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I agreed with Martin Wolf in late 2008 and early 2009 and agree with
him today. The stimulus package was too small — really only $537
billion with a less productive $250 billion tax cut added on to
comfort the few Republicans who supported the package. Michael

Obama was too cautious in fearful times
By Martin Wolf
Published: August 31 2010 22:48 | Last updated: August 31 2010 22:48

Suppose that the US presidential election of 1932 had, in fact, taken
place in 1930, at an early stage in the Great Depression. Suppose,
too, that Franklin Delano Roosevelt had won then, though not by the
landslide of 1932. How different subsequent events might have been.
The president might have watched helplessly as output and employment
collapsed. The decades of Democratic dominance might not have happened.

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On such chances the wheel of history turns. But this time was
different: the crisis brought Barack Obama to power close to the
beginning of the economic collapse. I (among others) then argued that
policy needed to be hugely aggressive. Alas, it was not. I noted on
February 4 2009, at the beginning of the new presidency: “Instead of
an overwhelming fiscal stimulus, what is emerging is too small, too
wasteful and too ill-focused.” A week later, I asked: “Has Barack
Obama’s presidency already failed? In normal times, this would be a
ludicrous question. But these are not normal times. They are times of
great danger. Today, the new US administration can disown
responsibility for its inheritance; tomorrow, it will own it. Today,
it can offer solutions; tomorrow it will have become the problem.
Today, it is in control of events; tomorrow, events will take control
of it. Doing too little is now far riskier than doing too much.” This
was right.

The direction of policy was not wrong: policymakers – though not all
economists – had learnt a great deal from the 1930s. Sensible people
knew that aggressive monetary and fiscal expansion was needed,
together with reconstruction of the financial sector.

But, as Larry Summers, Mr Obama’s chief economic adviser, had said:
“When markets overshoot, policymakers must overshoot too”.
Unfortunately, the administration failed to follow his excellent
advice. This has allowed opponents to claim that policy has been
ineffective when it has merely been inadequate.

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In consequence, the administration has lost credibility with the
public and the chances of a renewed fiscal expansion have disappeared.
With the Federal Reserve cautious, too, the likelihood of a lengthy
period of weak growth and heavy joblessness is high. So, too, are the
chances of domestic and global political friction.

True, the idea that the policies adopted in the last few months of the
Bush administration and the first months of this one were far better
than nothing is weirdly controversial in the US. A recent paper by
Alan Blinder, former vice-chairman of the Fed, and Mark Zandi of
Moody’s argues that such critics are wrong. They use a standard macro-
economic model to assess what would have happened without any
intervention, without the financial interventions (including monetary
policy) and without the fiscal action. They conclude that the peak to
trough decline in gross domestic product would have been close to 12
per cent with no policy response, compared to an actual decline of
just 4 per cent (see chart). Similarly, the unemployment rate would
have peaked at 16.5 per cent, instead of the actual 10 per cent. The
bigger collapse would also have meant a fiscal deficit of $2,600bn in
fiscal year 2011. The outcome is also disastrous with the modest
fiscal response but no financial policy response. It is a little
better the other way round.


The implication that the modest stimulus package of February 2009 – a
mere 5.7 per cent of 2009 GDP, spread over several years – made a
positive contribution is supported by the analysis of the
Congressional Budget Office: it argues that in 2010, US GDP will be
between 1.5 per cent and 4.1 per cent higher and the unemployment rate
between 0.7 and 1.8 percentage points lower, as a result of the package.

Panglossians who believe the private economy is always in equilibrium,
unless governments intervene, disagree. I wish there were some way to
run this experiment without hurting hundreds of millions of people.
But I find the idea that allowing the collapse of much of the
financial system, avoiding unconventional monetary policy and
struggling to close the fiscal deficit would have been consistent with
a more rapid and sustained recovery quite bizarre.

A fascinating perspective does come, however, from comparisons with
what happened in other advanced countries. The recession in US output
(and so demand) has been relatively small, but the decline in
employment has been exceptionally large, as a result of an
extraordinary surge in US productivity (see charts). This contrast
between what would happen to output and what would happen to
employment was missed in the initial Congressional Budget Office
analysis of the stimulus.

Since the US was the epicentre of the financial crisis, the relatively
small decline in output is remarkable. Moreover, since fiscal and
monetary stimuli bear directly on demand and output, not jobs, this is
a policy success. At the same time, the enthusiasm with which US
managers laid off workers is also extraordinary. No doubt, some of
this is due to the collapse in construction. But some of it must be
due to the ease with which US companies can lay off workers and the
incentives for managers to maintain profits in a downturn at the
expense of jobs.

Debate is emerging on how much of the surge in unemployment is
structural. My answer, from European experience, is that one way to
ensure it becomes structural is to let it linger. In the short run,
the simplest way to prevent that from happening is to expand demand
and so output. Since there is huge slack in the labour market, not the
slightest threat of inflation – far more a risk of deflation – and no
constraint from bond or foreign exchange markets on further monetary
and fiscal stimulus, these are the policies that have to be pursued.
Yet, alas, the Fed seems to have decided to fall asleep and the
administration has lost the initiative.

So what is going to happen? I assume that, after the midterm
elections, resurgent Republicans will offer new tax cuts and ignore
the fiscal deficits. They will pretend that this has nothing to do
with any reviled stimulus, though it is much the same thing –
increasing fiscal deficits, thereby offsetting private frugality. That
would put the administration on the spot. It would have to choose
between vetoing the tax cuts and accepting them, so allowing the
Republicans to get the credit for their “yacht and mansion-led”
recovery. Any recovery is better than none. But it could have been
much better than this. Those who were cautious when they should have
been bold will pay a big price.

martin.wolf@ft.com