Econbrowswer on Romer's recent testimony

Some Reflections on CEA Chair Christina Romer's JEC Testimony

While I agree with the view there is some cause for optimism, especially after the passage of the ARRA, I do believe there are two major risks to the outlook. The first concerns the effectiveness of interventions aimed at restoring the solvency of the banking sector, and spurring the resumption of lending. In light of the increase in the IMF's estimate of financial institution losses ($2.7 trillion vs. January estimate of $2.2 trillion for assets and loans originating in the United States), it is not at all clear that the US government currently has sufficient resources to recapitalize the system, and thereby restart lending.

Dr. Romer's testimony clearly indicates an intellectual understanding of the perils confronting us:

...Japan's experience in the 1990s shows the costs of skimping on bank rescue. Until banks are cleansed of highly uncertain assets and robustly capitalized they will be hesitant to lend, and lending is what we need them to do...

So far, we can't be sure that the appropriate steps to avoid this path will be taken, given the popular resistance to further resource transfers. Certainly, the incipient rebound in financial sector bonuses, and bank management resistance to additional regulation, seems likely to make it harder to build up a constituency for the difficult choices that will likely have to be made in the near future.

As Dr. Romer pointed out, there is a synergistic aspect to the measures undertaken; stimulus without repair of the financial system will, on its own, be insufficient to pull the economy out of recession. Similarly, repair of the financial system will be much more difficult if asset prices continue their decline. On the first point, we have little experience with measuring the effectiveness of fiscal policy in conditions of severe financial distress. The range of estimates that the CBO uses in generating its high-low forecasts pertain to the results obtained over periods when the financial system was operating in a normal or near normal manner. As one can see from the CBO's assessment of the effects of the ARRA, this range of impacts is quite large:

Figure 1 from CBO, Estimated Macroeconomic Impacts of the American Recovery and Reinvestment Act of 2009, March 2, 2009.

In times of financial sector stress, households and firms may opt to rebuild balance sheets instead of increase consumption and investment, thereby short-circuiting the Keynesian multiplier process. A recent IMF analysis suggests that two years after a peak in output, on average output will be 3 percent lower in a recession occurring in conjunction with a financial crisis compared to a recession occurring in the absence of financial crisis. (I will note as an aside that if one believes this effect is operative, then government purchases of goods and services is then a relatively more effective mode of stimulus than tax cuts, unless those tax cuts are directed to highly liquidity constrained households -- see here)

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