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America's Recent Economic Experiences: Lessons for the Futurerecording...
Transcription by Sam Maurer · Introduction and speech. Does not include Q&A. Perfect transcript.

[Frank Westhoff:]

[01:56] Well, it's my pleasure tonight, I'm delighted to introduce Joseph Stiglitz to you. As you obviously know, he's an Amherst alum, the class of 1964 -- I should say, the great class of 1964. Joe has had an absolutely extraordinary academic career. He's served on the faculties at Yale, where I first met him as a graduate student, Stanford, Princeton, All Souls College at Oxford, and presently Joe is a university professor at Columbia. As you no doubt know, a couple of years ago in 2001 Joe was awarded the Nobel Prize for his work in information economics. When an economist thinks of this field, Joe's name immediately comes to mind. He essentially created the field. But this work only represents one facet of Joe's contributions. In my humble view, it is this breadth of achievements that distinguishes Joe from other Nobel laureates. Allow me to quote from the citation he received when presented with the prestigious John Bates Clark Award early in his career. "Dr. Stiglitz is beyond compare for the range and variety of his theoretical achievements. From growth and capital to economics of discrimination, from information to uncertainty, from competitive equilibrium to monopolistic competition, contemporary economics is crisscrossed with his footprints."

[03:31] Joe has not been content with his accomplishments within academia, however. He has also pursued an extremely distinguished career as a public servant. President Clinton appointed Joe to the Council of Economic Advisors in 1993. Two years later, Clinton made Joe the Council's chair. He resigned from the Council in 1997 to accept the position of Senior Vice President and Chief Economist at the World Bank. At the Council, Joe led efforts to reform the telecommunication industry, banking industry, environmental regulation, housing and urban development, and a variety of other important areas. At the World Bank Joe argued against the one-size-fits-all stringent monetary and fiscal policy approach that the Bank has often imposed on nations experiencing financial crises. Instead, Joe urged a more flexible approach accounting for the unique problems and issues faced by each country. Well, I've spoken long enough. You came tonight to hear Joseph Stiglitz, not me. Tonight the title of this talk is "America's Recent Economic Experiences: Lessons for the Future". Please join me in welcoming Joseph Stiglitz. [applause]

***

[Joseph Stiglitz:]

[05:03] Well, thank you very much for that introduction. There is an old Chinese curse that begins, "may you live in interesting times," and the last 4 years for an economist has been very interesting. The economy hasn't performed particularly well, and one of the questions that people are talking about is why things are actually in many ways quite different from what standard economics would have taught. What I'm going to do today is talk first about what are some of the problems, some of the fact, and that will be fairly uncontroversial. I can't imagine anybody disagreeing with anything I'll say in that first part. The second part is more interpretive -- who's to blame, why has it turned out to be the way it is, and I can imagine a couple people disagreeing. But the final part is how I will rewrite my textbook as a result of what has happened in the last 4 years.

***

[06:14] In talking about what has happened to the economy, a good place to begin is to recognize that there's been an enormous gap over the last 4 years between the potential of the economy and its actual performance. The potential represents what could be produced given the labor supply, given the capital, given our technology, what we know about how to produce. If we go back to 2001, a remarkable change that had occurred over the previous decade was, the rate of increase in productivity -- the output per person -- had increased enormously over that decade. In the period of the '50s and '60s, productivity was growing at a rate roughly equal to 3% per year. And that's important, because increases in standard of living roughly are commensurate with increases in productivity. And then beginning around '73 to '93, for the next two decades, productivity increased at a markedly lower pace, at around 1.1%, 1%. And then somehow, and we won't say who is to receive credit for this, but somehow in the '90s -- in fact, beginning around '93, [laughter] when I arrived in Washington and when other other people arrived -- productivity started to increase.

[07:43] Now the good news is that the high rate of productivity increase has been sustained. The general view is that the economy's productivity increase, plus population, means that potentially the economy could grow at between 3 and 4 percent. Some people would think even higher than that. But we haven't grown that fast. And the result of this is that if you look at where we've actually grown and our potential, there's a big gap. And the magnitude of this is huge. If you take the midpoint of that range that I talked about, 3.5%, the cumulative gap over the last 4 years is approximately 1.7 trillion dollars. I don't know how you feel about that, but to me that's a lot of money. It's more than my usual salary. If we had been living up to our potential, that means the economy would have had 1.7 trillion -- I'm going to make sure you understand that's trillion, not billion, that's trillion dollars that we don't have -- and that money could have been used to finance education, health care, even fight additional wars, [laughter] whatever your favorite way of spending money is. It could have been spent and had a lot left over. Even at the much more modest 3% -- and almost everybody thinks that we could have grown faster than 3% -- the amount is close to 1.2 trillion dollars.

[09:25] Underlying this, as I said, is the fact that there has been this enormous increase in productivity, and this increase in productivity represents both a challenge and an opportunity. It's a double-edged sword. If the economy is well managed it means incomes will go up commensurately -- on average incomes go up roughly in tandem with productivity. So if our productivity is increasing at two and a half percent, incomes will be increasing over the long run at roughly two and a half percent. But it also means that you have to run harder to stay still. If you don't grow at the rate that your economy's potential allows you, and your productivity remains strong, it means there will be less demand for work. There will be less demand for labor, and then that will get reflected in increasing unemployment. And that's precisely what has happened. Not only is there increases in unemployment, the slackness in the labor market leads to lower wages and so it means that working people become worse off. And both of these things are exactly what have happened over the last 4 years.

