U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

57–277 PDF 2010

PERSPECTIVES ON THE U.S. ECONOMY 

HEARING 

BEFORE THE

COMMITTEE ON THE BUDGET 

HOUSE OF REPRESENTATIVES 

ONE HUNDRED ELEVENTH CONGRESS 

SECOND SESSION 

HEARING HELD IN WASHINGTON, DC, JULY 1, 2010 

Serial No. 111–28 

Printed for the use of the Committee on the Budget 

( 

Available on the Internet: 

http://www.gpoaccess.gov/congress/house/budget/index.html 
(II) 

COMMITTEE ON THE BUDGET 

JOHN M. SPRATT, JR., South Carolina, Chairman 

ALLYSON Y. SCHWARTZ, Pennsylvania 

MARCY KAPTUR, Ohio 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL BLUMENAUER, Oregon 

MARION BERRY, Arkansas 

ALLEN BOYD, Florida 

JAMES P. MCGOVERN, Massachusetts 

NIKI TSONGAS, Massachusetts 

BOB ETHERIDGE, North Carolina 

BETTY MCCOLLUM, Minnesota 

JOHN A. YARMUTH, Kentucky 

ROBERT E. ANDREWS, New Jersey 

ROSA L. DELAURO, Connecticut, 

CHET EDWARDS, Texas 

ROBERT C. ‘‘BOBBY’’ SCOTT, Virginia 

JAMES R. LANGEVIN, Rhode Island 

RICK LARSEN, Washington 

TIMOTHY H. BISHOP, New York 

GWEN MOORE, Wisconsin 

GERALD E. CONNOLLY, Virginia 

KURT SCHRADER, Oregon 

DENNIS MOORE, Kansas 

PAUL RYAN, Wisconsin, 

Ranking Minority Member 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

MARIO DIAZ–BALART, Florida 

MICHAEL K. SIMPSON, Idaho 

PATRICK T. MCHENRY, North Carolina 

CONNIE MACK, Florida 

JOHN CAMPBELL, California 

JIM JORDAN, Ohio 

DEVIN NUNES, California 

ROBERT B. ADERHOLT, Alabama 

CYNTHIA M. LUMMIS, Wyoming 

STEVE AUSTRIA, Ohio 

GREGG HARPER, Mississippi 

CHARLES K. DJOU, Hawaii 

PROFESSIONAL STAFF

THOMAS S. KAHN, Staff Director and Chief Counsel 

AUSTIN SMYTHE, Minority Staff Director 
(III) 

C O N T E N T S 

Page 

Hearing held in Washington, DC, July 1, 2010 .................................................... 1 

Hon. John M. Spratt, Jr., Chairman, Committee on the Budget ................. 1 

Prepared statement of ............................................................................... 3 

Hon. Paul Ryan, Ranking Minority Member, Committee on the Budget .... 4 

Martin Neil Baily, senior fellow, Bernard L. Schwartz chair, the Brookings Institution .............................................................................................. 5 

Prepared statement of ............................................................................... 8 

Response to questions submitted ............................................................. 67 

Mark Zandi, Ph.D., chief economist, Moody’s Analytics ................................ 19 

Prepared statement of ............................................................................... 24 

Response to question submitted ............................................................... 69 

John B. Taylor, Mary and Robert Raymond professor of economics; 

George P. Shultz senior fellow in economics, Hoover Institution, Stanford University .............................................................................................. 43 

Prepared statement of ............................................................................... 46 

Response to question submitted ............................................................... 68 

Hon. Robert B. Aderholt, a Representative in Congress from the State 

of Alabama, questions submitted and their responses .............................. 67 

(1) 

PERSPECTIVES ON THE U.S. ECONOMY 

THURSDAY, JULY 1, 2010 

HOUSE OF REPRESENTATIVES, 

COMMITTEE ON THE BUDGET, 

Washington, DC. 

The committee met, pursuant to call, at 1:17 p.m. in room 210, 

Cannon House Office Building, Hon. John Spratt [chairman of the 

committee] presiding. 

Present: Representatives Spratt, Schwartz, Kaptur, Becerra, 

Doggett, Etheridge, Scott, Connolly, Schrader, Moore, Ryan, Hensarling, Campbell, Lummis, and Djou. 

Chairman SPRATT. We meet today to discuss the economic recovery and the challenges that lie ahead of us. We are joined by three 

eminent economists to help us take stock of this situation. 

When this Congress, the 111th, took office along with the Obama 

administration in January of 2009, the economy was shrinking at 

a 5.4 percent negative rate of growth. A year and a half later, the 

economy is in its third straight quarter of economic growth, growing at 5.6 percent in the fourth quarter of 2009 and 2.7 percent the 

first quarter of 2010. 

A year and a half ago, the economy was losing jobs massively. 

In January of 2009, we lost 779,000 jobs in one month alone. Now, 

after a year and a half of concentrated fiscal initiatives, employers 

added nearly one million jobs between January and May of this 

year. 

As Chairman Bernanke recently told us in his testimony before 

this committee, the Federal Reserve, quote, anticipates that realgrowth domestic product will grow in the neighborhood of 3.5 percent over the course of 2010, at a somewhat faster pace, we hope, 

the next year. 

Nevertheless, the economy seldom recovers in a straight linear 

fashion. In May, the economy added 431,000 jobs on the strength 

of new Census hires, but forecasters anticipate that tomorrow’s job 

report will show that while we may have added as many as 

100,000 new private-sector jobs in June, a solid accomplishment, 

total nonfarm payrolls may still have fallen due to the end of many 

of these temporary Census jobs. 

The strength of our economy clearly lies in the private sector, but 

the action taken by this Congress and this administration we think 

have played a significant role. For example, it is the judgment of 

the Congressional Budget Office that the Recovery Act passed in 

February of 2009 has contributed significantly to the economic 

turnaround, raising GDP by 1.7 to 4.2 percentage points in the 
2 

fourth quarter of 2010, increasing employment by 1.2 million and 

2.8 million jobs overall. 

Meanwhile, the Treasury Department, the Federal Reserve, and 

the FDIC have been engaged in unprecedented efforts to stabilize 

banks and the financial system by injecting liquidity, capital, and 

by securing people’s savings and requiring banks to raise still more 

capital. 

In response to my question last month at the hearing on whether 

the TARP and the Recovery Act had been necessary to rescue the 

financial system and the economy, Chairman Bernanke replied, 

quote, Certainly we have averted what I think would have been, 

absent those interventions, an extraordinarily severe downturn, 

perhaps as great as the Great Depression. 

That from a person who is not known for exaggerated statements. 

The recession and the necessary recovery efforts have taken a 

toll on the budget in the short run. We, as Democrats, have been 

focused on the economic recovery. We have also pursued and 

sought fiscal responsibility for the long term. We want to see the 

economy and the budget recover step by step, hand in hand. 

Testifying before the President’s Fiscal Commission yesterday, 

the Director of CBO, Doug Elmendorf, observed that, once again, 

there is no contradiction between providing additional fiscal stimulus today while the unemployment rate is high and many factories and offices unutilized, imposing fiscal restraint several years 

from now when output and employment will probably be close to 

the peak of potential. 

Earlier this year, we passed statutory PAYGO, requiring that 

new mandatory spending or revenue reduction be paid for. In addition, the President established a bipartisan commission now at 

work to make recommendations to bring down the deficit to a sustainable level by 2015. And, finally, we may be close to an agreement on an enforcement level for 2011 appropriation bills. These 

fiscally responsible policies have been undertaken by this administration and this Congress to good effect. 

At this time, however, our key concern is, over the short run, 

what is the economic outlook? What can we expect in the months 

ahead of us? And what is the appropriate fiscal response at this 

particular point in time? 

We have with us today three eminent economists that will help 

us sort through the progress the economy has made and look to the 

future. 

First is Dr. Martin Baily, Senior Fellow at the Brookings Institution and former Chairman of the CEA under President Clinton. 

Second is Mark Zandi, co-founder of Moody’s Analytics and 

former adviser to Senator McCain as well as a number of Democrats. 

And, finally, we have Dr. John Taylor of Stanford University and 

the Hoover Institution, a former Under Secretary Treasurer for 

International Affairs under President Bush. 

We look forward to your testimony. We appreciate your being 

here. But before giving the floor to you, I want to turn to the ranking member for any statement he may care to make. Mr. Ryan. 

[The statement of Mr. Spratt follows:] 
3 

PREPARED STATEMENT OF HON. JOHN M. SPRATT, JR., CHAIRMAN, COMMITTEE ON

THE BUDGET

We meet today to discuss the progress of the economic recovery and the challenges that still lie ahead of us and we are joined by three eminent economists who 

will help us take stock. 

When the 111th Congress began and the current administration took office, the 

economy was shrinking at a 5.4 percent annualized rate. One year and a half later, 

the economy is experiencing its third straight quarter of economic growth, including 

5.6 percent growth in the fourth quarter of 2009 and 2.7 percent growth in the first 

quarter of 2010. 

A year and a half ago, the economy was hemorrhaging jobs. In January of 2009, 

we lost 779,000 jobs in one month alone. Now, after one and a half years of concentrated economic and fiscal initiatives, employers added nearly a million jobs between January and May of this year. And Chairman Ben Bernanke told us last 

month in his testimony that the Federal Reserve ‘‘anticipates that real gross domestic product will grow in the neighborhood of 31⁄2 percent over the course of 2010 as 

a whole and at a somewhat faster pace next year.’’ 

As Americans and policymakers have come to know all too well, the economy seldom recovers in a straight, linear fashion, but instead tends to zigzag. In May, the 

economy added 431,000 jobs on the strength of new Census hires. However, forecasters anticipate that tomorrow’s jobs report will show that while we may have 

added as many as 100,000 new, private sector jobs in June—which would be a solid 

accomplishment—total nonfarm payrolls may still have fallen due to the conclusion 

of many of these temporary Census jobs. 

The ultimate strength of our economy clearly lies in the private sector, but the 

actions taken by this Congress and by the Administration have also played a significant role. For example, it is the judgment of the non-partisan CBO that the Recovery Act, which we passed in February of 2009, has contributed significantly to the 

economic turnaround, raising real GDP by 1.7 to 4.2 percentage points in the fourth 

quarter of 2010, and increasing employment by between 1.2 million and 2.8 million 

jobs overall. Meanwhile, the Treasury Department, the Federal Reserve, and the 

FDIC have engaged in unprecedented and coordinated efforts to stabilize banks and 

the financial system by injecting liquidity, capital, securing people’s savings, and requiring banks to raise still more capital. In response to my question last month at 

our hearing on whether TARP and the Recovery Act had been necessary to rescue 

the financial system and the economy, Chairman Bernanke replied ‘‘Certainly we 

have averted what I think would have been, absent those interventions, an extraordinarily severe downturn, perhaps a great depression.’’ 

The recession and the necessary recovery efforts have taken an unavoidable toll 

on the budget in the short run. While we as Democrats have been focused on the 

economic recovery, we have also pursued fiscal responsibility. We want to see the 

economy and the budget recover step by step. Testifying before the President’s Fiscal Commission yesterday, CBO Director Doug Elmendorf observed that ‘‘There is 

no intrinsic contradiction between providing additional fiscal stimulus today, while 

the unemployment rate is high and many factories and offices are underused, and 

imposing fiscal restraint several years from now, when output and employment will 

probably be close to their potential.’’ 

Earlier this year we passed statutory PAYGO, requiring that new mandatory 

spending on revenue reductions be paid for. In addition, the President has established a bipartisan commission now at work to make recommendations to bring the 

deficit down to a sustainable level by 2015. [[And, finally, we may be close to reaching agreement on a House budget plan.]] These fiscally responsible policies are in 

direct contrast to the actions of the previous administration, which inherited a $5.6 

trillion surplus over 10 years and systematically turned it into large deficits, handing the current administration trillions of dollars of deficits for years to come. 

We will continue to pursue steps towards fiscal responsibility so that over the medium and long term we put the Nation on a path that will provide a foundation for 

a strong economy in the future. At the same time, the key concern in the short term 

remains the economic outlook. We have with us today, three eminent economists, 

who will help us sort out the progress the economy has made. First off is Dr. Martin 

Baily, a senior fellow at the Brookings Institution and former Chairman of the 

Council of Economic Advisers under President Clinton. Speaking second will be Dr. 

Mark Zandi, Chief Economist and Co-Founder of Moody’s Analytics and a former advisor to Senator McCain as well as Democrats. And finally, we have Dr. John Taylor 

of Stanford University and the Hoover Institution, a former Undersecretary of 

Treasury for International Affairs under President Bush. We look forward to hear-
4 

ing your testimony on economic developments and whether you agree with the Federal Reserve Chairman’s take on the economy or whether you see things differently. 

Before we hear from our witnesses, let me also turn to the ranking member, Mr. 

Ryan, for any statement he may care to make for an opening purpose. 

Mr. RYAN. Thank you, Mr. Chairman; and thank you to our three 

distinguished witnesses for being here with us today. I know some 

of you had to travel a great distance, and we are really grateful for 

your attendance. 

We convene this hearing under renewed concern about the health 

of our economy. Experts tell us that we are technically in the process of an economic recovery, but for too many Americans it feels 

more like an economic malaise. Private-sector job growth has been 

lackluster. The unemployment rate is hovering at a 25-year high; 

and fear and anxiety are, once again, gripping our financial markets. 

Most policymakers here in Congress are asking the right questions, namely, how do we spark sustained growth and job creation? 

But too many are searching for answers in the discredited economic 

playbook of borrow-and-spend Keynesian policies. We have seen 

this movie before, and we know how it ends. Ask the Europeans. 

You can’t take money from the private productive sector of our 

economy, funnel it through Washington, and expect to create 

wealth and sustained economic growth. Centralizing power in 

Washington, expanding government’s reach into all sectors of our 

economy and more and more aspects of our lives does not create 

jobs. 

Unfortunately, I believe our policy differences center more on ideology, not on economics. If a debate were purely about economics, 

the administration wouldn’t be doubling down on the renewed debtfinanced government spending spree. If it was about economics or 

even pragmatism, we wouldn’t be planning to hit the economy, 

struggling to recover from a deep recession, with a slew of new tax 

hikes. We wouldn’t be shackling our job-producing businesses with 

more regulations. But that is exactly what the administration and 

the majority in the Congress are doing. 

Americans want their representatives to do what works. They 

want common sense pragmatism, not blind progressivism. 

I reject the false premise that only forceful and sustained government intervention in the economy can secure this country’s renewed prosperity. Adherence to this premise has given us a damaging policy mixture. It has sparked a government spending spree 

and borrowing binge with no end in sight. It has led to a centralization of power in health care, energy, financial services, the 

auto industry, and more, tightening Washington’s grip on key sectors of our economy. It has fostered continued policy uncertainty 

about tomorrow, which stifles investment today. It has caused new 

barriers to growth that has rationalized the need for more tax 

hikes in the future. 

This Congress has failed to even produce a budget, and it has refused to consider the tough choices that deal with our massive debt 

burden, a debt burden growing exponentially larger with each kick 

of the can further down the road. 

Workers, taxpayers, and families across this country have been 

Guinea pigs in this neo-Keynesian experiment long enough. The results are in. Washington’s economic experiment has failed. 
5 

Let’s try something different. Let’s try something that works. Instead of erecting new hurdles for entrepreneurs, let’s reduce the 

government-imposed barriers to grow, produce, create, and innovate. Let’s instill a sense of certainty and confidence for investment 

in job creation. Let’s reform our anti-competitive Tax Code, restore 

the promise of our bankrupt entitlement programs, and work to lift 

our crippling debt burden. 

We need to chart a new fiscal and economic course, reforming 

government and putting in place a plan for growth, a plan for prosperity. 

I hope today’s hearing can help inform policymakers as to why 

the economy remains sluggish, jobs remain elusive, and the forecast remains bleak. I believe we can, and must, do better than this. 

