargain-basement prices, but this simply rewards the risk-taking of new investors who purchase the assets. 

Unfortunately, the overall losses in the financial sector are likely to vastly exceed the value of common equity, and the collateral, macroeconomic damage of inflicting the residual losses on other creditors is sufficiently great to merit federal intervention to absorb losses.  While the exact timing, scale and operational rules of such an intervention remains the subject of important deliberation, I believe it is sensible for the Congress to anticipate the need for additional resources, perhaps exceeding $1 trillion dollars, to address financial distress.

For this reason, it is imperative that the federal budgetary response to financial distress and fiscal stimulus be developed in the context of a strategy of budget process and policy changes to address the fundamental, long-run spending growth that feeds explosive debt. 

In principle, stimulus represents a one-time increase in the debt as taxes are cut and/or spending is increased temporarily.  In the current context, discussions center around a stimulus effort that would raise the debt-to-GDP ratio by about 10 percentage points.  If stimulus works well – again, in principle – GDP would rise more (or fall less) than otherwise, muting the increase in the debt-to-GDP burden.  Finally, when the temporary stimulus is withdrawn, further rises in debt abate. 

What are the budgetary consequences of this exercise?  Assuming that the basic growth rate of the economy is roughly 2.5 percent, a one-time rise in the debt-to-GDP ratio of 10 percent can be offset over five years of average growth. Put differently, one price of the stimulus exercise is that fundamental changes to the level of spending and taxes (unless paired) have to be put on hold for five years.  Adding in a comparable response to the financial crisis shows that the policy response will frame Congressional deliberations for the next decade.

Clearly, in addition to a large financial and borrowing cost, stimulus carries with it potentially large costs in terms of restrictions on future policies.  In light of this, it seems sensible to evaluate stimulus in these terms – in addition to the obvious need to help an economy that is clearly struggling and workers who are facing tough times and have lost jobs.

A first principle, then, is that the stimulus effort should avoid new policies that creating new spending programs.  From a debt perspective, these types of programs would exacerbate the underlying spending growth that is feeding unsustainable debt projections.  From a political-economy perspective, bringing to a stimulus exercise new programs about which there is little consensus likely would (and should) prolong debate and slow implementation. 

Finally, from an economic growth perspective, to the extent that there are productivity-enhancing investments that will provide economic returns in excess of their financing costs, then these are the types of activities that the federal government should undertake regardless of current economic conditions.  The empirical regularity that the large majority of these kinds of federal spending proposals do not make the grade outside of times of economic duress casts doubt on their claim to pro-growth status.  Moreover, it would make sense to find budgetary resources for these investments by reducing spending elsewhere.  To make the point starkly: if infrastructure investments will help the economy, in general, and the blue-collar, middle class, in particular, why should these not be financed by reductions in the entitlement benefits of the affluent?

A corollary to avoiding permanent new spending is that spending increases should be concentrated in fortifying the “automatic stabilizers.”  Programs like unemployment insurance benefits, food stamps (Supplemental Nutrition Assistance Program) and so forth automatically increase in scale during economic duress as more Americans qualify for benefits.  These kinds of programs offer two advantages.  First, they expand upon need, are tuned to the economic conditions on the ground, and minimize the traditional risk of arriving too late to be effective. Second, they automatically shrink as conditions improve – guaranteeing their temporary nature.  Neither of these advantages are present with new spending programs, even seemingly-modest “down payments” on future programs.

A second principle is that the focus should be on tax reductions.  Moreover, because temporary tax reductions are largely saved, any tax relief should be as long-term as possible, reduce taxes on pro-growth activities, and eliminate uncertainty about the future of tax policy.  To the extent that these tax changes are steps toward a fundamental reform, the additional debt would implicitly finance these transition costs as well.  For example, the U.S. code continues to impose a double tax on dividend income, the corporation income tax rate places U.S. firms at a competitive disadvantage, and the year-to-year uncertainty of the research and experimentation tax credit undermines its economic intent.  Each could be rectified in the near-term as steps toward a more integrated and efficient tax code.  Similarly, the payroll tax is widely recognized as imposing a burden on workers and interferes with labor market incentives at a time when getting people to work is a priority.  Reducing the payroll tax would raise issues regarding the structure and finance of retirement programs, but these issues must be resolved in any event.