[10:40] This is just a chart to show what has happened to economic growth. You see in the period of '96 to 2000 we were growing at 4% -- substantially higher than the 3.5% that I mentioned -- and then it plummeted down. We've been growing more recently at a somewhat more rapid pace -- still below our potential, but most importantly not enough to catch up with the loss. Typically at this juncture in a business cycle you're growing faster than your overall potential because there's a catch-up period. So you should be growing at 4, 5, 6, 7 percent. We're only growing roughly commensurate with our potential.

[11:25] The result of this situation where we don't have enough growth is that we have a higher unemployment rate and it's particularly high. In many ways people say, it's 5.6%, that's not that particularly high, but it is high compared to the rates that we showed we could achieve in the '90s, 3.8%. There are people who would like to get jobs and haven't. But in fact, one of the things I hope you are taught here is that the unemployment rate is not necessarily a good measure of the labor market, of what's wrong with the labor market. It understates the problem. One of the things is that when you have extended periods in which it's very difficult to get jobs, people become discouraged, they don't enter the labor force. Some of you many know, recent graduates often don't get jobs, and they go on to graduate school. That doesn't show up in the unemployment statistics, but many of those people would have preferred to be working than being bored in graduate school.

[12:38] So that's one aspect. But more serious is that the long-term unemployed have almost doubled. And if you're unemployed long enough, you just stop working. And one of the peculiarities of the way we collect statistics is that if you are so discouraged because you can't find a job that you stop looking, you're not called unemployed. Of course you're unemployed. But our statistics don't treat you as unemployed. So when they say the unemployment rate is 5.6%, they don't include any of these people who have stopped looking for a job.

[13:19] They also don't include people who are disabled. One of the things economists always talk about is, people respond to incentives. And one of the aspects of incentives is, if you're not going to work, you want to maximize your income for not working. This is an important point of advice which you should pay me for. Disability pays you more for not working than unemployment. So if you can qualify, if you can get a doctor to say that you are disabled, as opposed to just unemployed, your income will be higher and you don't have to work any harder. That is to say, you're not working. So you don't have to go down even once a month to show that you're not working. And so it is very common that people, when jobs aren't there, have migraine headaches, backaches, and disability rolls increase.

[14:21] In some countries this has become a really enormous problem. In the Netherlands the fraction of the population that was on disability at one point went up to 20%. And if you know people from the Netherlands, they're not exactly frail -- they're actually very robust. Well, in the United States in the last 4 years, the number of disabled people has increased by almost a million. And in case you didn't know, there has been no disease that has spread across the country secretly pushing people into unemployment. The only disease is a mismanaged economy and that unemployment is higher. Just to put it in perspective, this is about a 15% increase in the number of disabled people. Normal demographic increases would be about 4%. So we have a lot more people who are disabled simply because there are no jobs.

[15:23] The third aspect of this is that there are a lot of people who are working but only part time. And part time not because they choose to work part time, but because there are no full time jobs for them. They too are not called unemployed. So there are about 1.1 million additional workers today who are working part time involuntarily than there were 4 years ago. There's about a 25% increase. It's an enormous increase. Again, a reflection of a labor market that's not working very well. These jobs are particularly of concern because they typically don't have benefits -- they don't have health insurance, they don't have pensions -- and so these workers are working but their working conditions are not necessarily particularly good. The upshot of a lot of this is that in fact, the labor force participation, the fraction of people of working age that are working or say they want to work is actually at the lowest level that it's been in a decade.

[16:40] Now what I tried to explain just now was that there's not been enough growth to provide jobs for the new entrants in the labor force and the result of this is that we have this problem of growing joblessness, of unemployment. But it's also the case that growth is not enough. It used to be said that a rising tide lifts all boats -- this was sometimes called "tickle-down economics". Just focus on growth and eventually everybody benefits. Well, eventually may be a long time. Generally we recognize today that trickle-down economics doesn't work. It didn't work in the '80s, and it's not working today. I showed you before -- I showed you these growth rates -- so that even in these last 3 years we may not have been growing up to our potential, but we've had growth. The question is what's happened to the average family income. Well, the median family income has actually fallen, in real terms, over the last 4 years. The median household income is today $1500 lower than it was 4 years ago. So if you ask the typical family, are you worse off today than you were 4 years ago, the answer is a fairly unambiguous, yes they are worse off. And that even takes into account, if we put in the tax cut, they're even worse off even taking that into account. Part of what is going on is there are soaring health costs, energy costs, and education costs, all of which are hitting families particularly hard.

[18:28] This is just a little bit of an aside, but one of the interesting things is that Americans work harder than those in other countries, so a part of the discrepancy in standards of living -- in incomes -- is explained by the fact that we work so much harder. But in addition, what's been happening is that the number of hours worked has actually been going up and yet the benefits like health insurance and pensions have been going down. And this is just a chart to show that you can do multicolor graphics, [laughter] but the important point out of this is to show that Americans do work longer hours than others.

[19:11] Well, not surprisingly, how do you put together the two facts? The economy is growing, and the average person is getting poorer. We're not having trickle-down economics, we're having trickle-up. And what is really going on is very simple -- there's growing inequality. Those who major in English know that there was the period of Great Gatsby, the "Roaring Twenties", that was marked by a high level -- you get the impression, when you read a novel like that, there was an enormous amount of inequality. And if you look at the statistics, it's reflected in the statistics. The pictures that one gets from those books, from those kinds of novels, are actually accurate. The upper 5% got approximately 30% of the nation's personal income. An enormous amount of inequality. Interestingly, in the decades after the '20s, America became more equal and the fraction of the income held by the upper 5% was approximately halved to 15.9% by 1969. And what is so interesting is that in the last 30 years we've reversed that and we are back to the level of inequality that marked the '20s.