I appreciate your participation in today’s hearing, and I look forward to your testimony. 

Chairman SPRATT. Gentlemen, we have framed the issues for a 

lively hearing, and we look forward to your testimony. 

Before turning to you, a couple of housekeeping details. I ask 

unanimous consent that all members be allowed to submit an opening statement for the record at this point. 

Hearing no objection, so ordered. 

We recognize you for such time as you need to take. Your statements previously filed have been made part of the record, so you 

can summarize as you see fit. Let’s start with Dr. Baily. 

STATEMENT OF MARTIN BAILY, PH.D., SENIOR FELLOW, 

BROOKINGS INSTITUTION; MARK ZANDI, PH.D., CHIEF ECONOMIST, MOODY’S ANALYTICS; AND JOHN TAYLOR, PH.D., 

SENIOR FELLOW, HOOVER INSTITUTION 

STATEMENT OF MARTIN BAILY 

Mr. BAILY. Thank you, Chairman Spratt, Ranking Member Ryan, 

and members of the committee. It is a great privilege to testify. 

I am very pleased to be part of this very distinguished panel. I 

know Mark very well and John, and I am sure we will have some 

lively disagreements, but I have a lot of respect for their views. 

I didn’t come a long distance here, although, as I noted in my 

testimony, since the Recovery Act is digging up every street in 

Washington, it sometimes feels like a long distance just to get from 

Dupont Circle. 

There were many contributors to this crisis. I think there are 

folks, and John may be one of them, that sort of focus on a particular cause in this crisis, that it was the Federal Reserve interest 

rate policy. My friend Peter Wallison believes it was Fannie and 

Freddie and the GSEs that caused the problem. 

But, in my judgment, this really was, to use the cliche, a perfect 

storm. We had market failures on Wall Street, and even some of 

the Main Street banks did things that were very foolish in retrospect. I think there were policy failures, a lack of regulatory watchfulness, and also policy choices that were a mistake. So it is a variety of things that went wrong, and this really has been one of the 

nastiest recessions in history and certainly since the Great Depression. 
6 

I think it is important to stress this multiplicity of causes. Because when an economy goes into this kind of recession and we 

have this kind of financial crisis, we know it takes a long time to 

get out. That is the historical record. And Ken Rogoff and his coauthor have documented that very carefully. You cannot turn 

around an economy that quickly and easily. 

I think that there should be a lot of credit given to the measures 

that were taken to overcome this crisis. It started, obviously, under 

Secretary Paulson and President Bush. Secretary Paulson asked 

for the TARP and was eventually given that, and that was a resource that was absolutely essential to turn around the financial 

sector. We really were on the verge of a huge meltdown. 

I think there were some missteps taken on the way to getting the 

financial sector back, but eventually that was sorted out working 

with Secretary Geithner and Ben Bernanke. And the Wall Street 

banks are now, if not healthy, looking much stronger. I think the 

immediate crisis, the likelihood that those institutions are going to 

fail, has been alleviated. 

We have also had a lot of, as I said, smaller banks, and the FDIC 

has played a really important role. That has been expensive, too. 

That cost is going to be borne by the banks themselves in terms 

of higher fees, but for the society it has been a very expensive business to restore the financial sector. It has taken a long time. We 

are still not all the way there. There are still a lot of banks on the 

watchlist, between 700 and 800 banks still on the FDIC watchlist. 

So we have a ways to go on the financial sector, and that is restricting lending, and that is one of the factors that is slowing the 

recovery a little bit. But we could not have done this without the 

aggressive actions of the policymakers, including those of you here 

in Congress that somewhat reluctantly approved this. And the electorate doesn’t like it, I know that, but I think it was to your credit 

that it was done. 

I think the fiscal stimulus played an important role, too. I am actually not one of those who think we should use fiscal policy all the 

time to try to stabilize the economy. In normal times, I think the 

Fed does a good job of keeping the economy on track, and that is 

what we should do. 

There are, of course, the automatic stabilizers are very important. I mean, they are very important. So that when we go into a 

downturn, tax revenues fall and things like unemployment insurance rise, and they help stabilize this economy. But given the situation we were in, which I liken in my testimony to being in a foxhole with the shells crashing around us, we really needed additional help; and the fiscal stimulus provided that. 

Now, one can argue about this. I don’t think it is rocket science 

that if an economy is suffering because aggregate demand is weak, 

consumers aren’t spending, the housing market is collapsing, businesses aren’t investing, you need to find some way to keep demand 

going, to keep jobs, to keep people employed. In a full employment 

economy, it is a different story. And I would point out that when 

I was chairman of the Council of Economic Advisers, we had a balanced budget in both of the years that I was chair. 

So I am a believer in balanced budgets, and I am a believer in 

keeping Federal spending under control, but, in this situation, this 
7 

was the medicine we needed, and I think it was delivered, and it 

does seem to have worked. 

Let’s look at a comparison of where we were in the spring of 

2009. 

It was just so dangerous. GDP was falling. We were losing 

700,000 jobs a month. The financial sector was on the verge of collapse. Now, even by late 2009, the whole economic situation looks 

so much better. We have economic growth. We are beginning to get 

job growth. It is much too slow and much too hesitant, but it is beginning to happen. So it is just really a night-and-day comparison. 

Again, not to say everything is great. Everything is not great. 

Not to say we won’t have stumbles along the way. As Alan Greenspan I think said yesterday, in a normal recovery—and this is 

maybe not quite a normal recovery—you are going to get periods 

of slower growth. You are going to get hesitations. And when you 

get something like the aftershock in Europe, that is particularly 

true. So it is not a surprise that we are getting some weakness 

now. 

You know, the month before, the numbers look good. The last 

month, the numbers have looked not so good. That is the way it 

is going to go during the course of a normal recovery. 

I think Mark is going to talk—and he is one of the best modelers 

around—of what his model shows about the effect of stimulus. But 

I think one probably needs to go even beyond those models. When 

you get really a crisis situation, then the TARP and the stimulus 

spending become much more important. 

Now, what about going forward, to which Chairman Spratt referred? What do we need to do going forward? 

I guess my own view is sort of hold the course steady. I am still 

optimistic that we will get something like 3 percent to 4 percent 

growth this year. I don’t think that is a certainty, but I am hopeful 

that we will get that. 

What has happened in Europe has given us problems here. It is 

one of the main reasons the stock market has been weak just lately, and there is this sort of effect. It affects our trade, but it also 

affects confidence and business confidence. Quite large corporations 

are heavily involved in Europe, so some of their profits, some of 

their investment is derived from those markets. So, inevitably, that 

is having an effect on the U.S. 

Now, in the G-20 meeting, the President, President Obama, said 

to the Europeans purportedly that they need to keep their stimulus 

going. And they said, no, they weren’t going to do that. Was that 

right or not? I think they are sort of damned if they do and damned 

if they don’t, if you excuse my language. It was a situation where 

their own economies really would call for more stimulus, that they 

need that, because they are not growing rapidly. Even Germany, 

let’s say, which is in good budget position and their exports are 

growing, but even its overall economy is not growing. Certainly the 

others are not. 

So from that point of view, it would be a good idea to keep the 

stimulus going. But given the crisis they have on their financing 

and with the Euro, I think they probably are making a wise decision to not try to put in additional stimulus. 
8 

Now, what I hope they don’t do is try to contract or do fiscal consolidation too quickly. They do need to do fiscal consolidation, just 

as we do here in the United States, but I think they should do it 

slowly and not shoot themselves in the foot. If they push themselves back into another deep recession, it will affect not only us, 

but it will give them bigger deficits. Because, of course, declining 

tax revenues during a recession are a big reason why we have had 

deficits and why they have had deficits. 

In terms of the U.S., we are in a somewhat similar situation. We 

really have to weigh off those two forces: Can we afford to borrow 

any more or can we afford not to, so to speak, in order to keep the 

economic stimulus going? And I think those things are quite evenly 

balanced at this point. Again, I would probably like to see some additional stimulus, except for the fact that we have this constraint. 

As Larry Summers said back in the Clinton administration, one 

of the advantages of running a budget surplus is that you reload 

the fiscal canon. That means you can use fiscal policy without 

being concerned that you are borrowing too much or going to drive 

up interest rates or create a financial crisis. We are not in that situation now. Because we have had deficits for so many years, we 

are now somewhat vulnerable. I don’t think we are Greece, because 

the U.S. is a much bigger and much stronger economy and our interest rates right now are very low, but we don’t want to push the 

envelope there. 

So I have supported the extension of unemployment insurance. 

I think that is a good thing to do. And I think some additional help 

to the States is called for, but I would not institute, in my judgment, another major fiscal stimulus because of the borrowing constraints. If we end up, towards the end of this year, going back into 

a second dip recession, then I would reevaluate that depending on 

where financial markets stood. 

Thank you for the opportunity. 

[The prepared statement of Martin Baily follows:] 

PREPARED STATEMENT OF MARTIN NEIL BAILY, SENIOR FELLOW, BERNARD L. 

SCHWARTZ CHAIR, THE BROOKINGS INSTITUTION

Chairman Pratt, Ranking Member Ryan and members of the Committee, it is a 

privilege to testify to this committee on the economy. 

KEY POINTS IN THIS TESTIMONY

There were early signs of financial crisis even in 2006 and early 2007, and then 

financial markets seized up in the summer of 2007. Initially, the decline in GDP 

and jobs was mild, but the economy fell like a stone in the last quarter of 2008 and 

the first quarter of 2009. The situation in the spring of 2009 was extremely dire 

with the risk of continuing deep declines and collapse of the financial sector. 

There were many contributors to this crisis, market failures, regulatory failures 

and policy failures. Regardless, given the severity of the recession and the financial 

turmoil and the global reach of both elements, no policies could have restored full 

employment quickly or healed the problems in the financial sector rapidly. Financial 

crises and the ensuing recessions result in prolonged losses. 

The Treasury and the Federal Reserve were slow to react to the financial crisis, 

but once its enormity became clear they moved aggressively to fight it. Secretary 

Geithner was part of the team at the Federal Reserve dealing with the crisis from 

the outset and he provided continuity as the Obama team took over. The TARP was 

essential to restoring the financial sector and the FDIC played a vital role in resolving small and medium-sized banks. The stress tests in the spring of 2009 were a 

turning point in financial recovery in large part because the Treasury was able to 

promise bank capital if the private sector could not provide it. 
9 

The fiscal stimulus had to be deployed quickly and the money had to reach households and businesses as soon as possible. The states were facing large budget deficits that would trigger sharp cutbacks unless federal funds could provide emergency 

relief. The stimulus package was messy, but it did what it was supposed to do as 

evidenced by the recovery of growth in the fall of 2009. 

The fact that GDP growth was solid by the end of 2009 and that employment 

started to grow in 2010 is a miracle, given how bad the situation became. 

Despite the gains achieved, the jobs picture remains extremely bleak and the 

problems in Europe could result in a double dip recession here at home. Our ability 

to respond is weakened by the fact that there were federal budget deficits every year 

from 2002 on, and because the deficit ballooned in this crisis. 

The European crisis has forced some countries to curtail their stimulus packages 

and move towards fiscal consolidation. With the backing of the IMF, they are making a virtue of necessity and arguing that fiscal discipline will encourage growth 

even in the short run. I agree they should start down a well-marked path to lower 

deficits, but they should avoid acting too quickly. An aborted economic recovery will 

result in even worse budget deficits. 

The US situation is somewhat similar in that we also need to weigh the need for 

stronger demand growth against the limits on Treasury borrowing. The US economy 

is less constrained and markets are not flashing warnings about Treasury borrowing, given that interest rates are at historic lows. That could change, however, 

and we do not want to get too close to the edge of the cliff. If the economic recovery 

peters out, I would support a further fiscal stimulus, but only if accompanied by a 

clear and credible path towards lower deficits in the out years. 

Where We Were There were signs in 2006 and early 2007 that financial markets, 

particularly housing and mortgage-backed securities markets, were troubled. With 

the benefit of hindsight, we can see that the decline in median home prices that 

started in 2006, the collapse of 25 subprime lenders in early 2007 and the collapse 

of two Bear Stearns hedge funds in July 2007 were early-warning signs of much 

worse trouble to come. The financial crisis hit front and center in August of 2007 

when wholesale lending markets seized up, making it difficult or impossible for 

some financial institutions to roll over their short term borrowing. Chart 1 shows 

the ‘‘Ted Spread’’ the difference between the LIBOR interest rate and the 3-month 

Treasury bill interest rate, an indication of the willingness of financial institutions 

to lend to each other. It spiked up in 2007 as the crisis hit and then went through 

the roof in 2008 in the turmoil following the collapse of Lehman. 

The financial crisis worsened through 2008 and into 2009 as both large and small 

banks failed or were propped up. Wall Street was reeling but so were a lot of regional and local institutions. Many FDIC insured banks have failed and the number 

of banks currently considered to be problem banks reached 775 by the end of the 

first quarter 2010. These banks collectively hold $431 billion of assets, so the difficulties facing the banking sector are not over yet. 
10 

At first, it seemed as if the financial crisis would cause only modest collateral 

damage to the Main Street economy of jobs and production. Real GDP grew at 3.6 

percent in the third quarter of 2007 and 2.1 percent in the fourth quarter. Even 

the first half of 2008 was not too bad with a small decline in GDP in the first quarter and a modest increase in the second. By the second half of 2008, however, the 

economy went into freefall, particularly in the fourth quarter when GDP declined 

by 5.4 percent, followed by a 6.4 percent annual rate of decline in the first quarter 

of 2009. Chart 2 shows this pattern. 

Employment in this recession has been horrendous. Payroll employment started 

to decline by the end of 2007 and the freefall of GDP that occurred in the second 

half of 2008 was matched and then some in the labor market with monthly employment declines of around 700,000. As Chart 3 shows, the loss of employment in this 

recession dwarfs anything in prior recessions in the postwar period. The business 
11 

community became very scared by the speed and depth of the recession and moved 

very aggressively to cut costs in whatever ways they could find. Nonfarm payroll 

employment declined by 8.4 million jobs between December 2007 and December 

2010. 

The stock market directly affects households through their wealth holdings and 

affects the pension retirement accounts held by individuals and by companies. In 

addition, the stock market acts as a sign of confidence for everyone. If the stock 

market is plunging, families become reluctant to spend even if they do not have a 

significant stake in the market themselves. Chart 4 shows the movement of the 

S&P 500 index over the period 2001 to early 2010. After rising into the 1,500 to 

1,600 range in 2007 it plunged over the next several months, dropping below 700 

before recovering partially. Families that were counting on a comfortable retirement 

realized they lacked the necessary resources and would either have to keep working 

or adjust to a much reduced lifestyle. 
12 

1Total payroll employment received a temporary boost from Census hiring that will not persist. 2 Based on a standard ‘‘Okun’s Law’’ calculation that each percentage point decline in unemployment is associated with 2 percentage points of GDP relative to its trend or potential. 3 Calculation made by Ezra Greenberg of McKinsey & Company. 

4 Calculations by the McKinsey Global Institute based on Federal Reserve Data. 

WHERE WE ARE NOW

The good news is as follows: 

• After its frightening freefall in late 2008 and early 2009, the economy slowed 

its rate of decline in the second quarter of 2009 and resumed growth in the third 

quarter, averaging a solid 3.6 percent through the first quarter of 2010. A mainstream forecaster suggests growth of 3-4 percent for the next year or two. This is 

a remarkable turnaround with the pattern also shown in Chart 2. • The labor market has stabilized, with unemployment having peaked at 10.1 percent in October 2009 and now declining slowly to 9.7 percent in May. Payroll employment is rising, at a rate of about 200,000 a month for total payroll 1 and about 

100,000 for private nonfarm employment for 2010 through May. • The stock market has partially recovered from its swoon and is up substantially 

since March of 2009. Arguably, the high that it reached at its peak was above its 

sustainable level and it is now at an appropriate level in relation to earnings. I do 

not try to forecast stock price movements, but if the economy continues to recover, 

there is upside potential in the market. • According to the S&P Case-Shiller home price index for April, the large drop 

in home prices has ameliorated with the index up modestly over the prior year. 