A third principle is that the effort should provide clear signals to financial markets.  This should occur in three ways.  First, the programs should be transparent and document the economic impacts.  I favor the notion that earmarks should be banned from such legislation, and that the legislation itself should be available electronically for public scrutiny for a substantial period prior to vote.  The market could easily assess, then, the economic character of the policies. 

Second, markets should be able to assess what is being gained for such a significant commitment of federal funds, and its economic impact.  One should be able to display the path of the economy without stimulus, the path with stimulus, and the benefits of stimulus.  It has the ingredients needed to assess the net benefits.

Thirdly, I believe that it is important that the effort convey to markets a clear path to stabilizing and reducing the debt burden.  It would be useful if any stimulus legislation itself contained provisions that ensured a reduction in future debt as the economy improved.

A final consideration in the development of both stimulus and financial stabilization is the role of the housing market.  The housing bubble, the explosion of sub-prime mortgages, and the subsequent collapse of housing construction, housing values, and mortgage lending are at the center of this crisis.  One in six – 10 million – families are stuck with mortgage debt larger than the value of their house; millions more can’t make payments.  The result is vicious cycle of defaults, foreclosures, lower housing values, cash-strapped families, and ruined neighborhoods.  The policy tried thus far – “Hope Now” and “Hope for Homeowners” – have proven inadequate.  In the past, monetary policy has been the sole response to the damage from tech and other bubbles.  In the current situation, I believe a fiscal response is also needed.

What’s the solution?  As with financial institutions, I don’t believe we can let the standard foreclosure-bankruptcy process work unimpeded without further substantial macroeconomic fallout. Thus, I favor using the financial “bailout bill” resources to help homeowners refinance their homes so that the mortgages match the new housing values and the payments match their budgets.

This would serve as both stimulus and financial rescue.  With a manageable mortgage, families can spend on their other needs – that’s great stimulus.  With the threat of default eliminated, complex securities can be valued.  Banks can tidy up their balance sheets and get back to lending.  Putting the bailout money on the table will give everyone an incentive to jumpstart fixing these mortgages.

This approach is not perfect.  First, it is very expensive.  Second, even with sensible rules for eligibility of participation, some of the people who will get help were foolhardy, not victims.  Some bad lenders will not bear the full brunt of their actions.  But the broad economic benefits outweigh these costs.

This approach to the housing market is targeted on cleaning up the fallout of falling household valuations, using market forces – private sector underwriting and mortgage origination – and taxpayer subsidies to offset excessive losses.  It does not envision the federal government replacing private sector lenders.  There is no reason for the federal government to determine mortgage interest rates in the economy.  And I do not believe that the program should extend beyond current homeowners facing financial distress.

The Exit Strategy

As noted above, I believe that it is important for Congress to enact along with financial sector relief and fiscal stimulus, a clear signal to financial markets as to how spending will be reined in, debt burdens reduced, long-run fiscal balance achieved, and pro-growth conditions ensured.

However, I also believe that this is an important moment to clarify the role of fiscal policy and government intervention in the economy.  In the 1960s and 1970s, the notion of “fiscal fine-tuning” reached ascendancy.  It was believed that, along with activist monetary policies, discretionary changes in taxes and spending could be used to keep the economy at “full employment” and eliminate recessions.  In practice this effort failed. The end result was large government intervention in the economy, chronically-high inflation, and low-productivity growth.  Beginning with the 1980s, this approach fell into disrepute.

My concern is that the United States may be slipping back toward this failed policy regime.  Little concern is expressed over the potential for inflation.  Inflation is not a great concern over the next year, but the threat has not disappeared forever.  And Congress has enacted discretionary fiscal changes in 2001, 2002, 2003 in response to the 2001 recession, and is now undertaking is second round of stimulus in response to this downturn.   While I understand and concur with the need for action, I remain concerned that repeated, short-run efforts will undermine the long-run growth objectives that have served the United States so well.

Thank you for the opportunity to appear today.  I look forward to your questions.