[20:40] And I just put here a few other numbers that sometimes people find of interest. The top 1% of households hold 38% of the wealth of the United States. And Bill Gates, America's richest individual, has more wealth than the bottom 40% of the US population combined, or 120 million people. One of the natural questions that's asked is, well, maybe this is a characteristic of market economies, of capitalism. The answer is no, that's not the case. The United States is an outlier. We have more inequality than other countries. Not surprisingly, given that we have more incomes at the top, that also means that less of the income is at the bottom. So we also have not only more inequality, we also have more poverty. As I mentioned, the trend that I just described began in the '70s, continued through the '80s, was arrested in the '90s, but then in the last 4 years this trend of growing inequality has increased.

[21:52] Not surprisingly, given the high levels of inequality that mark America, it is not surprising that it will be reflected in a variety of ways of social malfunction. One of the other areas in which America is excelling is the number of people in prison. Some people say that actually, if we included this number, our unemployment rate would be even larger. These people are effectively taken out of the labor force and not called unemployed. And it's about 2% of the population. Again it's something where we are a marked outlier. Our prison population per 100,000 is three and a half to ten times that of other countries like Canada, Germany, Japan, and the UK. It's the highest among all the industrialized countries.

***

[22:52] Well, that was trying to paint a broad picture of the macroeconomics. I want to talk about the deficit, some of the problems, and there are four of them that I'm going to talk about -- the jobs deficit, the fiscal deficit, the trade deficit, and what I'll call the balance sheet deficit. The jobs deficit is really the counterpoint to what I talked about before, the not enough growth, and not enough growth being reflected in inadequate job creation. The way I think about the jobs deficit is that every month there are about 150,000 new individuals who enter the labor force, net. That means every year about 1.8 million. Over a period of 4 years we would need normally to create 7 million jobs. There's not a lot of precision in these numbers -- 6, 8 million is number of jobs that one needs for the new entrants in the labor force. How many jobs were created in the last 4 years? Minus 1 million. So the jobs deficit, the difference between the number of jobs that we needed to create and the number of jobs that were created is actually huge. In fact, if you look at the job creation in the private sector it's even worse. There's been a loss of over 1.5 million jobs in the private sector. The only part of the economy in which there's employment growing is the public sector, and it's grown by about half a million.

[24:29] Now, a natural question that one can ask is, isn't this a characteristic of a normal economic fluctuation? Economies have ups and downs and we had a recession. There's always a job loss in a recession. In fact, many people take that as almost the definition of a recession. Well, that's true, but this is the worst recovery from a recession that we've had since World War II. We've had 9 recessions since World War II and the recovery, the job creation has been the worst of any of those 9. In fact, it's the first time in 72 years -- presidents living through wars, through oil price shocks, through all kinds of phenomena -- it's the first time in 72 years that over a span of 4 years there's been net job destruction. There's also some serious questions about the quality of jobs. I'm not going to spend much time on it because there are real difficulties in measuring the quality of jobs, but if you look at simple statistics like a comparison of the industries where jobs are being created and those where they're being destroyed, the jobs that are being created are lower quality jobs. About a third of the jobs in recent months, of the job creation, have been in janitorial jobs, fast food, and temporary workers. Probably not the jobs that most of you aspire to when you graduate.

[26:16] The fiscal deficit has been talked about a lot. I'm not going to say a lot about it, except just to make the observation that it's been the largest turn around in the fiscal position of the United States in a short span of time, going from 2% of GDP surplus to a 5% deficit. I want to spend just a minute talking about, do deficits matter? The short answer to that question is, yes they do. Because particularly if you look at the nature of our deficits, we're financing our deficits basically by borrowing abroad. I'll come back to that because it has to do with our trade deficit as well. A deficit means that we're spending more than our income. You have to finance it somehow. We finance it effectively by borrowing abroad. That means that we are more indebted to those abroad. And that means that we will have to be shipping dollars abroad to service this debt -- to repay the debt, to pay interest on that debt. Right now that interest isn't very high because interest rates are at an all-time low. But one can predict with some degree of confidence that it's unlikely that they will remain at such a low level. So that means that future generations are poorer than they otherwise would have been.

[27:44] Well, that's the short answer. Let me give a little bit of a longer answer. The answer depends to a large extent on how the money is spent. Every firm borrows money. You don't criticize a firm for borrowing money. What you hope, though, is that when they borrow money, they take the money and they invest it. And when you look at a firm, you look at it's balance sheet, its liabilities -- what it's borrowed -- and its assets -- what is has to show for what it's borrowed. The reason I'm so concerned about the deficit is that we have nothing to show for it. We've borrowed an enormous amount of money over the last 4 years. The theory was somehow that it would lead to something that would lead us to be better off. In fact, if you look at investment, investment as a percentage of GDP, especially investment in business-fixed areas, which are related to production, has actually fallen by about 2% of GDP. So in that sense the wealth of the country is diminishing even as our liabilities abroad are increasing.