The bad news is also evident: 

• The unemployment rate is close to 10 percent while full employment is thought 

to be around 5 percent. This means that American output and incomes are about 

10 percent below their potential.2

• If employment growth continues at the rate of 200,000 a month it will take 

around seven years to get back to full employment.3

• Household wealth, including financial assets and housing wealth, is $11.7 trillion below its peak as of the end of 2009 and this decline has erased all of the 

wealth gains accumulated since the early 1990s.4

• The federal budget deficit was over $1.4 trillion in 2009 and is forecast to be 

over a trillion dollars a year through 2019 unless there are major policy changes. • Growth at 3-4 percent is below the usual level achieved in an economic recovery 

from a deep recession and there is a danger of a second dip recession. 

Without in any way discounting the economic challenge that remains, I will make 

the case in this testimony that the big policy measures taken to turn the economy 
13 

around have worked extraordinarily well, indeed much better than could have been 

expected. Around the Ides of March of 2009 the economic situation was truly frightening. Workers had been laid off at a rate of 700,000 a month for several months, 

GDP was plummeting, the housing market was collapsing, and the stock market 

was hitting lows not seen for 15 years. At that time, I would have reacted with disbelief to anyone who had predicted that by the fall of 2009 there would be solid economic growth; that the stock market would have rebounded; and that employment 

would start growing by 2010. The natural resilience of the American economy has, 

of course, helped this ongoing recovery, but it would not have been possible without 

the massive policy interventions undertaken by Congress and two Administrations. 

There were plenty of mistakes made in the period leading up to the crisis, some of 

them very serious. And mistakes were made in dealing with the crisis, some of them 

also serious. But the simple fact is that in the end the treatment worked and the 

economy is recovering. 

I read op-eds and hear commentary to the effect: Hey, it has been 18 months since 

Obama took office, so how come the economy has not recovered? He should quit 

blaming Bush for his problems. Such statements make no sense in terms of economic logic and represent political posturing. There were many causes of this crisis 

and plenty of blame to go around. Yes, the policies of the Bush Administration bear 

responsibility because they were based on the belief that financial markets did not 

need to be regulated. Federal housing policies pushed by both political parties, but 

especially by Democrats, contributed to the problem by encouraging over borrowing 

and too much home building. But, regardless of the causes of the crisis, this was 

a terrible global meltdown and recession and could not possibly have been reversed 

quickly. Former McCain advisor and Harvard economist Kenneth Rogoff has shown 

in his empirical studies with Carmen Reinhardt that economies always take a long 

time to recover from financial crises. Aftershocks of the global crisis, like the sovereign debt crisis in Europe, have slowed the pace of U.S. recovery and could threaten a double dip despite the progress to date. There are limits to the power of policymakers to affect economic outcomes. The policies that were followed have done what 

was expected of them; actually, they have worked much better than could have been 

expected—except for the fact that private employment gains are still very slow indeed. 

POLICIES USED TO RESTORE THE FINANCIAL SECTOR

The financial crisis was threatening to pull the U.S. and global economies into recession or even depression when the Bush Administration and Secretary Paulson 

asked for a fund of $700 billion—the TARP—to stabilize the financial sector. The 

Emergency Economic Stabilization Act, signed in October 2008, authorized the Department of Treasury to spend up to this amount to purchase or insure troubled assets, but with broad discretionary authority. The Treasury’s stated diagnosis of the 

financial crisis was that distressed mortgage-related assets had become impossible 

to trade and value because of the breakdown of normal market relationships. The 

TARP was to be used to facilitate the return of private valuation of these assets, 

including the use of reverse auctions. Treasury was willing to buy distressed mortgage-related assets on the open market in order to get this process started. As the 

crisis unfolded, it became clear that financial markets were too troubled and many 

of the assets were so bad that they simply had to be written down in the books of 

banks and other financial institutions. The proposed reverse auctions never got off 

the ground. 

Consequently, the TARP’s manner of intervention had to change. Under the Capital Purchase Program (CPP), one component of the TARP, money was used to stabilize and reinforce the core capital reserves of banks, primarily through the purchase of preferred shares. In October 2008, immediately after Congress created the 

program, the CPP bought $125 billion of preferred shares from nine of the nation’s 

largest banks. Hundreds of other banks applied and were accepted into the program 

in the following weeks. Ultimately, the TARP would purchase $205 billion in preferred shares from 707 financial institutions. It is important to note that the TARP 

was not simply used as a transfer to failing institutions. Even healthy banks were 

forced to accept money in an attempt to mask government opinions about which 

banks were healthier than others. 

Beyond the CPP, more extraordinary intervention was provided for critical and 

interconnected institutions. AIG received $40 billion from the purchase of preferred 

shares, money that was used, in part, to restructure two Federal Reserve credit 

lines that totaled $123 billion. The TARP also extended AIG a $30 billion preferred 

line of credit. Citigroup and Bank of America each received an additional $20 billion 

capital infusion on top of the $25 billion committed to each bank from the CPP. 
14 

5 AIG, of course was an insurance company not a broker dealer but it had developed a huge 

book of Credit Default Swaps through its operations in London. 6Three banks that received TARP money have failed: Midwest Bank and Trust Company, Pacific Coast National Bank, and United Commercial Bank. A fourth, CIT Group Inc., filed for 

bankruptcy. The expected loss from these 4 institutions is $2.7 billion, $2.3 billion from CIT 

Group Inc. alone. 7Through the Community Development Capital Initiative. 

Another problem is that ‘‘runs on banks’’ began to occur. Historically, a bank run 

occurred when retail depositors feared that their money in deposit accounts was not 

safe and they rushed to withdraw it before the bank went under. During the Great 

Depression, deposit insurance and the FDIC were created, and these policy changes 

have virtually eliminated the problem of retail bank runs in the United States. 

However, FDIC bank guarantees do not cover non-bank financial institutions, such 

as investment banks, which comprise the so-called shadow banking system. These 

institutions have grown increasingly important during the last decade, and in the 

lead up to the financial crisis they were engaged in a massive game of borrowing 

short and lending long. Given the lack of insurance as well as the generally opaque 

nature of their operations, brokers trading in derivatives and other securities were 

vulnerable to runs as their clients rushed to withdraw the funds they had deposited 

with them or avoided entering into new derivative or repo contracts. Bear Stearns 

went under as a result of this, followed by Lehman and then AIG.5 It turned out 

that money market mutual funds were holding large amounts of repo contracts as 

part of their asset portfolios and as they feared losses on these contracts, they, too, 

pulled them out of troubled companies like Lehman and faced losses. One such fund 

threatened to impose losses on retail depositors that had accounts with them (break 

the buck) and this caused a run on money market mutual funds. 

The Federal Reserve acted forcefully to contain the spreading damage, providing 

guarantees for depositors in money market funds (deposit insurance for these nonbank depositors) and guaranteeing interbank lending in order to stop the payments 

system worldwide from freezing up. Even with these measures there were disruptions as global trade plunged when importers and exporters were unable to obtain 

funding. 

One of the biggest turning points of the financial crisis was the Supervisory Capital Assessment Program (SCAP), informally known as the ‘‘bank stress tests.’’ This 

was a comprehensive, simultaneous assessment of the capital held by the banking 

groups of the 19 largest U.S. bank holding companies which collectively accounted 

for two-thirds of all deposits. Conducted by the Federal Reserve and bank supervisors, the effort was meant to determine if these groups had sufficient capital to 

withstand two macroeconomic scenarios, one with baseline conditions and the other 

a more pessimistic take on the economy in which the jobless rate would climb to 

10.3 percent. The results were to be made public so the skeletons were going to be 

brought out of the closet. 

Taken overall, the stress tests revealed that the banking industry was not as 

troubled as many had feared. Among the 19 surveyed, 9 were deemed to have sufficient capital already. The other 10 were told to raise a combined $75 billion in equity. The day after results were published, Wells Fargo and Morgan Stanley raised 

$7.5 billion and $8 billion, respectively. Goldman Sachs had raised $5 billion before 

the results were even released (though the report said they did not need any). Of 

the 19 banking groups that underwent stress tests, all but one were able to raise 

sufficient capital from issuing stock, selling business units, and strong earnings. 

GMAC, the troubled lending arm of General Motors, was said to need $11.5 billion, 

the most of any banking group as a percentage of assets—much of this money would 

come from the TARP in two subsequent rounds of funding. In the worst case scenario, the stress test report predicted losses by the 19 banks could total $600 billion. 

Nevertheless, the stock market reacted positively after the results were announced, 

with the S&P 500 climbing 2.4 percent that Friday. Soon afterwards, the strongest 

banks were able to begin repayment of their TARP funds. 

The TARP and SCAP programs worked. The vast majority of banks receiving the 

TARP funding remained open,6 and the large banks returned this funding more 

quickly than could have been expected from their problems, becoming much more 

stable and earning profits. As well as the capital injections, the low interest rate 

environment allowed them to make profits on the lending they made and their trading businesses were also profitable. 

Various other programs, unrelated to toxic assets, were housed in the TARP, 

given its broad mandate and the difficulty of earning new allocations from Congress. 

Hence the TARP was involved with the auto industry, mortgage modification, and 

providing capital to institutions that serve underrepresented communities.7 The 
15 

8GMAC and Chrysler Financial. 

automotive industry—including GM, Chrysler, and two of their financing arms8— has collectively received $64 billion, which is now held as a mixture of debt, equity, 

and preferred shares. The jury is still out on the sustainability of GM and Chrysler, 

but so far so good. They are both making a comeback and their survival prevented 

what would have been even more massive job losses. 

Wall Street has taken the bulk of the criticism in this crisis, but actually the financial system more broadly contributed to the crisis and many smaller and regional banks remain troubled. Many of the bad mortgage loans were originated by 

state regulated non-bank institutions and many insured small banks have been 

troubled. The TARP funds were used to help smaller institutions as well as larger 

ones but nevertheless several hundred FDIC banks have been placed into receivership and, as noted earlier, 775 are currently problem banks. The chart below shows 

FDIC bank failures over time. 

The FDIC has been faced with enormous challenges in this crisis and, under the 

leadership of Sheila Bair, has shown skill in resolving failing institutions. Not everything has gone right, and the FDIC programs have been pretty expensive (the 

costs will be borne by member banks in the form of higher deposit insurance premiums not directly by taxpayers). The FDIC programs to reduce foreclosures and 

keep people in houses have not been very successful—although no plan has proven 

good at that. Despite these issues, our economy is much, much better off today for 

having the FDIC on the watch and ready to deal with failing banks. It is hard to 

think how bad the situation would have become without the FDIC to step in and 

resolve failing banks. 

Costs of the TARP: According to a March 2010 CBO report, the CPP part of the 

TARP should earn $2 billion in profit. Net income from investments in Citigroup 

and Bank of America will total $5 billion. That said, total returns will still be negative, largely because of anticipated losses from the automotive industry ($34 billion), 

AIG ($36 billion), and a home loan modification program ($22 billion). The total cost 

of the TARP program should be roughly $100 billion net, much smaller than February 2009 forecasts of more than $500 billion. At less than 1 percent of GDP, that 

cost is well below historical averages of 13 percent of GDP, according to IMF numbers. As Ben Bernanke, chairman of the Federal Reserve, said, ‘‘This is a pretty 

good return on investment.’’ 

In summary, the policies to restore the financial sector are working. The recovery 

of the sector is not complete but the period of extreme anxiety is over and banks 

are positioned to lend more as recovery takes hold. This was done with costs that 

are large but not disproportionate to the problems being faced. 

FISCAL POLICY USED TO COMBAT THE RECESSION

At the end of the Clinton Administration, the federal budget was in substantial 

surplus and one of the many advantages of this was that we had ‘‘reloaded the fiscal 

cannon,’’ in the words of then Treasury Secretary Lawrence Summers. This meant 

that in the event of a serious recession in the future, expansionary fiscal policy 

could be used to mitigate the unemployment and lost output that would result. The 

Bush Administration decided that the surpluses should be used to finance very large 

tax cuts and the result has been chronic federal budget deficits from 2001 through 

the present. I was not opposed to tax cuts as a way of returning families’ incomes 

back to them and easing the tax burden, but the size of the cuts was excessive. It 
16 

is irresponsible for the United States to run chronic deficits and become reliant on 

foreign capital inflows to finance our domestic investment. Moreover, it meant that 

we entered the crisis in 2007 in a vulnerable fiscal condition. The fiscal cannon was 

short on powder. 

Recessions always cause deficits because tax revenues fall, and the severe recession of the past three years is no exception. Much of the deficit of $1.4 trillion in 

2009 was the result of the loss of tax revenue that followed the economic decline. 

The chart below shows that federal revenues declined $515 billion or 31 percent 

from their peak to the trough. 

Some expenditures rise automatically in recessions, notably unemployment insurance benefits, and these also add to deficits. It is important to note that these ‘‘automatic stabilizers’’ are vital to the maintenance of economic stability. Without any 

action by Congress, tax revenues fall and some types of spending rise, cushioning 

households and businesses from the downturn. Historically, these stabilizers have 

formed the frontline defense against more severe recessions and it is important that 

their effect not be offset by ill-timed actions to reduce the deficit—Herbert Hoover 

economics. As in other things in life, timing is everything. Chronic deficits are bad, 

in fact the budget should be balanced or even a little in surplus on average. But 

at times of recession deficits are a necessary evil. 

In an effort to hold off the recession, the Bush Administration had proposed and 

Congress had passed a stimulus package in 2007, mostly consisting of temporary 

tax cuts. I supported this policy, but it clearly did not solve a problem that was 

much bigger than we knew. During the transition, President Obama and his team 

proposed a much larger stimulus package of $787 billion, which was enacted in 

early 2009 and the chart below shows a breakdown of this spending by 

creditloan.com on the basis of who got the money and what was it used for. 
17 

As you can see from the left side of the chart, the largest portion of the stimulus 

went to governments—federal agencies, state and local governments. As you know, 

states and localities are almost all in terrible trouble financially and are making 

cuts in spending. In the long run it is a good thing that our state and local governments are forced to operate with balanced budget constraints. But in a recession 

like the one we are going through, cuts in such spending contribute to the recession. 

In my judgment, it was a good choice to support states and localities. The spending 

on infrastructure and energy efficiency was a mixed bag and not part of a coherent 

national strategy to deal with energy or infrastructure problems. Understandably, 

perhaps, it was decided to act quickly and avoid political or implementation delays 

as far as possible. Judging by the District of Columbia, the infrastructure spending 

is being used to dig up every road on my commute home, but this does create jobs 

and hopefully is to good effect in the longer run. Nearly $300 billion or 38 percent of the total went to individuals, and that may 

be a surprise to some. This money was received either in the form of lower taxes 

or in higher support payments but, either way, it was money in the pockets of 

American families that could be used to help them through the crisis and add to 

their consumption. About 17 percent of the total was used for businesses, not an 

especially large number. 

Overall, the stimulus package was messy, and some of the spending was wasteful. 

But the context must be kept in mind. A sizeable stimulus had to be passed quickly 

to protect against an even deeper recession and there were 535 cooks stirring the 

pot. The stimulus package did add to aggregate demand and reduced the size of the 

recession. 

Predictions about the Effectiveness of the Stimulus. President Obama asked his 

economic team—specifically Christina Romer, now CEA Chair, and Jared Bernstein, 

of the Vice President’s staff—to prepare an estimate of the impact of his proposed 

stimulus package. They predicted that the package would generate 3.3 to 4.1 million 

additional jobs in 2010 and add 3.7 percent to GDP growth, compared to the 

counterfactual of no stimulus. Their forecasts have been criticized because employment was terrible in 2009 and GDP fell sharply in the first half of that year, but 

that is a misunderstanding of what they did. They looked at the incremental effect 

of the policy, relative to the no-policy alternative. I note also that their forecasts 

about the impact of the stimulus on GDP look reasonable in light of the second half 

of 2009 and early 2010. 

