economy growing more quickly? the fact that fiscal policy has turned significantly more restrictive is the most important reason. the impulse from state and local governments that subtracted from growth earlier in the recovery has gone from negative to close to neutral. but this has been overwhelmed by the sharp shift in federal fiscal policy from mild restraint in 2012 to much greater restraint in 2013 ( exhibit 8 ). the increase in payroll tax rates, the rise in high income tax rates, the increase in taxes associated with the affordable care act, and now the sequester – if sustained – will result in fiscal drag of about 1 3 / 4 percentage points of gdp in 2013. 2 i view this as an unfortunate outcome. while the u. s. must put its public finances on a sustainable footing, this should be done in a manner that best achieves both our near - term and long - term objectives. in my opinion, a u. s. fiscal policy well - suited for the current set of circumstances would start with a very mild degree of restraint in the near - term that would credibly build to substantial consolidation over the next several decades. of course, it is for congress to judge what combination of tax increases and spending cuts should be undertaken to achieve this. nevertheless, the aging of our population and simple math suggest that entitlement reform would need to be part of such a plan. also, in an ideal world, fiscal policy would have broad - based bipartisan support. that would reduce uncertainty and reassure households and businesses that the u. s. was on a sustainable long - term path. instead, we have nearly the opposite : significant retrenchment in the near - term, but no credible action over the long - term, with partisan divisions and significant uncertainty about what will happen next. will the sequester, for example, be sustained or not? economic outlook looking at the outlook for 2013, i believe that growth in the first half will be sluggish as the fiscal contraction blunts the economy ’ s forward advance. while first quarter gdp growth will likely rebound to a 2 to 3 percent annualized rate following the dip in the fourth quarter, this will be due in large part to temporary factors. 3 before taking into account fiscal multipliers. this includes a modest boost from inventory investment following the substantial drag of the prior quarter, a recovery in farm output following last year ’ s drought, and less drag from defense outlays following the steep plunge of the fourth quarter. rebuilding

like. nonetheless, the estimates we have are informative and, again, a bit surprising. for example, for 2005, the latest year for which we have reasonably complete data, the developing economies as a group reported a gross capital inflow of $ 720 billion, more than double the inflow recorded for 1996 ( imf, 2007b ). so how did we end up with a switch to net outflows? in 2005, gross capital outflows from the developing economies totaled almost $ 1. 2 trillion – more than a tripling of the 1996 figure. thus, we see that the question we have to answer is not, " why has capital stopped flowing from the industrial countries to the developing economies? " in gross terms it has not stopped ; in fact, the flow has accelerated! the question instead is, " why are the developing economies investing so much in the industrial countries? " in a moment i will turn to several explanations for the recent pattern of capital flows. before doing that, however, we should take one additional insight from the gross figures : of the gross capital outflow from the developing economies in 2005, fully half reflects the further accumulation of foreign exchange reserves by the official sector. to be sure, a large part of this reserve accumulation was by the seventeen economies singled out earlier as large capital exporters ( imf, 2007c ). but the other 131 economies also recorded substantial reserve accumulations. once we put aside these official reserve flows, it turns out that, in 2005, private capital flowed, on net, from the industrial economies to the developing economies. why is capital flowing uphill? why does it matter? recognizing that the aggregate data lump together the very different circumstances of different economies, it is still true that, on the whole, net capital is flowing from the developing to the industrial world. economists sometimes refer to this phenomenon as capital flowing " uphill " because it appears to contradict economic logic ( see prasad, rajan, and subramanian, 2006 ). there are two elements of that logic. first, in developing economies, labor is generally much more available than capital ; accordingly, capital should in principle be more productive in these economies and should thus flow there from the relatively labor - scarce industrial countries. second, the relatively rapid income growth expected by developing economies as they catch up to industrial countries should provide them with incentives to borrow against their expected higher future incomes. these considerations lead economists to puzzle over both the net outflow of capital