[28:58] So what happened, where did the money go? We didn't borrow it to invest, what did we do? We basically borrowed to finance a tax cut for upper-income Americans. There were some people who said, well somehow the money would, even if it didn't trickle down to the poor, it would trickle down into investment. But it didn't happen. And the result of that is that our capital stock has not been growing as well as it should. Worse in the long run is that our worsening fiscal position will put constraints on expenditures going forward. In other words -- and I witnessed this very strongly during the Clinton administration -- when you're facing a deficit situation you have to start cutting out everything. And the things that are often easiest to cut out are thing like investments in research, investments in infrastructure, because the consequences of cutting that out aren't apparent for 10, 20 years further down the line. What was the source of the great productivity increase, the boom of the nineties? One of the things was the Internet. Another thing was biotech. Under that was research that was funded by the US government. Some of it was by the European government, but it was government financed research that laid the foundations for all the boom of the '90s. But we won't be able to make those investments. Those are the kinds of things that will be cut out because of the fiscal stringency, because of the deficits that were caused by the huge tax cuts for upper income Americans.

[30:53] There is the further problem, that I note at the bottom of the slide, that deficits will also undermine our ability to meet commitments to future generations, and in that sense it risks abrogating the social compact across generations. The gap in the Social Security, people have talked about it. We could have fully funded our Social Security program for the next 75 years with only a fraction of the total tax cut that was enacted in 2001 and 2003. So instead of doing that we could have put our Social Security program, using just a fraction of that money, on completely firm fiscal basis for the next 75 years.

[31:39] The trade deficit. I spend a lot of my time in developing countries these days, and one of the things the United States does and the IMF does is go around and lecture countries about living within their means. You know, you shouldn't borrow, you should live within your means. Well, here we have a situation of the richest country in the world not being able to live within its means. The richest country in the world is borrowing between one and a half and two billion dollars a day from other countries, which by definition are poorer. In terms of standard economics it's a very anomalous situation. I think it has some very serious potential consequences. It is a potential source of global financial instability. All over the world people are asking, do we have too many of these dollars? We're sending over 500 billion dollars every year, and eventually people are going to say, this is a risky currency. And if they had any doubts, what's happened in the last year with the value of the dollar falling markedly has reinforced those qualms.

[32:56] It could happen that there would be a run on the dollar. Some people say, well if the United States were any other country, the IMF would be here bashing us over the head saying we're a banana republic, irresponsible, and telling everybody to take their money out of the country as fast as possible. Now we're not like any other country. We can get away with this for a very long time. But some people think that we can get away with it forever, and I think increasingly most economists think that's wrong. We've had runs on the American dollar. In the early '70s there was a run on the American dollar that led us to abandon the fixed exchange rate system. That's when we went into a flexible exchange rate system. And it could happen again.

[33:49] The final problem is -- you know, economics is always referred to as the "dismal science" and we always talk about doom and gloom, but actually usually I'm an optimist. But I have gotten over the last 4 years much more into the doom and gloom business. And I think that there are reasons that this is one of the cases where one should be concerned. Well, the fourth problem is this household indebtedness. It's not a surprise. Interest rates came down -- I'll talk a little bit later about why, but with the low interest rates people started to borrow. The interesting thing is that standard textbooks, at least in the past, used to talk about lowering interest rates leading to more investment. That's not what happened. Very little additional investment. If you remember, two slides ago I talked about how in fact, investment as a share of GDP has actually gone down. So if there's been a response it's not been a very strong response.

[34:55] What actually happened was it did help stimulate the economy but it did it by encouraging people to borrow more and have a consumption binge. And so they are more in debt, they refinanced their mortgages, and so going forward their balance sheet position is worse. The debt-household income ratio is at an all-time record of around 40%, and not surprisingly bankruptcies are up. They're up about 30%. Not everybody's going bankrupt, it's still a small percentage, but it's a significant increase in the the bankruptcy. One of the reasons I'm concerned about this is that it is likely, or certainly may dampen the economic recovery. Because a typical pattern of an economic recovery involves interest rates rising, and that's particularly true given the amount that the US government has been borrowing for the deficit. Well as interest rates rise, households will have less cash. Less cash to spend on other things. Moreover, typically when interest rates rise the value of housing prices, real estate falls, and so their balance sheet can get in a precarious position. Their liabilities relative to their assets may go down -- or will go down.

[36:25] Well, I spent most of my time looking at the overall macroeconomic picture. I want to spend just a moment talking about a couple of the sectoral problems. The first is energy. Everybody knows about the high oil prices, oil prices setting records, and these high oil prices are likely to dampen the economic recovery further. The exact magnitude is of some dispute, but almost everybody agrees that it is one of the factors that will slow down the economy -- the global economy and the American economy.

[37:00] The other sector I want to talk about is health. Again it's a dramatic change over 4 years. The average family health insurance premiums have increased 64%. That's an enormous number in a span of 4 years. Not surprisingly with that level of premium increase, a lot of people have decided not to get insurance. An additional 4 to 5 million people are not insured today, total the number is 45 million. And why that's of concern is that people who don't have health insurance typically don't get as good medical care. Often they get it, but in the emergency room of hospitals after they let the problems get worse, and so in fact health status goes down for those who don't have health insurance. It is one of the reasons why America is in this anomalous position of while we spend more on health care than any other country, our healthcare performance -- our health performance -- is not particularly impressive. Depending on the statistics that you look at, we're 22nd, 26th, in life expectancy. And some other statistics say that in some cities in the United States infant mortality rates compare with those of less developed countries. It is really an abysmal picture.