A financial crisis and recession like the one we are in represents a discontinuity 

in our economic path. Econometricians are very skilled at sorting out the historical 

patterns of economic data and using them to say what is the most likely future 

given past experience. This crisis is not anything like any recent history and has 

produced very severe economic stresses. The employment declines in the United 

States in this recession have been much larger than would have been predicted 

given the path of GDP and much larger than in European countries with similar 

GDP declines. The stimulus package did not preserve as many jobs as Romer and 
18 

9GDP is measured with considerable uncertainty, especially data from recent quarters. There 

is an alternative way of getting at the same concept through total income, Gross Domestic Income or GDI. Based on the income side of the National Accounts, the recession has been much 

deeper than is implied by the GDP data. One explanation of the huge loss of jobs is that the 

fall in income and output have been understated by the available GDP statistics. 

Bernstein had hoped, but that is because the old employment patterns broke down, 

which is not something they could have predicted. Productivity also soared in 2009, 

a very unusual occurrence in a deep recession.9

I do not support frequent use of active fiscal policy to respond to the business 

cycle ups and downs, but in 2008 and 2009 we were stuck in a foxhole with the 

shells landing all around and it was a good time to call for reinforcements. The 

stimulus package provided that much-needed help. 

TODAY’S GROWTH AND DEFICIT CHALLENGE

In the recent G-20 meetings reportedly there was tension between the United 

States and Europe over continued fiscal stimulus. Understandably, President 

Obama is worried about the sluggish global recovery and wants to sustain fiscal 

stimulus. European countries argue that the fiscal crisis is too severe to allow continued stimulus and there must be a clear path to fiscal consolidation. The IMF officials at the meeting supported this view. The argument is that these countries do 

not have the freedom to pursue expansionary fiscal policies. The debt and deficit 

problems in Greece and the dangers in Spain, Portugal, Italy, Ireland and the UK 

are enough to reduce the range of policy choices. 

Standard economic policy analysis indicates that increases in government spending or cuts in taxes will stimulate aggregate demand and hence economic growth 

in times of recession. I applied this logic to the U.S. stimulus package in claiming 

that it helped sustain demand during the downturn. Another example is China, 

which introduced a large stimulus package when the global downturn hit to offset 

the decline in their exports. This program has been judged successful and economic 

growth in China has been sustained. Does this economic logic break down when 

there is a threat of sovereign debt default and a fear of the financial turmoil that 

would result from this? Some policymakers in Europe even argue that fiscal consolidation will provide such great reassurance to markets and will so increase business 

and consumer confidence that the overall effect will be expansionary. 

I am not willing to stand the usual economic logic completely on its head. Fiscal 

consolidation in Europe will have a direct effect in taking money out of people’s 

pockets and cutting jobs and this will reduce demand and economic growth as a 

first-round effect. Nevertheless, I am sympathetic to a more moderate version of the 

European argument because the fears of renewed financial turmoil are real and potentially damaging to economic recovery and this must condition policy decisions. 

My advice to Europe would be to move as slowly as they can towards fiscal consolidation. If they act too quickly, they will shoot themselves in the foot and end up 

with a deeper recession and even bigger deficits. But they do have to be mindful 

of the limits they face on sovereign borrowing. They should take moderate but 

meaningful steps towards smaller budget deficits now and put in place policies that 

will continue progress towards budget balance as their economies recover from recession. Keep in mind also that European economies generally have much more extensive safety nets than does the United States. These social programs have created 

problems for them in terms of incentives, but they do have the advantage of providing strong automatic stabilizers to the economy because consumption is protected 

in downturns. 

To what extent is the United States in the same position? The chart below shows 

a private forecast of likely federal deficits in the United States in the absence of 

any major policies to change the picture. This is a very scary picture. A trillion dollars a year is a lot of money to be borrowing. The U.S. Treasury does have some 

advantages, however, relative to Europe because of the size of our economy and the 

depth of the financial markets. And even though the projected deficits look large, 

the prospects for U.S. growth are pretty good and there are ways the deficit could 

be reduced if we only chose to follow them. Today, the yield on 10-year Treasuries 

is under three percent, so the market is saying that there is no problem so far in 

the ability of the Treasury to borrow, indeed these rates are among the lowest in 

history. 

Treasury rates are low now because lending to the US government looks good relative to global alternatives but market views could change over the next few years 

and perhaps even sooner. If Treasury interest rates rise significantly, this will 

crowd out private investment or even trigger another crisis if the dollar were to drop 

precipitously. No one knows if or when the U.S. Treasury might have its Greece mo-
19 

ment. Surely, this will not happen over the next year or two, but quite possibly it 

could happen over the next five years. And it would be foolish to push the envelope 

and let a disaster happen. 

Given the reality of huge deficits, I do not support major fiscal expansion measures right now that would increase the deficit. I did support a continued extension 

of unemployment benefits and modest additional help to the states, measures that 

would not have significantly worsened the deficit. If the U.S. economy were to slip 

back into second dip recession later this year or next year, then my view would 

change and I would consider it necessary to provide another fiscal stimulus to the 

economy despite the risks to Treasury funding. Ideally, the Administration and Congress would agree soon on meaningful policies to reduce the budget deficit in out 

years (for example, a measure that put federal health care spending on a balancedbudget basis over a multiyear period). This would create confidence in global markets and would allow for further stimulus this year or next, if that were to prove 

necessary, but it would not take purchasing power out of the economy today. 

CONCLUSIONS

You do not expect the bear to dance well; it is a miracle if it dances at all. The 

policies that restored the financial sector and helped turn around this very deep recession were not pretty but they were the right policies and they helped save the 

U.S. economy and indeed the global economy. The high unemployment, fluctuating 

stock market, struggling housing market and sluggish recovery that unfortunately 

are still with us are making the Administration and many other policymakers unpopular. It is too bad that the electorate does not give credit for the turnaround that 

has happened. It should. 

Chairman SPRATT. Thank you. 

Dr. ZANDI

STATEMENT OF MARK ZANDI 

Mr. ZANDI. Thank you, Chairman Spratt, Congressman Ryan, 

and the rest of the committee, for the opportunity to be here today. 

These are my own views and not those of the Moody’s Corporation. I will make four points in my remarks. 

Point number one. The recession, the great recession has given 

way to an economic recovery, and it is largely due to the policy response. 
20 

The recession ended almost precisely a year ago. GDP growth 

over the past year has been approximately 3 percent year over 

year, and we have begun to see job growth since the beginning of 

2010. Subtracting from the Census hiring, the temporary Census 

hiring and the loss of the Census jobs that are coming, we have 

seen average monthly private-sector job growth of about 100,000 

since the beginning of the year, and that is what I would expect 

to see for the month of June when we get that data point on Friday, which is an important point. The unemployment rate has stabilized as a result, obviously very high, close to 10 percent, but it 

has stabilized at that level since this time last year. 

The recovery is broadening out. It began in manufacturing. It is 

now evident in distribution and transportation. We are seeing 

growth in various technology industries, some professional services, 

a bit in retailing. I would anticipate leisure, hospitality, financial 

services starting to hire more aggressively as we make our way 

through the year. 

The recovery is also broadening out across the country. If you 

look at the Nation’s almost 400 metropolitan areas, two-thirds of 

them, roughly speaking, are now in a recovery. Just for context, if 

you go back to the depth of the recession in late 2008, early 2009, 

only 10 percent of the Nation’s metropolitan areas were expanding. 

So that is a significant improvement. 

The policy response has been key to this turnaround. I think we 

all can take exception to any individual aspect of the response. 

Some folks don’t like the bank bailout, others the auto bailout, the 

housing tax credit, cash for clunkers. There were many, numerous 

policy efforts. Each of us probably didn’t like some aspect of the response. 

But the totality of the response I think was unprecedented and 

aggressive and ultimately very successful. I don’t think we would 

be experiencing a recovery at this point without those efforts; and 

that includes everything from what the Federal Reserve has done 

in providing liquidity to the financial system and shoring up the 

banking system, to what the FDIC has done with respect to insurance limits and guaranteeing bank debt temporarily, to what the 

Treasury has done with respect to the bank’s stress testing process, 

to—as importantly or more importantly—what Congress has done 

with respect to all the elements of the TARP and fiscal stimulus. 

In my view, the fiscal stimulus was absolutely vital to jumpstarting this economy. It is no accident that this recovery began at 

precisely the same time that the stimulus was providing its maximum economic benefit to the economy. So, point number one, we 

are now in recovery, and it is because of the policy effort. 

Point number two, the recovery is still fragile. The economic expansion is not in full swing. We are not off and running yet. There 

are a number of reasons for concern. Let me list a few. 

First, going back to the job market. Most of the improvement in 

the job market is related to an end of businesses laying off workers. 

We are not seeing any appreciable pickup in hiring. Some modest 

pickup in the last couple 3 months, but it is very modest. 

I think there are a couple impediments to hiring. One is a lack 

of credit, particularly to small businesses. 
21 

Here is a statistic that is important: Establishments that employ 

fewer than 100 employees—let’s call it a small business—employ 

half of all the workers in our country, and they accounted for nearly two-thirds of the net job creation in the last economic expansion. 

If small business isn’t hiring and if they are not hiring because of 

credit, we have got a problem. So that is an impediment. 

The other issue is confidence. It was only a year ago that many 

businesses were suffering near-death experiences, and I think it is 

difficult to—as a businessperson and being a small business owner 

myself, I can attest to the fact that you don’t forget something like 

that quickly. 

I also think policy uncertainty is an issue. I do think we are having very significant policy debates that are very important. We 

need to have them. But it is important to recognize that when you 

are having them it does create angst among the business community. And that is everything from health care reform to financial 

regulatory reform to energy policy to immigration policy. 

And I would have to say, just based on my experience just talking to business people in my work, they are very nervous about tax 

policy, that the tax rates are going up at the beginning of next year 

if there aren’t changes, and that needs to be nailed down quickly, 

I think. That would make a big difference. 

A second issue with respect to the recovery is what is going on 

in State and local government. That is a problem. State and local 

governments have very large budget holes. Those budget holes are 

smaller today than they were this time last year, but last year’s 

budget hole was filled largely with the stimulus money. So that 

forestalled the most Draconian budget-cutting job loss and tax increase. 

It didn’t forestall those budget cuts. There were very significant 

cuts. In fact, State and local government employment is down 

190,000 jobs from where it was 1 year ago. That is significant. But 

the job cutting was modest. It was not an overwhelming economic 

problem. If State and local governments do not get more help, they 

will have no choice but to significantly cut payrolls, cut other programs, which means a loss of private-sector jobs, and raise taxes 

at just the wrong time when the economic recovery is fragile. So 

reason number two for concern is what is going on at State and 

local governments. 

Third, the foreclosure crisis is ongoing. It is not over. There are 

4.3 million first-mortgage loans that are in default or headed in 

that direction, 90 days and over delinquent. For context, there are 

49 million first-mortgage loans outstanding. That is a lot of loans. 

Those loans have been piling up in the foreclosure process because 

of the various loan mitigation efforts. Servicers, mortgage servicers 

are now figuring them out. They will begin to start pushing these 

loans that don’t qualify for a modification through the foreclosure 

process to a sale, either short sale or foreclosure sale. 

That will begin hitting the housing market this summer and fall. 

House prices are going to continue to decline. Nothing really works 

well in our economy if house prices are falling. It is still the largest 

asset in most people’s balance sheet, and financial institutions 

aren’t going to extend credit if house prices are falling. 
22 

Going back to small business. Small businesspeople put up their 

homes as collateral for loans. Banks aren’t going to make a loan 

if they are unsure of the value of the home underlying that loan. 

So point number two, broadly, is that the recovery is still very 

fragile. We are not off and running yet. We still have work to do. 

This goes to point number three, and that is I think it would be 

premature for policymakers to exit out of their support for the 

economy too quickly. For the Federal Reserve, that means not raising interest rates. But the Federal Reserve shows no inclination to 

do that at any time in the near future. With unemployment where 

it is and unlikely to move lower any time soon, I don’t anticipate 

that. 

Unfortunately, the Federal Reserve can’t do much more than 

what it is doing. It could restart credit-easing efforts to try to bring 

down long-term interest rates, but long-term interest rates are already at record lows and it is not having much of an impact on 

housing demand and other activities. So I don’t think that that 

would be of measurable help. 

So this puts more pressure on you, as fiscal policymakers. And 

I think it is important—in fact, I would say it is vital—that you 

continue to provide some additional temporary stimulus to the 

economy, and I would recommend three things. 

First, I would extend emergency unemployment insurance benefits. Two to three hundred thousand folks are running off those 

rolls every week; 1.3 million are already off the rolls because those 

benefits have not been extended. This is going to hurt personal income and consumer spending very quickly, because these folks get 

the money and they spend it. 

Moreover, it is very difficult to gauge how this is going to affect 

consumer confidence, which, as we can see, is incredibly fragile. So 

I think it is vital to extend UI. 

Second, I would provide more help to State and local government. They have a budget hole, by my reckoning, that is close to 

$100 billion. I think it would be appropriate to fill about a third 

of that budget hole. That means they still have to go through very 

significant cutting and restructuring, but it would reduce the impact that would have on our job market in the next few months 

and on the broader economy in the next few months. 

And, third, I would expand out the ability of the Small Business 

Administration to make more credit available to small business. 

That was shown to be a very effective part of the fiscal stimulus. 

That should be renewed and expanded. That is a good mechanism 

for getting cash out to small businesses quickly. 

So, point number three, I think it is very important for policymakers, fiscal policymakers, for you to remain aggressive until the 

coast is, in fact, clear, until the unemployment rate is definitively 

moving lower. 

Finally, point number four goes to our fiscal situation, which is 

indeed very serious. And, as such, I think it is entirely appropriate—in fact, it is desirable—that this additional stimulus that I 

have recommended is paid for not this year, not in 2011, but when 

the economy is off and running and the unemployment rate is moving south, let’s say 2012, 2013, 2014. So I think it should be paid 

for. 
23 

Now, having said that, I don’t think paying for it should be a 

precondition for this stimulus that I have recommended, that it is 

too important to the economy in the near term to get done. So I 

would suggest that it is okay, fine, to run a larger budget deficit 

than otherwise would be the case in the near term to make sure 

that we do jump-start this economy and we get going here. 

Finally, let me say this. I do think once the economy is on a 

sound footing it is critically important that you do pivot as quickly 

as possible and address the long-term fiscal situation. I think without those efforts our long-term economic prospects will be significantly diminished. 

Thank you. 

[The prepared statement of Mark Zandi follows:] 
24 
25 
26 
27 
28 
29 
30 
31 
32 
33 
34 
35 
36 
37 
38 
39 
40 
41 
42 
43 

Chairman SPRATT. Thank you, Dr. Zandi. 

Dr. TAYLOR

STATEMENT OF JOHN TAYLOR 

Mr. TAYLOR. Thank you, Mr. Chairman, Ranking Member Ryan 

for inviting me to testify. I appreciate the opportunity. 

I think the economic recovery has slowed significantly, if you 

look at the numbers carefully. Just, for example, in the fourth 

quarter of last year we had growth at 5.6 percent. That has slowed 

by more than half, to 2.7 in the first quarter of this year and probably around 3 percent the rest of the year. So it is what economists 
44 

think of as a U-shaped recovery, not the V-shaped, and some are 

even worrying about a double dipper or W-shaped recovery. 

