The Economic Outlook for the Next U.S. Administration: A Faculty & Alumni Panel Discussion

Some fifty Berkeley alumni and Economics faculty gathered recently in a Goldman Sachs conference room to discuss the economic outlook for the next U.S. administration-a lunchtime event planned months ago, but which became particularly urgent and timely in the wake of the housing market meltdown and volatile stock markets.

Google's chief economist and UC Berkeley professor Hal Varian, moderated the event, a special discussion bringing faculty engaged in cutting-edge research together with knowledgeable alumni and friends.

Varian-who is on faculty in the Economics Department, the Haas School of Business and the School of Information-kicked off the lively afternoon with some humor: A hiker slips off the trail, Varian told the gathering, and down a precipice. Clutching a tree branch, the hiker calls out for help. A voice comes from the sky, replying that help is on the way, but only if the man has faith and lets go of the branch. The man pauses, and asks: "Is there anybody else up there?"

The hiker's apprehension, Varian noted, might describe the mood of many watching the national and international economic picture in its recent tumult. Indeed, each faculty presentation during the roundtable event-covering monetary policy, fiscal policy and the international economic outlook-was an up-to-the-minute analysis of highly dynamic market and policy developments.

Professor Christina Romer started off the afternoon with a presentation about monetary policy. Last summer is when the markets began to unravel, she said, housing prices began to plummet and big banking institutions inched closer to insolvency as mortgage-backed securities became unsafe. Financial markets stopped lending to one another.

"The Federal Reserve and the Treasury have come to the rescue," Romer noted. "Extraordinary things have been done to get cash into the commercial system. A buffet of new programs was set up to get funds out there so banks have a way to lend."

In recent years, said Romer, the nation's monetary policy has moved away from the excesses of the 1970s. Policy has been moderate and well tempered. Economists are also better at forecasting, enabling the Federal Reserve to counteract what they see coming on the horizon. Very recently, however, there were significant blind spots in that forecasting capacity.

"The trouble is, we're discovering we did well on broad, macro-economics indicators, but other things were brewing in the background that we were slow to realize," Romer noted. These things included technological innovation in financial markets. "Some really smart people have thought of creative ways to come up with new financial instruments, and deregulation allowed them to put new instruments to work. The downside is that we were exposed to a lot of vulnerability."

At this point a participant posed a question: What are we to draw from the extreme volatility of the markets? What can history tell us?

Romer is the Class of 1957 Professor of Economics. She teaches Berkeley's Introduction to Economics undergraduate course, and her research includes studying U.S. monetary policy from the Great Depression to the present. She responded to the question while bringing up a graphic on a display screen behind her. In 1929 there was an immediate drop in new car registrations as a response to the crash. The same has taken place today. Durable good sales have gone down, as they did in 1929.

Economists, Romer noted, have looked long and hard at how that crash in asset markets translated into the economy.

"It's not the crash or the amount of wealth that is destroyed," she said. "In fact, it's that the volatility in stock price makes people uncertain, nervous. If you see this volatility, you spend less. You say, 'maybe now's not the time to buy a car at all.' All the measures of volatility are off the charts in this episode. And that can be devastating for consumer spending."

Looking back only as far as 2001, said the second presenter, Professor Alan Auerbach, we can see one of the biggest reasons the economy deteriorated. The tax cuts of that year were phased in over a period of a few years. Meanwhile, government spending went up, particularly in the areas of defense and homeland security.

"It's hard to find any area of the federal budget," Auerbach said, "where spending hasn't increased."

Expenditures are expected to continue to go up over the next 75 years, he added, even if the tax cuts of 2001 are renewed.

"There are enormous gaps between revenues and spending," he said. "We know something is going to happen, we just don't know what."

Auerbach is the Robert D. Burch Professor of Economics and Law as well as Director of the Robert D. Burch Center for Tax Policy and Public Finance. His current research focuses in part on the effects of tax cuts during the G.W. Bush presidency.

"You've described the 'bogey man' as this gap or misalignment between revenues and expenditures," a participant noted. "What is the most important consequence of that gap?"

One consequence, Auerbach noted, is that our nation will get into debt "to the point where people just aren't buying anymore. This is not something we've experienced before."

Professor Maurice Obstfeld, who delivered the final presentation, about the international economic policy outlook, cautioned that the next presidential administration must take care to resolve global imbalances and avoid the trade warfare that erupted during the Great Depression.

"The United States borrowed heavily to finance the economic boom that preceded the subprime mortgage crisis," Obstfeld told the group.

"We're about to see a change," said Obstfeld, Class of 1958 Professor of Economics and Director of the Center for International and Development Economic Research.

Commodity prices are falling at an astonishing rate, he added. Agricultural products, metals, energy and even livestock prices are way down.

"Emerging markets rely on those exports, and they are in big trouble," Obstfeld said. "Some are in meltdown and are approaching the (International Monetary Fund) for assistance."

International reserves are down as more capital is drawn out by industrialized nations.

"We are going into reverse. All of this has implications for financing the U.S. deficit and the dollar," he said.

A participant asked whether the recent rise in the dollar is an anomaly or a natural phenomenon.

The run-up of the dollar, Obstfeld replied, is a misguided demand for dollar liquidity. In the early 1990s the Japanese economy went into recession and the yen reached its highest level ever. Now the U.S. is in a similar bind.

"The fall in U.S. competitiveness will create tremendous pressures in Congress for a protectionist response, which will put the dollar at risk," Obstfeld added. Coordinated international cuts to interest rates could help, he said.

"The possibility of zero interest rates worries me," he added. "Policies that keep us away from a zero rate are good because with zero rates, people suspect that the Federal Reserve is out of ammunition."

The new administration, added Professor Romer, would also be wise to avoid cutting taxes as a way to increase consumer spending.

"I'm not sure that would work," she said. A better approach would be to invest in state infrastructure projects.

"Like the WPA (Roosevelt's Works Progress Administration)," noted a participant.

"Exactly. We need to do smart spending and public investments," Romer said. "It's cheap and people want jobs."

Moderator Hal Varian added that today's market conditions present a "once in a lifetime opportunity for economists. At least we hope it's once in a lifetime."