[38:34] The problems that I've talked about are related. I already mentioned that the higher energy costs are likely to put a damper on the economy. The high health insurance premiums are almost surely one of the factors contributing to the reluctance of firms to hire, particularly to hire people full-time, one of the reasons why there's been such an increase in part-time employment.

***

[38:58] Well, as I've said, I don't think anybody can disagree with what I've said so far. It may not be the way they would want to paint the picture, but this is the picture. I mean these are just the facts. There may be other facts, but we'll talk about them. One question, are we about to turn a corner? I think we're not, but these are the facts. What I thought was going to be the controversial part of the talk is this next section where I talk about who's to blame. And you may be able to forecast where I'm going on this. [laughter] But I want to hold you off for just a minute. And there are two issues in talking about who's to blame.

[39:52] The first is the question of what we call counter-factual history. Of asking the question, what would have happened if. We don't have two worlds out here, one where in the year 2001 we had done something different and one where we did what we did. If we had that kind of controlled experiment, which you do in some of the other -- I wouldn't say real sciences, but in some of the other sciences. If you had those controlled experiments we would be able to say with a greater deal of confidence that, aha, it was because we did this wrong thing that the economy is in such bad shape today. But we have a lot of economic theory and a lot of economic experience with lots of countries, so we don't enter into this without any knowledge. What we wind up doing is thought experiments. We can go through and ask, what were the likely consequences of this, this, or this policy. And that is the basis on which one can try to make an inference and answer the question of who's to blame.

[41:11] It's important to recognize in framing the issue of the counterfactual, a lot of the political debate is oriented to trying to frame that issue in the wrong way. And I say "wrong" -- in a way that is irrelevant. For instance -- I'll come in a minute to looking in more detail at these issues -- but for instance one of the things that you hear over and over again is the statement, the tax cut helped stimulate the economy and were it not for the tax cut the economy would be weaker. That's probably true, but that's totally uninteresting. Now why do I say that? Because in 2001 everybody agreed that the economy was going into a downturn. Everybody agreed that we needed a stimulus. Most people agreed that it should take the form of a tax cut. The debate was not over whether there should be a tax cut -- it was the design of the stimulus package, the mix of policies that would stimulate the economy. And the question is, was there an alternative set of policies that would have been more effective in stimulating the economy?

[42:35] Now the second issue is the problem of 20/20 hindsight. It's often easier to see things after the fact and say oh, we should have done this. But that's also not fair. You have to be able to make, say, what they should have done given the information they had or that they should have had doing a reasonable amount of due diligence. So in order to make this a fair comparison I will look at two policies that were on the table in the Spring of 2001 -- the one we actually did, and the one I had proposed [laughter] and actually published in the Washington Post. And the bottom line of where I'm going is, we would be so much better off [laughter] if only. Now, the claims that you will hear from some people is that the economy was weak in 2000 because of the bursting of the dot com bubble. The problem was compounded by 9/11 and then the Iraq war and without tax cuts the economy would have been even weaker. Each of these statements is true, but they are, as I say, largely irrelevant.

[43:48] The critique is that every president inherits a mixed bag. Clinton for instance inherited a large deficit, growing inequality, and a weak economy. The economy turned around, poverty was reduced, and the tax increases and expenditure cuts turned the deficit into a large surplus. Now the difference in some sense is that the current administration entered with a very important asset. It had a 2% surplus. It could have used that surplus to stimulate the economy. It knew the economy was weak. In fact, it even talked the economy down to help get the tax cut through. The real problem was that it was a failed stimulus. The tax cut was not designed to stimulate the economy and did not provide much stimulus. In fact, most of the provisions of the tax cut, the ideas behind it, were put together well before the economy looked weak. They just then used the weakness of the economy as a basis for trying to sell it.

[45:02] Some parts of the tax proposal, like the elimination of the inheritance tax, actually provided negative stimulus, actually depressed the economy. That's a standard exercise which I'm sure some of you will have in some homework problem in one of your courses. Much of the stimulus that was there was provided by congressional amendments but were not in the original tax proposal -- like aid to the states and localities in 2003. The result of the fact that it was a not well designed tax cut is that it provided relatively little bang for the buck. Bang for the buck means how much stimulus do you get for each dollar you spend. One way of thinking about it is to go back to the observation I made a little bit earlier that we went from a 2% surplus to a 5% deficit. That's a 7% of GDP turnaround. Normally with a 7% of GDP turnaround the economy should be going gangbusters. We should be worried about inflation. But instead we've had this very anemic recovery.

[46:14] I think the example which provides the simplest illustration of this is the dividend tax cut. There were three arguments behind the dividend tax cut, or three parts of the analysis. One was that we had double taxation, that income that comes into a corporation is taxed at the corporate level and then taxed a second time when it gets distributed at the individual level. So double taxation -- nobody likes double taxation. The fact that you get taxed on your income and then you get taxed on a sales tax, that's double taxation -- people forget that we actually have systems that have double taxation over them. But for rich people to be taxed twice, double taxation, that's viewed to be an anathema. So that was one, double taxation. The second one was that we needed to stimulate investment, and that the way we could do that is if we reduce the tax on dividends, eliminate it, it would stimulate the price of shares and the higher price of shares would lead to more investment.