In my view, the problem here is largely a great deal of uncertainty about what is happening with economic policy. I think there 

is also uncertainty about how some obvious inconsistencies in policy are going to be resolved. There is uncertainty about tax increases, there is uncertainty about regulatory reform, there is uncertainty about how the Fed will unwind its operations, and perhaps the biggest uncertainty now is what is going to happen with 

the rapidly growing debt. 

In this respect, I think that CBO’s release yesterday of their annual long-term budget outlook is quite of concern. I had some 

charts in my testimony which try to illustrate this. 

If you have a chance to look on page 1, there is a chart which 

I put together from the data reported in the CBO long-term outlook. It reports debt as a share of GDP in the United States. We 

used to think that the gigantic increase in World War II was about 

as much as we would ever have. If you look at this chart, it looks 

like a small blip compared to where we are going, according to 

CBO, if we don’t do something about it. 947 percent of GDP. It is 

just astronomical. Obviously, the United States of America will not 

be the United States of America if we let this happen. So resolving 

this inconsistency I think is one of the biggest drags on the economy at this point. 

On the other hand, if we address it, address it in a sensible way, 

I believe we can start to restore confidence, start to grow more 

robustly again, and ultimately get that unemployment rate declining back. 

So what is holding us back? What is holding us back from just 

moving ahead right away? I think the main factor is people are 

worried about removing stimulus, so to speak. And my distinguished colleagues on this panel have already referred to that. In 

my view, there shouldn’t be much worry from either ending or even 

removing some of the so-called fiscal stimulus, and my written testimony tries to describe why. 

I basically, respectfully, but also strongly, disagree with the view 

that the stimulus has been a big factor in the recovery. And there 

are various ways to think about this. I think one is to try to realize 

that those who argue—those economists who argue that it was a 

big factor are using models about which there is not a large degree 

of agreement. I try to illustrate this on some charts on page 3 of 

my testimony, if you would look at those. 

I took some charts which were originally published in the New 

York Times which purport to show that the stimulus was effective, 

and they look at three different models. Actually, one of the models 

is from Mark Zandi’s group. And you can see, if you just glance at 

the black line, that is sort of what has happened or what is forecast 

to happen, and the gray line is what the models say what would 

have happened without the stimulus, and the three models in the 

left which were in the New York Times show a big effect. 

The problem is, those aren’t the only models around. To illustrate this, I took another model, actually, one that me and my colleagues at Stanford have looked at quite a bit. It is a model developed by the European Central Bank. It is also a quite common kind 
45 

of model that academics use in their own research, and you can see 

there is very little effect. In fact, to make the point completely, if 

you take the view of the modeling of Professor Robert Barro at 

Harvard, there is actually no effect of the stimulus, using exactly 

the same reasoning that people who use models of this kind. 

So the bottom line here is I view the right model as something 

where there is very little impact of the stimulus. But at least you 

have to recognize there is a tremendous amount of disagreement. 

I think in terms of understanding what has happened, it is important to go beyond models, quite frankly. Models have their problems, I can speak to that as an economic modeler, and look at actually what happened. So the other charts in my testimony try to 

look at what actually happened, and page 4 is one example. 

We have actually had a couple stimulus packages in this downturn. One was back in 2008 and the other in 2009. And if you look 

at my chart, you can see that part of those packages were to send 

checks to people, rebate checks or advance tax cuts. And, in both 

cases, in 2008 and 2009, you can see from the red line personal income rose substantially. But if you look at the lower line and see 

what people spent, look at their consumption—remember, these 

were supposed to jump-start consumption—you see very little impact whatsoever. So I think if you look at the data, look what actually happened, stop simulating models and look at what actually 

happened, you see very little impact of this part of the stimulus 

packages. 

But, of course, the stimulus packages have more than just sending cash to people. They actually have to do with changing government purchases. As Martin indicated, you can see some of this 

when you drive around Washington. But let’s look at really what 

happened in terms of government purchases. So if you look at page 

5 of my testimony, I think it is a pretty simple illustration of this 

great recession, the recovery, the weakening of the recovery, and 

what are the factors. 

So the chart at the very top is a picture of real GDP growth. And 

you can see the blue line, it comes down, goes about down to pass 

minus 6, and you have this recovery up to 5.6, and then the slowdown, as I mentioned in my introduction. You can find out how 

much of that growth is due to different parts of GDP, investment, 

consumption, government purchases, net exports. So I did that. 

And you can see, if you look at the contribution of investment, 

private investment, the private economy, it almost tells the whole 

story: a huge decline in investment in the panic, a huge increase 

in investment after the panic, a slowdown in investment now. So 

it is the private sector that is driving this. 

And to actually illustrate this further, look at the chart at the 

bottom of page 5, and you can see that, through these ups and 

downs in the economy, changes in government purchases have 

played almost no role whatsoever. Now, this doesn’t prove anything, but it certainly convinces me that one should be wary about 

claims that this fiscal stimulus did very much. In fact, my view is 

that it has done remarkably little. 

So where does this lead me? It seems to me the conclusion is that 

we should focus on this problem of the debt and the deficit, address 

the consolidation issues now. Don’t delay. Because concerns about 
46 

either ending or not continuing with stimulus packages, get started 

now, orderly way. It doesn’t have to be Draconian. But I think that 

as soon as people realize that this is what you are trying to do confidence will be restored and you can see the recovery picking up 

again. 

Thank you very much. 

[The prepared statement of John Taylor follows:] 

PREPARED STATEMENT OF JOHN B. TAYLOR, MARY AND ROBERT RAYMOND PROFESSOR

OF ECONOMICS; GEORGE P. SHULTZ SENIOR FELLOW IN ECONOMICS, HOOVER INSTITUTION, STANFORD UNIVERSITY

Thank you, Chairman Spratt, Ranking Member Ryan, and other members of the 

House Committee on the Budget for inviting me to testify on ‘‘Perspectives on the 

U.S. Economy.’’ 

The recovery of the U.S. economy has slowed significantly since the start of this 

year. After rebounding to 5.6 percent in the fourth quarter of last year, real GDP 

growth slipped to 2.7 percent in the first quarter and is expected to remain in the 

3 percent range for the rest of the year. In the lingo of economics it is a U-shaped 

recovery rather than a V-shaped recovery and some economists are now predicting 

a double dip, or a W-shaped recovery. As a result of the slower economic growth 

unemployment remains high and is expected to decline slowly. 

UNCERTAINTY AND FISCAL POLICY INCONSISTENCIES

In my view the weakness in the recovery is mainly due to uncertainty about economic policy and concerns about how large policy inconsistencies will be resolved in 

the future. The long term budget outlook released yesterday by the Congressional 

Budget Office (CBO) is a timely reminder of these inconsistencies as this alarming 

chart of past and future federal debt illustrates. 

The chart shows the federal debt as a share of GDP going back to the beginning 

of the United States and continuing into the future assuming that fiscal policy is 

not changed as defined by the CBO’s alternative scenario. You can see the increase 

in the debt ratio during World War II, which fortunately was reversed in the years 

after the war. The CBO’s projection through the next decade shows a similar increase in federal debt as a share of GDP as in World War II. The projections for 

future decades then explode. According to the CBO, the debt reaches an unbelievable 947 percent of GDP by 2084 which dwarfs the peak debt incurred during World 

War II. So something has to give, and people are beginning to wonder what. 
47 

The near term increase in the debt is due to the recession, the stimulus packages, 

and other recent expansions in government spending growth. The longer term increase is due to the inability to rein in spending on entitlement programs. Thus it 

is not only the fiscal response to the crisis that has caused debt problems for the 

United States. But the response to the crisis has distracted us from efforts to address the problems. Adding to the uncertainty is that many tax provisions are 

scheduled to expire in just 6 months, and without legislative action, there will be 

substantial tax increases on all Americans. There is also a looming change in financial market regulations which add uncertainty to a financial system still recovering 

from the crisis. 

A clear and credible path of fiscal consolidation is clearly needed and would do 

much to remove uncertainty about future policy and thereby build confidence. The 

reason why such a plan is not being articulated and carried out now is an apparent 

concern that such a consolidation would remove needed stimulus from the economy. 

In my view, the fiscal stimulus packages did not stimulate very much if at all and 

ending them would not have such negative consequences. But the debate is a serious one and for this reason I want to devote the rest of my testimony to explaining 

why I disagree with those that claim the stimulus has worked. 

EVIDENCE FROM THE MODELS: NO CONSENSUS THAT THE STIMULUS HAD A SIGNIFICANT

IMPACT

Unfortunately most attempts to answer the question ‘‘What was the impact of the 

fiscal stimulus?’’ are still based on economic models in which the answer is builtin, and was built-in well before the stimulus package was enacted. Frequently the 

same economic models that said, a year and half ago, that the impact would be large 

are now used to show that the impact is in fact large. In other words these assessments are not based on the actual experience with the stimulus. I think this has 

confused public discourse. 

An example is an article in the New York Times (11/21/2009) with the headline 

‘‘New Consensus Sees Stimulus Package as a Worthy Step,’’ which states that ‘‘accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working. 

The legislation, a variety of economists say, is helping an economy in free fall a year 

ago to grow again and shed fewer jobs than it otherwise would.’’ 

As evidence the article includes simulation results from three models, which are 

reproduced in the three charts on the left below. Each of the three graphs on the 

left corresponds to a model maintained by the group shown above the graph. All 

three graphs show that without the stimulus the recovery would be considerably 

weaker. The difference between the black line and the gray line is their estimated 

impact of the stimulus. But this difference was built-in to these models before the 

stimulus, and in this sense there are no new hard data or experiences here. 

In fact other economic models predicted that the stimulus would not be very effective, and, using the same approach those now say that it has not been very effective. 

To illustrate this I show two other graphs on the right-hand side of the chart which 

did not appear in the New York Times article. The first one is based a model estimated by Frank Smets, Director of Research at the European Central Bank, and 

his colleague Raf Wouters. The difference between the black and the gray lines is 

what is predicted by that model. Note that the impact is very small. The second additional graph on the right is based on the research of Professor Robert Barro of 

Harvard University who reported in an article in the Wall Street Journal ‘‘when I 

attempted to estimate directly the multiplier associated with peacetime government 

purchases, I got a number insignificantly different from zero.’’ So according to that 

research, the difference between the black and the gray line should be about zero, 

which is what that graph shows. So there is no consensus among models or theories 

that the stimulus had a significant impact. 
48 

Other evidence from models comes from an International Monetary Fund study 

which reports estimates of government spending impacts which are much smaller 

than those previously reported by the Administration. The IMF uses a very large 

complex model called the Global Integrated Monetary and Fiscal (GIMF) Model. It 

shows that a one percent increase in government purchases (as a share of GDP) increases GDP by a maximum of 0.7 percent and then fades out rapidly. This means 

that government spending crowds out other components of GDP (investment, consumption, net exports) immediately and by a large amount. The IMF estimate is 

much less than the impact reported in a paper released last year by Christina 

Romer of the Council of Economic Advisers and Jared Bernstein of the Vice President’s Office. 

John Cogan, Volker Wieland, Tobias Cwik and I raised questions about the 

Romer-Bernstein estimates soon after they were released in January 2009 because 

the estimates seemed to be much different from comparable estimates based on 

more modern models. In fact, we found the economic impacts to be much smaller. 

Since then many technical papers have been written on this subject and in my view 

the consensus is that the impacts are much smaller than originally reported by 

Romer and Bernstein. 

EVIDENCE FROM THE FACTS: THE STIMULUS DID NOT HAVE A SIGNIFICANT IMPACT

Now let me go beyond the models and look at the direct impacts using data. Consider first the 2008 discretionary countercyclical fiscal stimulus—the Economic 

Stimulus Act of 2008—in which checks were sent to people on a one-time basis and 

aggregate disposable personal income jumped dramatically though temporarily. The 

objective of the stimulus was to jump-start consumption demand and thereby jumpstart the economy. However, aggregate personal consumption expenditures did not 

increase by much at all around the time of the stimulus payments. For the discretionary fiscal stimulus which was passed in February 2009—the American Recovery 

and Reinvestment Act of 2009—checks were also sent; they were smaller and more 

drawn out than the 2008 stimulus, but the impact was about the same: no noticeable effect on consumption. Both cases are illustrated in the chart below. This is 

what basic economics—in particular the permanent income theory and the life cycle 

theory of consumption—would predict from such temporary lump-sum payments. 

In addition, my analysis of the government spending part of the stimulus suggests 

that it had little to do with the turnaround in economic activity. Indeed the swings 

in economic growth from positive to negative during the recession and again to positive during the recovery (including the slowdown to 2.7 percent growth rate of real 

GDP in the first quarter) provides evidence that changes in government spending 

had at best a very small contribution to the recovery. Most of the recovery has been 

due to investment—including inventory investment, which was positive in the first 

quarter after declining for all of last year—and has little to do with discretionary 

stimulus packages. The two charts show the percentage contribution of investment 

and government purchases to real GDP. 
49 
50 

The charts clearly indicate that the changes in real GDP growth have been mostly 

due to changes in investment and little to changes in government purchases. In fact, 

government purchases were a drag (a negative contribution to real GDP growth) in 

the fourth quarter of 2009 and the first quarter of 2010. 

One could argue that government spending might have declined by a larger 

amount without the stimulus because the stimulus package prevented state and 

local government from cutting spending. More research is needed to determine what 

would have happened in the counterfactual of ‘‘no discretionary stimulus,’’ but in the 

meantime these data at the least suggest that the recovery and the slowdown have 

been due to changes in investment not government purchases. 

CONCLUSION

The combination of the unsustainable debt projections illustrated in my first chart 

and the little if any impact of the stimulus packages illustrated in my other charts 

has clear policy implications: Fiscal policy should avoid further debt-increasing stimulus packages which do little to stimulate employment or GDP. Fiscal policy should 

focus on reducing the deficit and the growth of the debt-to-GDP ratio. Reforming 

existing entitlement programs to hold their growth down and limiting the creation 

of additional entitlement programs are essential. 

Chairman SPRATT. Thank you, sir. 

Let me read you what Dr. Bernanke had to say, each one of you, 

and ask you do you think it is a fair statement. 

‘‘Certainly we have averted what I think would have been, absent those interventions, an extraordinarily severe downturn and 

perhaps a Great Depression.’’ 

Is this overstating it for dramatic effect? Is this exaggerating the 

risk? And do you accept his judgment that, absent those interventions, we would have had severe consequences? Dr. Baily? 

Mr. BAILY. I would generally agree with what Ben Bernanke 

said. And, by the way, I think he is one of the heroes of this. He 

made mistakes before the crisis, but when he got hold of things he 

did a lot of the right things, working with Congress and the administration. 

Would we have gone into a Great Depression? I think our economy is a little bit more stable, the institutions and so on are more 

stable than they were in the Great Depression. And we do have deposit insurance. We do have unemployment insurance. So I am not 

sure we would have gone 25 percent unemployment, but basically 

he is right. We already did go into a very nasty recession, and it 

would have been much worse without those things. 

Chairman SPRATT. Dr. Zandi? 

Mr. ZANDI. Yes, I would have agreed with that view, that without 

the policy response the recession would have devolved into another 

depression; and, in all likelihood, we would still be struggling with 

that. 

And one other quick point. I think if we go back into recession, 

which I would put the odds at still being low but uncomfortably 

high and rising—if we go back into recession, we cannot rule out 

that we would go back into a depression. 

Chairman SPRATT. Dr. Taylor. 

Mr. TAYLOR. Yes. I disagree with that interpretation. Of course, 

it is a generalization. But I have looked carefully at many of the 

programs and new facilities that the Federal Reserve has implemented, and I have tried to divide it into things done before the 

panic and the fall of 2008, those during the panic of 2008, and 

those since the panic of 2008. 
51 

By and large, the ones done before the panic I think were quite 

harmful; and, in fact, I think you can argue they led to the panic. 

The ones—some during the panic I think were constructive. They 

indicated there were some markets that were actually shut down 

and were helpful. The ones after the panic, I would go back and 

say it seems to me they have not been very effective. 