[47:23] Well, those sets of hypotheses, there were problems with each of those. The first is if you thought a minute about what caused the economic downturn in the first place, to a large extent it was caused by over-investment in the '90s. And we knew that as a result of that it was going to be very difficult to stimulate investment. One of the standard statistics that people throw out is that 97% of the fiber optics that were laid saw no light. Now, we know what happened when the Fed lowered interest rates down to a record level. It didn't stimulate investment, for an obvious reason. If you're a firm and you're sitting on this excess capacity of fiber optics -- 97% is not being used -- and somebody says to you, you can borrow at a 2% less interest rate, are you going to run to the store and say, OK I'll buy some more excess capacity to make zero return? No, you're not. And they didn't. So lowering interest rates did not stimulate investment. Why do you think then -- why did they think -- that raising stock prices, if it did that, by 5% is going to lead the same firms to run down and say, let's build some more excess capacity cause our share price is up? Of course they didn't.

[48:49] The second point was, it wasn't likely that share price would go up very much. Because this whole issue of double taxation was to a large extent a red herring. Most Americans have most of their wealth in forms that are not double-taxed. Most Americans have their wealth in pension funds and IRAs. There's no double taxation. It's only a small minority of people. And therefore the expected impact on prices was relatively small, relatively hard to detect. This issue of double taxation, as I said, was really a red herring, and one of the reasons that one suspects that is if that were really what was going on, there are ways of eliminating the double taxation that maintain progressivity. In fact those are the ways that are used in Europe. We have some in other parts of our tax code called S Corporation where you basically attribute income and taxes back to the household sector. So you could have eliminated double taxation and maintained progressivity.

[49:55] But the agenda here was not a worry about double taxation, it was to reduce progressivity. In fact, during the discussion some people raised the question, the problem is in the United States isn't double taxation, the problem is some firms aren't paying taxes at all. And so in response to that they put in a provision that said you can only get the tax deduction from corporations if the corporation pays the tax. But then, in a way that often happens, as the bill was going through Congress at the last minute they struck out that provision. So you get that tax deduction on your dividend whether or not the corporation has paid any tax. So in fact this whole thing about double taxation was just a smokescreen to reduce the degree of progressivity.

[50:50] As I said, there were alternatives, and I'll only mention one, that would have provided far more bang for the buck. It would have begun with strengthening unemployment insurance. The United States has one of the worst unemployment systems of any of the advanced industrial countries. That means when you lose your job your income goes way, way down. The replacement rate is under 30%. That is to say, the unemployment insurance only covers about 30% of your normal income.

[51:23] If you give an unemployed person more income, they almost surely will spend it. The marginal propensity to consume is very high. It's not true of upper income individuals. In fact we should have known this about upper income individuals because we raised the taxes on upper income individuals in 1993. Did they have any depressing effect on the economy? Not that anybody can detect. In fact, it was the beginning of the boom. Why did one think that by lowering the taxes on them it would lead to a boom? No reason. So the point here is you want to focus your tax cuts on people who are likely to spend it, on people who have high marginal propensities to consume. Strengthening unemployment insurance would have done that.

[52:13] One of the real attractions of strengthening unemployment insurance is that it's an automatic stabilizer. There was some concern, some debate about how deep the economic downturn was going to be. At that time I was more concerned that it was going to be deeper. Some of the people in the administration did not think that it was going to be very deep. But the advantage of unemployment insurance is, you don't have to answer that question. If the recession is deep the money gets shoveled out. If the recession is not very deep you don't spend any money. It's very different from a tax cut. So that's why we call these automatic stabilizers.

[53:00] A second automatic stabilizer that I talked about was aid to states and localities. It is almost inevitable when the economy goes down, the revenues of states and localities go down. It hadn't happened yet in 2001 but we could see it happening very clearly. And the problem is that most states and localities have what they call balanced budget frameworks. If their revenues go down they have to either cut back expenditures or raise taxes, and that acts as a big depressant on the economy. Again what I said was very simple. Let's fill in the gap. Let's maintain their revenues. If their revenues don't go down then we won't have to spend any money, but it's again an automatic stabilizer. In fact, my forecast turned out to be exactly correct. Revenues went way down and it was a major depressant on the economy. And social services in many states were reduced. One of the reasons why tuition has gone up so much in so many states is because their budget was hit so badly.

[54:05] The third thing is rather than having tax cuts targeted to the upper 1% I argued for tax cuts for lower and middle income Americans. And finally, rather than across the board tax cuts, dividend tax cuts, things like that, I said let's target the corporate tax cuts, the taxes to the corporate sector, to those who will actually spend the money. Target it to where it will stimulate the economy, i.e. only get the tax cut if you will invest. And that's what's called investment tax credit. We've had that in the past and it has worked.

[54:41] So I would argue that this alternative, this counter-factual, would have provided a lot more bang for the buck. It would have stimulated the economy. Our economy today would be much stronger than it is and our deficit would be much lower than it is. One of the implications of the badly designed tax cut is that because it wasn't stimulating the economy very much it forced the burden on monetary policy. Typically that's not too bad because we say one of the advantages of lowering interest rates is it stimulates investment, and that increases the strength of the economy going forward. But that was totally inappropriate for this economic downturn because lowering interest rates would not very likely stimulate investment very much, particularly in the productive sectors, in the corporate sector. And it was anticipatable that it would not -- it didn't. It did help stimulate the economy, but only because households got more in debt, refinanced their mortgages, and consumption went up, but leaving this legacy of higher indebtedness.

[55:56] There's one other aspect that I want to mention just very briefly, and that is that while the deficit has partly to do with the weak economy, the tax cuts, and military expenditures, there's another fundamental problem and that is the abandoning the PAYGO framework, the framework where you pay for expenditures as you incur them. This was the framework that was used throughout the '90s and provided the fiscal discipline that restored fiscal sanity to the United States after 12 years in which the deficit had gone from close to zero to 5, 6%. The PAYGO framework actually worked. It was actually adopted in 1990, but we abandoned it in the last 4 years.

[56:44] What is so striking to me was that the same people who were responsible for a lot of the fiscal profligacy were the same people who tried in '94 and '95 to get a balanced budget amendment passed to the Constitution. Now what we said in '94 and '95 was, that was a mistake. Economies have fluctuations, they have ups and downs. We may have another recession, particularly if an incompetent government got elected. [laughter] But even with complete competency the economy has fluctuations and it may be desirable to have a deficit. And it was a very hard fought battle. What is so striking is that the very people that argued for having their hands tied now argue that deficits don't matter. They say deficits don't matter. I guess it's called cognitive dissonance or something like that [laughter] but it is truly astounding.

[57:53] What's also the case is that this profligacy is not just for education, not for things that we all value. There's been a very large increase in old-fashioned corporate welfare. For instance, farm subsidies have doubled -- in contravening our agreement with the WTO and all the developing countries -- and that's one of the reasons that the Cancun talks failed at the WTO. The understanding was that they were going to cut the farm subsidies. Sometimes I joke that one of the problems is that they make a lot of sign errors. Instead of maximizing the bang for the buck they minimized the bang for the buck, instead of cutting the farm subsidies they increased it, just a few sign mistakes [laughter] and that's what you have happen.

[58:53] Well anyway, those of you who follow the legislation that's going through Congress may have been astounded at some of the things that were put in the Senate bill where to correct a problem in tax structure which is an illegal subsidy for exporters. To compensate them for 4 billion dollars we have passed a -- I think it's about 130 billion dollar subsidy bill. The numbers aren't quite comparable because they're different time periods, but the basic thing is everybody wants to help manufacturing so they decided that Haliburton was a manufacturing firm. They decided under this bill to give a big subsidy to tobacco farmers, to buy them out. They decided those corporations abroad who have been avoiding all taxes by keeping their money abroad can now bring the money back facing a tax rate of just over 5%. So it's like rewarding people for not paying taxes.

[1:00:11] What I hope I've done so far is to explain the problems. The gap between the potential and actual GDP and the job deficit are largely explained by the poorly designed stimulus. The fiscal deficit is explained by the tax cut that did not provide much stimulus and the elimination of fiscal discipline by not paying any attention to the PAYGO principle. The trade deficit -- I haven't said much about that, but this is called the twin deficit problem. It is often the case that when the fiscal deficit soars, so does the trade deficit. It happened in the early '80s. And if I have more time I can try to explain why that is. And the growing household indebtedness was a result of the fact that the failed fiscal policy pushed the burden of stimulation onto monetary policy.

[1:01:03] I'll spend just a minute on the two other sectoral issues. Health -- there are two huge problems, soaring cost and lack of coverage, and the current policies may contribute to both. For instance, one of the policies that was adopted in the prescription drug program forbids bargaining over drug policies. Well, if the government is a big buyer and says to the monopolist, the seller, the guy who has the drugs, we're not allowed to bargain with you, what do you think is going to happen to drug prices? Probably going to go up. Already drug prices are higher in the United States than most other countries where they do bargain. It was a most peculiar way to deal with problems of soaring costs.

[1:01:54] The second problem is one that I'll spend just a minute on, cause it's an interesting problem from my perspective, it deals with the problem of asymmetric information which is related to my work on economics and information. One of the aspects of the American healthcare system is that a relatively small percentage -- 1 out of 250 -- have very high costs. Very high, over $50,000. Now, if you're an insurance company and you're in the job of maximizing your profits, you have two ways of doing that. You have to control your costs. One of them is somebody comes to you and says, I need quadruple bypass surgery, and you say no, we're trying to control costs, you can only have a triple bypass surgery. We're only authorizing three valves replaced now. Well, that doesn't make you very popular, and in fact you probably can't do that. So it's very hard -- if the doctor says you need quadruple bypass surgery, you're probably going to get it. Most people don't voluntarily say, the marginal cost of an extra valve is zero, I'll buy more of those. [laughter] It's just not part of the psychology.

[0:03:20] So what is the main way that you have of controlling costs? Well, it's to get rid of these guys that are expensive. But they're like hot potatoes. If you get rid of them, if you have them on your roles, they don't disappear. When you get rid of them it's not like their heart recovers. They still have a bad heart. So they either go to another insurance company, they pay themselves, or more likely they can't get insurance, they go to the hospital, they get some kind of health care anyway, and the public pays for it in one way or another. So the bottom line that I'm trying to emphasize is that the insurance companies spend a lot of time and energy engaged in a process called clean skimming or cherry picking to try to get the best mix of people. That's why you want to be in an occupation like academia where people don't work very much and therefore have very little strain and they live long times and they don't have all these health costs. And insurance premiums are relatively low compared to people who actually work. [laughter] And so the insurance companies are always trying to sell insurance policies to these healthy groups as opposed to the unhealthy groups.

[1:04:44] Well, if that's the nature of the problem and you were sitting there, one of the problems is soaring costs and you think, how can I make this problem worse, you say don't allow the government to bargain. Well they sat and thought and thought, how can I make the problem of asymmetric information worse? Well, make it easier for the healthy people to get out of the insurance pool. Cause if they don't buy insurance, what's going to happen to the insurance premium? You're only going to have the really sick people in the insurance premium and health insurance costs are going to go up, coverage is going to go down, you're going to make the problem worse. I could give you this as a homework problem. How do you make the problem worse? Well, you create what are called HSA, health security accounts, and you say, if you're wealthy enough to be in a high tax bracket you can take a tax deduction if you put money aside to self-insure. But who's going to self-insure? It's easy to self-insure if you're young like you and you don't expect to have a problem. But if you expect to have a problem you're not going to self-insure.