So I believe that if you just look back through all the interventions and if we had actually followed policies that were followed 

much of the 1980s and 1990s, we wouldn’t have not only the—we 

wouldn’t have had even the recession we had. And so, in my view, 

the way to think about the policy is a better policy could have 

avoided the whole mess, and I have seen no evidence that the policy that was taken avoided another Great Depression. 

Chairman SPRATT. Dr. Taylor, you have shown some graphs 

which you think cast some doubt on whether or not there was a 

causal connection between the Recovery Act and the performance 

of the economy. To all three of you, how do we establish a causal 

connection between economic policies taken and the apparent turnaround of the economy in a rather dramatic fashion over a period 

of 12 months? What is the correct way to establish causality? 

Mr. TAYLOR. I think timing is probably the best way to do it, Mr. 

Chairman. If you look at monthly data, for example, on orders, investment orders definitely bottomed in December of 2008, January, 

2009, forward-looking order statistics. It seems to me that represented a fact that people realized the panic was over and it 

wasn’t going to be as bad as they thought. That is pretty simultaneous with the second group of measures I mentioned that were 

taking place during the panic, and so that is why I say some of 

those I think were helpful. 

But this fiscal stimulus package, the originally $878 billion, that 

came after that. So I think the timing is important. 

Plus you have to really look at the data, look at the numbers. 

And, as I showed you, my numbers seem to say that the private 

investment, including inventory investment, by the way, both accentuated that downturn and was part of the reason for the rapid 

boom. 

So I believe you can learn a lot from looking at the numbers 

themselves. It is not foolproof. You need to have sort of a model or 

a theory to think through what would have happened otherwise, 

try to do that. But you have to look at the numbers and look at 

the timing. That is what I have tried to do. 

Chairman SPRATT. Dr. Zandi, Dr. Baily, how do you determine 

this causality between policies taken and results achieved? 

Mr. ZANDI. Well, I also think timing is important, and I think the 

timing is very consistent with the view that the stimulus, the fiscal 

stimulus—and I am speaking of the ARRA—jump-started the recovery. 

I am speaking from memory, but Q-1 ’09 the economy contracted, 

as measured by real GDP, at just over a 5 percent annualized rate. 

In Q-2, it contracted approximately 2 percent; and by Q-3 we had 

positive growth. This is precisely when the stimulus kicked in. We 

had no stimulus in Q-1 ’09; we had 60, 70 billion in Q-2; and about 

80, 90 billion in Q-3. And that is precisely when we went from a 
52 

very severe recession with rapidly rising unemployment to economic growth and stable unemployment. 

So I think timing is very, very important. And the timing, from 

my perspective, is very strong evidence that the stimulus has 

worked well. And even using the graphs that John has presented, 

I think we can explain exactly what is going on in those charts if 

we look at the data a little bit more carefully. So it is a matter of 

I think extensive debate, but I think the timing is clear evidence 

of the stimulus’ benefit. 

Chairman SPRATT. Dr. Baily. 

Mr. BAILY. John looks at model results, and obviously models do 

differ. But I think a set of reasonably mainstream models, including Mark’s Moody model, Global Insights, Macro Advisers, the 

main forecasting models that have been successful in forecasting 

the economy, they didn’t necessarily forecast the depth of this recession but have proven their worth over the years. They generally 

show that the stimulus had a significant impact. 

John mentions Robert Barro’s model. Well, Bob Barro is a wonderful economist, but he very firmly believes, starting from the beginning, that fiscal policy won’t do anything to stabilize the economy. That has been one of his viewpoints for years and years. And 

he believes that if you cut taxes now, for example, people won’t 

change their spending because they will anticipate taxes are going 

to rise later. I think that is a little bit fanciful. 

So I think some of these models are more plausible than others, 

and I think the more sensible models show the effect. 

In terms of government purchases, well, I would agree with John 

in the following sense: Government purchases were not by any 

means the biggest driver of this recovery. I think the fact that they 

continued to go forward even though we were going into this downturn was helpful. So the fact that they did not fall dramatically, 

and particularly the State and local spending didn’t fall dramatically, was a positive item. But quite a bit of the stimulus was not 

directed toward government spending. It was directed towards tax 

cuts or benefit increases of some kind and went into people’s pockets. And, again, it is just the underlying logic. 

I am sympathetic to the view, in a full-employment economy, if 

the government increases its spending, probably someone else in 

the private sector is going to cut back their spending if you are 

going to maintain overall balance. But during a recession when you 

have got a huge shortage of demand, when employment is falling, 

when GDP is falling, you don’t get that offset. It is just a net addition to jobs and income. 

Chairman SPRATT. Thank you. 

And let me turn now to Mr. Ryan for any questions, because it 

looks like we have a vote coming up. 

Mr. RYAN. I will try to keep mine briefer than normal. 

We have John Taylor here. You are from California. You are not 

here that often. So I want to go into monetary policy just for a 

minute, if I could, since we don’t have the opportunity to have this 

kind of conversation; and, these days, that monetary policy matters 

a great deal. 

You wrote a great book sort of indicting the Fed funds rate, the 

loose money in 2003 to 2005, getting us off the Taylor rule, off the 
53 

great moderation. Give us a sense of where you see monetary policy 

now, how this unwinds, and what is your read of your rule? 

Some people say we ought to have a negative fed funds rate. 

What is your take on where rates ought to be now? And what is 

the unwinding going to look like, in your opinion, and when will 

the timing of it occur? And interest on reserves. I am very concerned about that tool, on how, when it is deployed to fight an 

eventual inflation problem—obviously, not one right now—will that 

basically precipitate another credit crunch? 

Mr. TAYLOR. Thank you very much. 

I think there is no question in my view—and I think more and 

more people are looking at this—that the very low rates in 2003, 

2004, 2005 did accentuate the housing boom and ultimately the 

bust. There are different ways to look at it. If you look at other 

countries, that seems to be a major factor as well. Of course, there 

is still debate about it. 

When you look at the current level of the Federal funds rate, of 

course, we are in a much different situation now. We are just coming out of a deep recession. The inflation rate is lower. There is not 

inflationary pressure. So the low interest rate that is there now 

seems to me about right. 

I don’t think that if you use a Taylor rule, at least as I originally 

defined it, you see negative rates. I think that some people change 

the rule and they do other things. So I think it is about right, right 

now. And what that suggests is that if we are unfortunate and inflation starts to pick up sooner than we think, or even if we are 

fortunate and the economy starts to move faster than as markets 

indicated, then the Federal Reserve will have to raise rates if they 

are going to prevent a future inflation or actually prevent another 

downturn later in typical boom-bust style. 

With respect to the unwinding of the huge balance sheet, over $1 

trillion of reserve balances which largely is due to the purchases 

of mortgage-backed securities, I am concerned that that could occur 

too rapidly or too slowly. It is one of the uncertainties that is out 

there about how this is going to be unwound. I would prefer that 

the Federal Reserve reduces that balance sheet rather than try to 

pay interest on reserves or try to actually go out and do some actions itself with respect to its own securities. I think that would be 

a much quicker way to get back to what was working. 

Because, after all, it seems to me, if you follow my logic, what 

we were doing before monetary policy got off track worked very 

well. We had this long great moderation, expansion in the 1980s, 

expansion in the 1990s, two minor recessions during that period. 

So as soon as we can get back to that policy, I think the better off 

we will be. And we don’t do that by trying to do new things like 

interest on reserves, using that as a way to manage the Federal 

funds rate, but rather use just money, the supply and demand for 

money, to get to the funds rate that we need. 

Mr. RYAN. Multiplier effects. 

I have read Bernstein/Romer, read some of Mark’s work. You did 

a piece with two German economists. I can’t recall their names. I 

read it a while ago. Bob Barro, we have heard his stuff. Why are 

the multiplier rates lower, in your view, than what, say, Bernstein/ 

Romer claims? 
54 

Mr. TAYLOR. Well, the models used by Bernstein/Romer, which 

by the way they didn’t indicate which models they were, unfortunately. But as far as we can tell, there was one type of model used 

at the Federal Reserve and one private-sector model. As far as I 

know, those models don’t have expectations built in very well. They 

don’t model the financial market’s expectations of the impact of future interest rates or inflation. And, in fact, there are many models 

that have been developed in the last 20, 30 years, the kind of models that we teach our graduate students. Almost all the universities 

do take account of expectations. So people will see, for example, 

that if there is a stimulus package, that means their taxes are 

going to increase to some extent in the future. 

Mr. RYAN. It is a Neo-Keynesian model—— 

Mr. TAYLOR. It is called new Keynesian. It has the word Keynesian in it. Absolutely. It has very many of the rigidities and things 

like that that are typical Keynesian models. They are good models, 

but they do have this crowding out that can come pretty quickly 

even when the economy is at reduced levels of operation. 

Mr. RYAN. I will cut my thing short. 

Dr. Baily, you had a really interesting op-ed today in the Journal 

on multinationals. When it comes to tax policy, obviously, they are 

very elastic and sensitive to it. Is repealing deferral, trimming back 

on the tax, the foreign tax credit, is that helpful? Is that a good 

idea for fiscal policy with respect to multinationals going forward? 

Mr. BAILY. I don’t want to give you a direct answer to that question. What I would—— 

Mr. RYAN. Most economists don’t. 

Mr. BAILY. Well, give me a break here. I think it is appropriate 

to take a good, hard look at how we tax corporations. We don’t collect a lot of revenue from corporations and so—— 

Mr. RYAN. Relative to? 

Mr. BAILY. Relative to the tax rate. We have a high marginal tax 

rate of 40 percent, but we don’t collect a lot of revenue. So I don’t 

think the corporate tax is very efficient. I think we do need to 

make sure—and maybe this goes in your direction—that the way 

we treat our corporations is in line with the way other countries 

do so that we don’t give them a competitive disadvantage. So I 

agree with you there. 

I would mention, by the way, if we are talking about taxes, one 

of the things we do is give a very strong preference for borrowing 

in our society, both at the personal level and at the corporate level. 

Mr. RYAN. That is the negative in your view. 

Mr. BAILY. So maybe we could do a deal with the corporations. 

We will cut their corporate tax rate but maybe they pay a little 

more tax on interest and level that playing field a little bit. 

Mr. RYAN. Should we go to a territorial system? Most of the rest 

of the world is. Do you think worldwide, hamstring us, we ought 

to go territorial? 

Mr. BAILY. I think it is certainly worth looking at. I am not a 

tax expert at that level, I am afraid, but I think it is something 

that can be considered, yes. 

Mr. RYAN. Do the rest of you agree that our bias in favor of debt 

is a distortion that ought to be remedied? What is—you can just 

give a quick answer. 
55 

Mr. ZANDI. Yes. 

Mr. BAILY. Yes. 

Mr. TAYLOR. I do. 

Mr. RYAN. Thank you. 

I want to give other people time. Thank you very much. 

Chairman SPRATT. At this particular point in time I recognize 

Mr. Becerra. 

Mr. BECERRA. Thank you, Mr. Chairman; and thank you, gentlemen, for your testimony. And recognizing our time is short, let me 

go to Dr. Zandi and ask a quick question. 

Dr. Zandi, when you were an economic adviser for then-Presidential candidate John McCain, Senator McCain, in his Presidential campaign, you and others who were advising him economically, did you foresee at that point back in 2007, 2008, the depths 

and the grip of this economic—great recession, I guess you would 

call it at this stage, that we are now trying to escape? 

Mr. ZANDI. No, I can’t say that I did, no. 

Mr. BECERRA. And could you have foreseen the economic consequences that we now find ourselves in as we try to escape the 

grips of this great recession? 

Mr. ZANDI. I am less surprised at how difficult it is for the recovery to get going, because this was a very, very severe shock with 

enormous implications. So it is not surprising to me that this is a 

weak recovery. 

Mr. BECERRA. And there are always the Scrooges and the folks 

who say America has got the glass half empty these days, the pessimists that won’t accept some good news. And while we are still 

in the midst of this great recession, the fact is over the last 5 to 

6 months we have created about 1 million new jobs in this country. 

Compare that to the last month that George Bush was in office, 

where in that 1 month of January, 2009, we lost close to 800,000 

jobs, big turnaround. 

Obviously, we have a long way to go. And you mentioned, as the 

chairman in his remarks mentioned, that Chairman Bernanke has 

mentioned, that we need to continue to make sure we can climb out 

of this dark hole and that if we act too quickly to squeeze ourselves 

out of this fiscal deficit that we face this year and this national 

debt that we are facing that we might actually squeeze out the economic recovery. 

And yesterday, in testimony before the President’s fiscal commission, I believe Mr. Elmendorf, Doug Elmendorf of the Congressional 

Budget Office, said something about the same as what you just 

said. He essentially said—again, speaking your economic language—‘‘There is no intrinsic contradiction between providing additional fiscal stimulus today while the unemployment rate is high 

and many factories and offices are underused and imposing fiscal 

restraint several years from now when output and employment will 

probably be close to their potential.’’ 

Is what Mr. Elmendorf said consistent with what you were saying? 

Mr. ZANDI. Exactly. I wish I could say it as nicely as he just said 

it. 

Mr. BECERRA. I think I prefer the way you said it. It is more like 

plain English. 
56 

Mr. ZANDI. I think that is entirely correct, yes. 

Mr. BECERRA. Dr. Baily, quick question for you as well. 

You mentioned in your testimony that we had to be very careful 

how we go about trying to get ourselves out of this black hole, but 

my sense was that you also believe that fiscal stimulus, where we 

try to help that recovery accelerate, is essential, although we have 

to be careful that it is modest enough to give us a chance to make 

sure that we can do the fiscally responsible thing with our budgets 

into the future. 

Mr. BAILY. I think it would be helpful. I think, as Mark said, a 

lot of people are living off unemployment insurance, and I think it 

would be helpful to give them some consumption—some income so 

they can keep consuming. 

And on the States and localities that are in just terrible budget 

situation—now, you know, obviously, we want our States and localities to be disciplined over the long run, but I think right now none 

of them foresaw this any more than the rest of us did, and it is 

a good thing to help them. 

Mr. BECERRA. Don’t cut off the swimmer’s ability to swim out of 

the pond before it is too late and drown. 

Mr. BAILY. Exactly. Now, you do have to send, I think, the right 

signal that you really are thinking substantively, and I applaud the 

commission and I hope that it is effective and I hope its recommendations result in changes in policy, but we do need to signal 

both ourselves and the rest of the world that we are going to do 

something about these huge deficits. 

Mr. BECERRA. Thank you. 

And, Dr. Taylor, before I run out of time, first, can you convey 

back to Stanford our best wishes, tell them that we gave you some 

Stanford weather here in Washington, D.C., today. It is nice to 

know we have got someone from our alma mater here with us. 

I would love if you—and, unfortunately, my time is getting ready 

to expire, Mr. Chairman, but perhaps I can ask the doctor that he 

might give me his comments about the situation in Ireland, which 

my sense is tried to apply the brakes on any kind of stimulus and, 

in fact, went the other way, more along the lines that I think you 

talked about and that is to try to be fiscally responsible with our 

budget, and my understanding is things are pretty bad. 

I am going to real quickly just mention that Ireland’s downturn 

has been sharper than if the government had spent more to keep 

people working. Lacking stimulus money, the Irish economy shrank 

7.1 percent last year and remains in recession. Joblessness in the 

country is above 13 percent. The ranks of their long-term unemployed have more than doubled, and the budget went from surpluses just a few years ago in 2006 and 2007 to a staggering deficit 

of 14.3 percent of gross domestic product last year, and it continues 

to deteriorate. 

I would be interested to hear your comments. I don’t have time, 

but if you can go ahead and give me some comments on how you 

see the situation in Ireland I would very much appreciate that. 

Mr. TAYLOR. Just very quickly now? 

Mr. BECERRA. Well, I know I am out of time, but go right ahead. 