[1:06:01] So this is called a self-selection mechanism. It exacerbates the discrimination and leaves the pool of people left over as the sicker group leading to higher health insurance. There is an alternative way where if you focus on the problem you can say, how can we make it better? Rather than saying these a little less than one half of one percent of the population, if we can get them out of the insurance pool. They're a social risk. They didn't deliberately decide to have a weak heart. It's bad enough that they have the misfortune of having a weak heart. Let's take that as a social responsibility of society. Take them out of the insurance pool. Now you decrease the problem of asymmetric information. And that is an alternative proposal.

[1:06:56] Let me talk about the oil price. Again you can see a failure to diagnose the nature of the problem and therefore the nature of the solution. In a way, the current problem is mainly a concern about supply and eruption, and inadequacy of supply for keeping up with demand. You can begin by talking about oil prices and supply and demand and that balance, and supply has not been keeping up. Why? Because the Middle East has become more unstable. Nobody wants to go invest in the Middle East given the degree of instability. There are problems in other parts of the world, but that is at the core of the problem.

[1:07:45] Now, we knew even before Iraq about the instability in the Middle East. There was an alternative approach. Rather than trying to subsidize corporations to drill more, you could have focused on the demand side. Let's reduce our demand, our consumption of oil. And let's try to increase the supply of alternatives, of substitutes. Everybody talks about it, but actually this administration has cut expenditures for research in alternatives. And what's ironic is that there was a completely wrong diagnosis of the problem of market failures, of where you should intervene. The problem was excess demand. Why? Because there was an externality. When you consume energy there is pollution created -- greenhouse gases, other forms of pollution. And that's a real social cost. And yet people when they buy electricity don't pay that social cost. The result of that is there's excess consumption.

[1:00:04] So you needed to correct that market failure. There's no significant market failure on the supply. The market failure's on the demand, and that's what you should have done. But ironically they talked about using voluntary measures on the demand side but corporate subsidies on the supply side. The policy which they tried to put forward actually raised even further questions. I don't know if you remember, but they argued early on -- it would not have solved the problem today but I just wanted to talk about it -- they argued early on for drilling in Alaska and increasing production. The basic fact is the United States has a small fraction of the world's oil supplies. And yet we consume a very large fraction. We consume over 25% of all the oil produced in the world. That means we cannot be self-reliant.

[1:10:07] What does it mean, then if we are to drill more of our oil? Unless we really develop alternative energies, unless we conserve more, we will inevitably become more dependent on others. As our oil wells dry up, as they already are, we become more vulnerable. So the policy which I call "drain America first" actually makes the US over the long term less secure. It makes us more vulnerable to supply interruptions.

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[1:10:43] Let me very quickly try to talk about some lessons for future textbooks. I'll go through this very quickly. The first is that poorly designed deficits may not provide much stimulus. When the economy faces worries about deficits it's important to maximize the bang for the buck. The second is that deficits can grow quickly when fiscal discipline is dropped. The third is that lower interest rates may not lead to more productivity-enhancing investments, but rather to more consumption. The fourth is that bubbles can have a strong adverse affect after they break and distort resources before. And one question that economists are debating all over the world is has relying on low interest rates led to a real estate bubble. It may be too early to tell, but the policy is resulting in a high level of risk.

[1:11:31] And that is one framework that I think is important through which to look at policy going forward -- one has to look not only at how you solve problems today, but what implications do they have for the risks of the future. So yes, you might have gotten a little extra consumption today from what we otherwise had by having this policy of letting American households get more into debt, but it's risky. It means that our recovery in the future is likely to be frailer, more fragile than it otherwise would have been. Draining America now may give us a little more oil now and make us less vulnerable today, but over the long run it makes us more vulnerable. Again, it's a risky strategy.

[1:12:18] At the microeconomic level, the big lesson I think is trying to achieve a balance between markets and the government, and recognizing that there are many instances where markets are not efficient, where they fail. And trying to direct policy to try to resolve those market failures. The health insurance market is one area where markets do not typically work well. Another area is energy demand where there are these large externalities associated with pollution.

[1:12:53] In my discussion in the first part I talked about the glaring inequality in the United States. I did not, however, in the second part blame the current administration for that. Typically the inequality today is a function of policies in the past. Policies today will affect the degree of inequality and poverty in the future. If you cut out funding for things like Project Headstart, it will have an effect in the future. But we won't know about it for 10, 15, 20 years. But while the government today can't do a great deal about the underlying inequality today, it has to or ought to take into account the consequences of this high level of inequality. The bottom line out of that is given that inequality has been growing so markedly over the last 30 years and including over the last 4 years, it was exactly the wrong time to have a tax cut aimed at the top. One could not have designed a more inappropriate policy if you are worried about these kinds of social problems.

[1:14:20] Well, here are the last three lessons. Tax cuts for the rich are not the solution to every economic problem. [laughter] Nor are subsidies for corporations the best solution to every ailment. And finally, this has implications in a wide variety of areas, when a policy fails, we think why it might be failing rather than trying more of the same. [laughter]

Thank you.

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[Questions and Answers]