Mr. TAYLOR. I think when you look at Ireland you have to recognize where they were coming into this. It is like Portugal. It is like 
57 

Greece. High debt levels mainly because of an over-stimulus and so 

they are partly reacting to something that was so excessive. 

If you want to look at examples that are I think more helpful to 

the current situation, look at Poland. Poland is the only country in 

the entire European Union that didn’t even have a recession. They 

didn’t have a recession because they followed I think a sensible policy. 

Mr. BECERRA. But we did have a recession here, and while Poland may be a good example, Poland didn’t have a recession. We 

are in the depths of a great recession. 

Mr. TAYLOR. They didn’t have a recession because they followed 

these good policies. We had a recession I think in part—— 

Mr. BECERRA. But our problem is we probably didn’t follow those 

good policies because President Obama inherited an economy that 

was in the depths of a great recession. So while it may not be exactly like Ireland and it may not be exactly like Poland, I am interested in understanding, because my sense is for those who say we 

shouldn’t do economic stimulus are speaking much the way the 

Irish were speaking about how they would get out of their great 

recession, and as far as I can tell, they are still in theirs, and they 

are trying to fiscally constrain it. 

Mr. TAYLOR. What I am suggesting is that we don’t have more 

stimulus at this point. The idea you can trade off in stimulus now, 

catch up later, I think that is a fine-tuning approach that has 

failed many times in the past. 

What I think is most important if we get on with the business 

now of consolidation, it doesn’t have to be Draconian. The point has 

to be laid out clearly in an orderly way. I think that could bolster 

confidence, indicate that the United States Government is moving 

ahead on the thing that the American people are concerned about, 

and I think that would help the economy much more than another 

stimulus. 

Mr. BECERRA. Appreciate that. And if you have any comments on 

Ireland, I would love to hear them. 

Mr. ZANDI. Can I make one quick point on that? 

If you look at every European country that is going through fiscal 

austerity right now, their bond spreads have actually widened out. 

One interpretation of that, and I think it is a reasonable one, is 

that investors are nervous that the austerity is undermining their 

economy and therefore their ability to execute on these austerity 

plans. So I think that is increasingly good evidence that if you don’t 

get out of a weak economy you are never going to be able to address your long-term fiscal problems. 

Mr. BECERRA. To that point, I think the article I was reading 

from pointed out that the spread between Ireland’s bond—what it 

pays for bonds and Germany pays for bonds is about 3 percent. 

Mr. ZANDI. Right, it has widened out. 

Mr. BECERRA. It is tough for them to get any money unless they 

pay a whole bunch for it. 

I appreciate that very much, gentlemen. Thank you for your testimony. 

Chairman SPRATT. Mr. Scott. 

Mr. SCOTT. Thank you, Mr. Chairman. 
58 

We have been lectured by the other side about fiscal responsibility, and I think if can we just get that first chart up, this chart, 

the red is Republican administrations, blue is Democratic administrations. And you can see that we dug ourselves out of a ditch in 

1993 and put us into a surplus situation, such a surplus that it was 

not allowed to continue. We were headed toward paying off the national debt held by the public by 2008. 

Chairman Greenspan, when he testified in 2001, was talking 

about, in answer to questions, what would happen to the bond market when there are no government bonds, what would happen with 

interest rates. President Clinton had to veto Republican budgets all 

through that to make sure that that blue line wasn’t changed. If 

you wanted to know what would happen if he had not vetoed those 

bills, you can see President Bush signed those budgets and you see 

where we ended up in the ditch. 

The next chart, we see that the incredible thing is, notwithstanding the fact that during the Bush administration they overspent the budget about $1 trillion a year, they produced the worst 

job growth since the—goes back to the Great Depression. 
59 

Now, the attack on the Democrats is we have a big deficit, but 

we also know that we have—we need to make sure that the complaint is precise. The complaint is that we have a big deficit that 

is there because of the policies put into effect by the Bush administration and the Democratic administration has not dismantled the 

Bush policies quickly enough. That is the chart. Now, the fact is 

we made a deliberate choice not to build the deficit until we got 

the job situation fixed. 

And the other chart, we see where we were when—the red is the 

end of the Bush administration. We can see the blue, digging ourselves out of the ditch and beginning to create jobs. 
60 

Dr. Zandi, if we had had serious deficit reduction during the first 

year and a half of the Obama administration, what effect would 

that have had on jobs? And serious deficit reduction would mean, 

of course, increased taxes or reduced spending. 

Mr. ZANDI. Of course, that would be very counterproductive and 

be consistent with no policy response and the idea that we would 

still be in a downturn. 

Mr. SCOTT. In addition to the counterproductive effect of cutting 

spending and increasing taxes in the middle of a recession, what 

drag effect has there been because of cuts at the State level? How 

much have States cut their spending, thereby reducing jobs, that 

we have had to try to offset? 

Mr. ZANDI. If you look at it in the context of State and local government spending as a contribution to GDP growth, in an average 

year since World War II, State and local governments add about 

a quarter percentage point to GDP growth every year. Over the 

past year, they have subtracted from GDP growth by approximately 20-basis points, 2 percentage points. And if they don’t get 

any additional aid from the Federal Government, then over the 

coming year—of course, I have to do a number of assumptions—but 

that will be a negative contribution of somewhere around 35, 40 

basis points, .4 percentage points. So that is a swing from normal 

times of at least half a percentage point. 

Mr. SCOTT. Now, in terms of budget cuts, have the States not cut 

their budgets about $500 billion already? 

Mr. ZANDI. I don’t know the exact number, but they have clearly 

gone through some very significant budget cuts. 

Mr. SCOTT. On the order of magnitude about $500 billion? 

Mr. ZANDI. I think if you total it all the way back, in the hundreds of billions sounds about right to me. 

Mr. SCOTT. And localities have been doing the same thing? 

Mr. ZANDI. Yes, and I am including both State and local governments in those hundreds of billion of dollars, yes. 

Mr. SCOTT. Say again? 

Mr. ZANDI. The several hundred billion dollars would be both 

State and local together. 

Mr. SCOTT. Okay. And so the first several hundred billion dollars 

of stimulus, all that did was to catch the people that had been laid 

off by the localities? 

Mr. ZANDI. Exactly. If you take a look over the past year, the 

budget hole was about $150 billion for State and local together, and 

that is almost precisely what State and local governments got as 

part of the stimulus package. 

Mr. SCOTT. Dr. Baily, did you want to comment on the drag that 

States have caused and the necessity of the Federal Government 

to actually increase spending which has a detrimental effect on the 

budget? As soon as we get the jobs back, we will do the responsible 

thing and get the budget under control. Because that first chart 

showed we know how to do it, and we will do it, but we just can’t 

do it in the middle of a recession. Did you want to make a comment? 

Mr. BAILY. I think I agree with pretty much everything you said, 

and certainly I think it goes to the earlier discussion. When you see 

the stimulus and say, well, it didn’t prevent the recession from 
61 

happening, that is in part because States and localities were cutting so much employment that you were really just filling in the 

hole they were creating. So I think I agree with you very much on 

that. 

Going forward, I think dealing with the deficit is going to be 

tougher than it was during the Clinton years. It was plenty tough 

then, but we did get very strong economic growth, and we had not 

yet reached the sort of some of the pressures that come from the 

baby boom generation retiring. So I think it is going to be a tougher challenge down the road as we deal with the deficit. But on the 

points you made and that Mark made I agree with you completely. 

Mr. SCOTT. Well, people suggested that the Clinton administration was lucky because of the economic growth, but it is kind of 

paraphrasing that sports analogy, the more fiscally responsible we 

were, the luckier we got. 

Mr. BAILY. I think we were lucky, but I also think that the administration did the right things, and, you know, it was Congress 

as well as the administration. But I think Clinton—the general 

Clinton-Rubin policy was to try to allow markets to work but to get 

the budget back on track and to regulate responsibly, and I think 

those policies worked extraordinarily well. 

Mr. SCOTT. So we made our luck because we were fiscally responsible and we had that loaded cannon every time something—— 

Mr. BAILY. Exactly. 

Mr. SCOTT. We had a surplus that was sufficient to pay off the 

national debt. If this recession had occurred back in the Clinton 

years, we could have had the stimulus out of the surplus without 

having to borrow the money. 

Mr. BAILY. Exactly. 

Chairman SPRATT. Thank you, Mr. Scott. 

Mr. ETHERIDGE. 

Mr. ETHERIDGE. Thank you, Mr. Chairman. 

Let me thank these gentlemen this afternoon for being here. 

Early on, I was a small businessman long before I got into this 

business and understand something about balancing your books 

and keeping your books right. But, at the same time, there are 

times when you are required to make an investment, and I think 

you have to be prudent in how you make that investment if you 

want to grow. And if you are a businessperson and you continue 

to cut, you can’t get there, but you have got to have prudent investments. 

Dr. Zandi, let me ask you a question, because the economic recovery, many are saying, is still fragile. I think you have said that. 

All three of you have indicated that one way or another. 

Do you agree with the Federal Reserve Chairman Bernanke, as 

the chairman said earlier, when he testified at our last hearing 

that the danger of scaling back too soon may be far greater than 

some of the other things we could do if we want to keep this economy from really sliding into some more problems? 

Mr. ZANDI. Yes, I would agree with that. I think the odds are 

that if fiscal policymakers did nothing else that the economy would 

still probably get through this period without going back into recession. 
62 

But, having said that, I think the odds are uncomfortably high 

that I am wrong and that we would go back. And more importantly 

than that, if we do go back into recession, there is no good policy 

response. The Federal Reserve cannot respond effectively, and you 

won’t be able to effectively respond because at that point the deficit 

will be ballooning out. 

So, given that, I think it is prudent risk management to err on 

the side of doing too much rather than too little over the next 6 

to 12 months. 

Mr. ETHERIDGE. Let me ask one additional question along that 

line. Because we have been struggling here, as you well know, for 

several months on Federal medical assistance percentages going to 

the States. We have talked with our Governor, and I think something like 34 Governors have included it in their budgets, and in 

North Carolina that is about half a billion dollars. It is a substantial amount. If it doesn’t flow, then they will be cutting education 

and a host of other things. 

And many States are really suffering from unemployment. My 

home State is higher than the national averages—— 

Can you speak for just a moment about the importance of this 

kind of aid, how this blends with the other—you touched on it 

some—and if it continues to decline, what effect it will have on the 

overall deficit in the short term as well as in the long term as we 

are trying to dig out of this hole? 

Mr. ZANDI. Well, I think that the need for helping—the Federal 

Government to help State and local governments through this mess 

next fiscal year is very important for the reasons we have discussed. The most efficient way I think to do that is to help them 

with the Medicaid program, the costs related to FMAP; and if the 

Federal Government is able to provide help for FMAP say for the 

second half of fiscal year 2011, that would free up resources that 

will allow them to forestall more serious job cuts, program cuts, 

and tax increases. They will have to do it anyway, because their 

budget hole is that large and there is no way the Federal Government is going to help them to the degree to forestall it. It will be 

significant but at least it will forestall the most Draconian cutting. 

Mr. ETHERIDGE. Let me ask one additional question or maybe 

two if we can get them in in time. 

Congress passed—I introduced a piece of legislation and the administration worked on it, we got it through—called the HIRE Act 

to create credit for people hiring people who are unemployed. Is it 

too early to know if this is really working? 

I have talked with some people in the last few days. One company has already hired 50 people. Now, whether or not they would 

have hired them or not, I don’t know, but they are going to get the 

tax credit. So that is an advantage. I would be interested in your 

thought on that. 

Mr. ZANDI. I think it is too early to evaluate that program based 

on macroeconomic data. I think right now it is mostly anecdotal. 

I do think as you approach the deadline, which I believe is November, December, I think you will start to see—in the next few 

months, we should see a little bit more take-up. But, you know, so 

far, the macroeconomic data is not sufficient to be able to evaluate 

it. 
63 

Mr. ETHERIDGE. Dr. Taylor, let me ask you one question. Because 

you didn’t talk about the recession or how deep it was. What you 

talked about was panic. I would be interested in your definition of 

panic. 

Mr. TAYLOR. I was referring to the period mainly in the fall of 

2008 when the financial markets froze up, equity prices fell by 30 

percent in 2 or 3 weeks, and that really went around the world, actually, equity prices. It was a major hit to the world economy in 

that particular period. So that is what I mean by the panic. The 

crisis is sort of a longer period beginning—— 

Mr. ETHERIDGE. Right. During that panic period, as it was descending, we lost about $17 trillion in value of retirement income, 

housing, et cetera, 8 million jobs, and all these things were a part 

of that panic piece—— 

Mr. TAYLOR. Part of the panic. And I think without that panic 

we obviously were going into a recession anyway, but that is really 

what made this the great recession. That panic was really a terrible shock. And I think, in my looking at the numbers, people realized were stabilizing by December of 2008, and if you look at the 

monthly data, you see investment beginning to recover by January. 

So that panic was very important, and so in my analysis of this 

whole great recession, that is why I focused on it. 

Mr. ETHERIDGE. I am not an economist. I just have enough training in 101 to know that the markets are doing some of the same 

things all over again, I have noticed over the last several days, and 

people are getting nervous all over again. 

Thank you, Mr. Chairman. I yield back. 

Chairman SPRATT. Thank you, Mr. Etheridge. 

Mr. RYAn has further questions, and Mr. Hensarling I believe is 

on his way. Mr. Ryan. 

Mr. RYAN. I am just curious. I would like to ask each of you. Sovereign debt is now becoming a new kind of toxic asset, I suppose. 

Give us your take on the risk of contagion washing up on our 

shores with respect to Europe. Do you think the European bailout 

program, whatever you want to call that, is going to work and what 

is the risk of default among the PIGS, Greece? And if a default 

does occur, what do you think happens to our bond market? 

Dr. Baily and going over, why don’t we just do that? 

Mr. BAILY. It is very hard to see Greece getting out of its mess 

without some of kind of restructuring, which means to say a partial 

default on those bonds. If you look at—I think John mentioned in 

his testimony there are some fundamental structural problems in 

the euro, that some of the countries are just not competitive. Germany got its costs under control and became competitive, and 

Greece and some of the other countries did not. And so that puts 

you in a bind. Because if you are going to repay that debt, basically 

you have got to transfer money to the other countries in Europe. 

The only way to transfer the money is to make the money by exporting, and if you are not competitive exporting, you are really 

locked up. 

So I think they are going to have to restructure. I think there 

is a threat that the euro could unravel, although I think it is very 

unlikely. I don’t think Greece and Spain and Portugal would leave 
64 

the euro, because they would see their own interest rates rise so 

much that they don’t want to. 

A country that in a sense might be thinking about it is Germany, 

because they are, in a sense, carrying the weight of the other countries. But then again I don’t think Germany will because Europe 

is a big export market, and so I think it will hold together, but it 

is proving to be fairly costly. 

Your question was, will this wash up on our shores? Well, it has 

washed up on our shores. Every time there was sort of a new story 

about problems in Europe our stock market lost a couple hundred 

points and that foments some of the concerns and panics here, and 

it is amazing how these financial crises do spread around the 

world. I mean, some of it is also interdependent in trade but also 

a lot of the same companies operate, a lot of the banks operate 

across borders. 

You would sort of think, well, Greece is such a tiny country and 

it is only a fraction of California, never mind the United States, but 

it does seem to create an unsettled feeling in the markets that 

could affect us. 

I think the blessing in disguise for Greece is that it maybe has 

given all of us a lesson in that we can’t just borrow and borrow and 

borrow forever, that at some point we are going to have to deal 

with deficits. As I say, not necessarily today but down the road we 

have to do that. 

Mr. ZANDI. My sense is that the European policymakers will contain the crisis, that what they have done so far is really quite impressive and they still have room to maneuver. The trillion dollar 

package from the EU IMF is equal to all of the sovereign debt of 

Greece, Portugal, Spain, Ireland that will mature over the next 5 

years. So I don’t think there is any real possibility of a default anytime in that period of time. 

And the ECB, European Central Bank, is engaged in purchases 

of sovereign debt. Mostly, it appears they are buying Greek and 

Portuguese debt. They can expand that out. 

Mr. RYAN. How do they sterilize? They claim to be sterilizing. 

They are not easing. How do they do that? 

Mr. ZANDI. They are issuing securities into the marketplace to 

drain the liquidity. So they are buying the bonds that is providing 

liquidity and they are issuing other securities. 

Mr. RYAN. And the market is working for that? 

Mr. ZANDI. So far, so good. The ECB target rate is still 1 percent, 

and they have been able to target that pretty well, but they could 

decide if things start to weaken to not sterilize, right? They have 

room to maneuver there, too, and the European economy is roughly 

the same size as the U.S. economy, the Federal Reserve about $300 

billion worth of Treasury bonds, when they were credit easing, put 

it in the same kind of ballpark, they could buy up $300 billion. 

Now, so far, the impact on our economy has been meaningful, but 

it is modest. There is positive and there is negative. The negative, 

obviously, is the equity market. 

The bond market has been a positive, right? Long-term interest 

rates have come in. The 10-year Treasury yield is below 3 percent. 

There is a flight to quality. People still believe, and rightfully so, 

that we are the AAA credit on the planet. We have the strongest 
65 

economy. We have a large economy. We have managed our affairs 

extraordinarily well over centuries. So I think they trust us and I 

think with good reason. So I think we are the beneficiaries and we 

have latitude in the near term to continue to borrow to help finance and support our economy. 

Mr. TAYLOR. I do think Greece will have to restructure their 

debt. I think it can be done in a pretty orderly way, so I wouldn’t 

call it default or something that would shock the markets. Their 

foreign bonds are all denominated in euros. That is a fairly 

straightforward operation. Some of the debt is issued under Greek 

law, some under English law. So it is pretty simple to do. 

I think it would have been much better if they did it earlier because then we wouldn’t have had to have this huge bailout package 

which creates its own worries down the road because other countries may get into the same situation. 

I think the ECB’s intervention is quite worrisome from the perspective of monetary policy. They are actually buying distressed 

debt. Central banks are supposed to be insuring the money supply 

and interest rates, keeping things stable. So this is taking them 

into a really new phase. They didn’t want to do it. I think they 

want to get out of it as fast as they can. 

I think I agree with Mark, and I put it this way. Contagion can 

be through markets but it can also be through policy. So often bad 

policy is contagious. It spreads across countries. It seems to me 

that what we might be finding here is the reaction in Europe to 

Greece is spreading. At that G-20 meeting where the United States 

was told a few things, I think is beneficial for us as well because 

that feels like a contagion of some better policies. 

Mr. RYAN. Thank you. 

I see we have got somebody back. 

Chairman SPRATT. I recognize Mr. Hensarling. 

Mr. HENSARLING. Thank you, Mr. Chairman. I am glad that you 

have reconvened us. I wish it would be to take up a budget, but 

we haven’t lost hope yet. Maybe that day will occur sometime this 

year. 

I see that at least two of the three of our panelists have been 

published in the Wall Street Journal today. I am not sure what to 

accord this honor to. And, Dr. Zandi, I haven’t read one of your opeds recently, but I did read your book, and it was helpful. 

Mr. ZANDI. Thank you. 

Mr. HENSARLING. It was helpful. I appreciate that. 

Mr. ZANDI. I am going to start working harder. 

Mr. HENSARLING. Apparently, you need to work a little harder 

here. 

Dr. Taylor, before I ask you about your editorial, I am actually 

going to ask you if you had read one by Dr. Meltzer that appeared 

in the Wall Street Journal yesterday on why Obamanomics has 

failed. He seems to take up a theme that you have about a kind 

of seed of uncertainty that had been sowed due to major policy initiatives. He states in his editorial piece, ‘‘Second, the administration and Congress have through their deeds and work heightened 

uncertainty about the economic future. High uncertainty is the 

enemy of investment and growth.’’ 
66 

I assume that you agree with that; and, if so, could you go into 

greater detail in what you base your thesis on that uncertainty is 

part of what is keeping back our economic growth? 

Mr. TAYLOR. Sure, and I do agree with Allan Meltzer in that 

piece. The uncertainty is due to several factors. It is just the depth 

that I mentioned is coming in a way we have never seen it before. 

Look, in our history this is well beyond, many times, what we have 

seen before. So that, if you like, new situation creates uncertainty. 

People don’t know how it is going to get resolved. 

There is an inconsistency. You can’t have all that debt created 

and have the inflation forecast the things that people are predicting. So there is an inconsistency that has to be resolved, and 

people don’t know how it is going to be resolved. That is an inherent uncertainty. 

I think also you referred to my piece in the Journal today. That 

highlights another form of uncertainty, a massive change in how 

our financial institutions will be regulated, their relationship with 

government, a very complicated set of changes which people don’t 

know exactly how it is going to work. It is a very complex bill. 

Mr. HENSARLING. Including one of the authors of the legislation, 

Senator Dodd. You may have read his quote in the newspaper. 

Mr. TAYLOR. I missed that. 

But I think if you just go down the line you see this great uncertainty, plus globally you see situations like the sovereign debt that 

Congressman Ryan was referring to. We haven’t seen that for a 

long time. I think that is affecting our markets. I say there is a 

lot of evidence for this. It is hard to measure. I don’t want to say 

we have great models and theories of it, but I have never seen it 

like this before. It is very concerning to me. 

Mr. HENSARLING. The chairman, the ranking member, and myself all serve on the President’s Fiscal Responsibility Commission. 

We had a session yesterday and heard from Dr. Elmendorf. There 

still appears to be a continuing debate within the Commission on 

whether or not it is possible to both lay out a plan of fiscal sustainability for the long term while we debate government stimulus in 

the short term. I myself have strong opinions that the stimulus has 

failed, and I think it is a bad policy. 

But, setting that aside—and I know that Chairman Bernanke’s 

name has been invoked here. I believe he has said something along 

the lines of how important it would be to job growth today to lay 

out a plan of fiscal sustainability. And so do you have an opinion 

whether these are competing goals, complementary goals? Can 

Congress or this Commission, in specific, walk and chew gum at 

the same time? 

Mr. TAYLOR. I guess I would say it would be tremendously valuable for confidence if a plan could be laid out, a credible plan, to 

keep the debt from exploding, which is where it is going right now, 

to keep it at a low level, to try to get it down. 

There is not really an inconsistency. I think I would prefer if that 

path began right now with the budget you are starting to deliberate with, but even if that is up a little bit, then you can lay out 

the plan. So there is no—there is so much advantage—I used to do 

simulations of models that showed that you can get fiscal stimulus 

from having a good plan laid out for consolidation in the future. It 
67 

builds confidence. It affects interest rates in a healthy way. So I 

think it would be beneficial to the economy, plus it would have the 

added advantage of showing that government is really doing something that is hard to do. 

Mr. HENSARLING. In the absence of other members, if the chairman might indulge me one more question—I didn’t hear the word 

‘‘no’’—in your piece, Dr. Taylor, you mentioned that I believe by far 

the most significant error of omission in this bill—referring to the 

financial regulatory markets bill—is the failure to reform Fannie 

Mae and Freddie Mac, the government-sponsored enterprises. Can 

you elaborate on just how significant an omission this is? And by 

lack of reform, to what extent does that contribute to the uncertainty that in turn contributes to our high unemployment rate? 

Mr. TAYLOR. Well, it is an omission because if you would like the 

reform bill to address the financial crisis and, therefore, deal with 

it, that was one of the big factors in the financial crisis, the encouragement by Fannie and Freddie to buy risky mortgages, which accentuated the housing boom. So in terms of addressing the financial crisis, it was essential to have that in there. 

Also, by not having it in there, if the bill actually goes through 

without that, it will be very hard to get it later. Because, as you 

know, comprehensive reform has the advantage of balancing off different interests, and so that balancing is now going to be much 

harder to do if Fannie and Freddie want to build a future. 

With respect to the uncertainty, yes, the housing market isn’t 

moving along as much as you think. I think Mark Zandi’s referred 

to that. I think there is uncertainty about what the Fed has done, 

what Fannie and Freddie are going to do in the future. So some 

clarification of that would be I think very valuable for the same 

reasons I mentioned. 

Mr. HENSARLING. Thank you. 

Thank you, Mr. Chairman. 

Chairman SPRATT. Gentlemen, thank you very much for your testimony today. We have got several votes coming up on the floor. We 

could continue this fruitful conversation for the rest of the afternoon, but thank you for coming. Thanks for your clarity and forbearance and your answers. We very much appreciate it, and we 

will be calling upon you in the future, I am sure. Thank you again. 

The hearing stands adjourned. 

[Questions submitted by Mr. Aderholt and their responses follow:] 

QUESTIONS SUBMITTED TO WITNESSES BY HON. ROBERT B. ADERHOLT, A

REPRESENTATIVE IN CONGRESS FROM THE STATE OF ALABAMA

DR. BAILY

1. In your testimony, you state that the financial crisis was caused by a ‘‘perfect 

storm’’ of problems, one of which was regulator errors. Today, I hear from many community bankers in my district that overzealous regulators are hurting their ability 

to loan money to their customers. Do you believe such knee-jerk reactions as over-regulating may hurt the recovery more than it will help? 

As discussed in my testimony, poor decisions by regulators did contribute to the 

financial crisis. Regulators and credit rating agencies were caught up in the same 

spirit of excessive risk taking that was endemic amongst financial institutions and 

ordinary market participants alike. In addition, government regulators failed to adequately oversee Fannie Mae and Freddie Mac, whose behavior did contribute to the 
68 

development of a housing bubble, an important—but not singular—cause of the crisis. 

However, the mistakes made by regulators were often a result of a systematic decline in the premium placed on risk following 25 years of strong performance in the 

financial sector and the belief that the business cycle had effectively vanished. All 

sorts of investors and financial institutions learned that financial risks were profitable and became less risk averse. Regulators remained more risk averse than the 

financial system writ large, but in times of excessive risk taking, regulators that are 

more conservative than the average investor are unlikely to provide adequate oversight. As a result, bubbles were allowed to pervade the financial system, in housing 

and other sectors. 

The number of bank failures continues to remain high, with 118 in 2010 alone 

(through August 20), most of which are small banks. In addition, 775 banks continue to be classified as problem banks by the FDIC. These banks continue to have 

bad assets on their balance sheets and regulators can and should play an important 

role in ensuring that community banks are brought back to health responsibly, 

without returning to excessively risky lending standards that characterized the period immediately preceding the crisis. 

During the boom years regulators erred in the direction of not being strict enough 

and in not requiring more stringent lending standards. However, the pendulum may 

have swung back too far in the other direction as banks are discouraged from making loans even when the prospects for repayment are good, if rather risky. It is important that we find the right balance of protecting depositors and taxpayers while 

encouraging economic growth. 

2. In the question and answers with Congressman Becerra, you noted that ‘‘the 

right signal does have to be sent’’ to the world that the United States is serious in 

its commitment to put our fiscal house in order. Is the House of Representatives failing to pass a budget for the first time in 35 years the signal we want to send to the 

world regarding our fiscal stability? Do you see any negative consequences resulting 

from the failure of passing a budget for fiscal year 2011? 

The failure to pass a budget is a problem and does not send the right signal to 

the world that the United States government can manage its fiscal affairs. I will 

not comment on who is to blame for the lack of agreement on the budget. In order 

to balance the federal budget over the next ten years it will be necessary to both 

increase revenues and curb spending. I hope that Republicans and Democrats will 

recognize this and work together to restore our fiscal integrity. 

3. The Constitution does not give spending authority to a Presidentially-appointed 

Commission; it gives it to elected officials who comprise the House of Representatives 

and who must face the voters every two years to be re-elected. Isn’t the refusal to pass 

a budget a direct refusal to do the job House Members are elected to do? 

It is my understanding that the Commission will make recommendations and 

then Congress will act on those suggestions, while of course retaining its constitutional powers. Unfortunately the budget process has become mired in politics, a politics that is not grounded in reality. Any political leader that suggests raising taxes 

is vilified. Any political leader who suggests serious efforts to curb federal health 

spending or proposes measures to balance the long term Social Security budget is 

also subject to attack. Until Congress overcomes this poisonous atmosphere it will 

be difficult to achieve budget agreements. The Presidential Commission is a brave 

effort to cut through the politics and I hope that its recommendations can form the 

basis for a more constructive bipartisan dialog aimed at solving the terrible fiscal 

crisis we face. 

DR. TAYLOR

1. As you know, the House of Representatives recently passed the conference committee version of the Financial Reform Bill. Unfortunately, this bill does little to reform government sponsored enterprises (GSEs) such as Fannie Mae and Freddie 

Mac. Does failing to address GSE reform in the financial reform bill leave the economy and financial sector exposed to another possible meltdown? 

Failing to reform Fannie Mae and Freddie Mac leaves the economy and the financial sector in a more risky situation. Fannie Mae and Freddie Mac now sit with an 

estimated several hundred dollar cost to taxpayers and no path to resolution. Effectively their obligations add to the federal debt which is already starting to reach 

unsustainable levels. 

These agencies were encouraged to expand and buy securities many of which were 

backed by mortgages that were very risky. Five years ago legislation, such as the 

Federal Housing Enterprise Regulatory Reform Act of 2005, was proposed to control 
69 

these excesses, but it was not passed into law. These actions of these agencies 

should be added to the list of government interventions that were part of the problem leading to the financial crisis. Without reform the same series of events could 

occur again. 

Unfortunately, neither the conference committee report nor the final Dodd-Frank 

financial legislation dealt with Fannie Mae and Freddie Mac, so reform is still needed. Doing so outside of that broader reform effort will be very difficult, but it is essential to get started. 

DR. ZANDI

1. You noted that Congress must pivot to the ‘‘long-term fiscal situation once the 

recovery is complete’’. What policies would create a ‘‘long-term fiscal situation’’ that 

is conducive to economic growth and leaves future generations of Americans with a 

fiscally secure country? Do you prefer cutting spending or tax increases? 

To ensure the nation’s long-term fiscal sustainability, policymakers should work 

to reduce the nation’s cyclically adjusted federal budget deficit to GDP ratio to no 

more than 3% by fiscal year 2021. The current cyclical adjusted deficit to GDP ratio 

is almost 6%. 

To accomplish this objective will require both federal government spending cuts 

and tax increases. I would prefer that the majority of the required deficit reduction 

be done through spending cuts; something close to 2⁄3 spending cuts and 1⁄3 tax increases would be a reasonable goal. Based on an assessment of previous fiscal austerity efforts here in the U.S. and overseas suggests that government spending cuts 

rather than tax increases results in better longer-term economic performance. 

With regard to spending restraint, a good first step would be address the current 

short-falls in the nation’s Social Security system. This is a well-defined problem that 

if addressed could result in significant deficit reduction. With regard to tax increases, a good first step would be to cap the amount of tax deductions to some percent of taxpayers’ total tax liability. This too would contribute significantly to deficit 

reduction. Taken together and fully implemented by FY 2014, these actions would 

go a long way to obtaining the goal of a 3% cyclically adjusted deficit to GDP ratio 

by 2021. 

It is likely that policymakers will eventually need to do even more to address our 

longer-term fiscal problems as the large baby-boomer generation retires and uses 

the entitlement programs more intensively. To do this, growth in the costs of the 

Medicare and Medicaid programs will likely have to addressed. Comprehensive tax 

reform will also be necessary given that the nation’s current tax system is complex, 

opaque, unfair, and is an impediment to strong long-term economic growth. 

Returning the nation to fiscal sustainability will not be easy, but it is very doable, 

and of course we have no choice but to do it. 

[Whereupon, at 2:48 p.m., the committee was adjourned.] 

Æ