[Economic Report of the President (2010)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 2

RESCUING THE ECONOMY
FROM THE GREAT RECESSION

The first and most fundamental task the Administration faced when
President Obama took office was to rescue an economy in freefall. In
November 2008, employment was declining at a rate of more than half a
million jobs per month, and credit markets were stretched almost to
the breaking point. As the economy entered 2009, the decline
accelerated, with job loss in January reaching almost three-
quarters of a million. The President responded by working with Congress
to take unprecedented actions. These steps, together with measures
taken by the Federal Reserve and other financial regulators, have
succeeded in stabilizing the economy and beginning the process of
healing a severely shaken economic and financial system. But much work
remains. With high unemployment and continued job losses, it is clear
that recovery must remain the key focus of 2010.

An Economy in Freefall

According to the National Bureau of Economic Research, the United
States entered a recession in December 2007. Unlike most postwar
recessions, this downturn was not caused by tight monetary policy
aimed at curbing inflation. Although economists will surely analyze
this downturn extensively in the years to come, there is widespread
consensus that its central precipitating factor was a boom and bust in
asset prices, especially house prices. The boom was fueled in part by
irresponsible and in some cases predatory lending practices, risky
investment strategies, faulty credit ratings, and lax regulation. When
the boom ended, the result was widespread defaults and crippling
blows to key financial institutions, magnifying the decline in house
prices and causing enormous spill overs to the remainder of the
economy.

The Run-Up to the Recession

The rise in house prices during the boom was remarkable. As Figure
2-1 shows, real house prices almost doubled between 1997 and 2006. By
2006, they were more than 50 percent above the highest level they had
reached in the 20th century.



Stock prices also rose rapidly. The Standard and Poor's (S&P) 500,
for example, rose 101 percent between its low in 2002 and its high in
2007. That rise, though dramatic, was not unprecedented. Indeed, in
the five years before its peak in March 2000, during the ``tech
bubble,'' the S&P 500 rose 205 percent, while the more technology-
focused NASDAQ index rose 506 percent.
The run-up in asset prices was associated with a surge in
construction and consumer spending. Residential construction rose
sharply as developers responded to the increase in housing demand.
From the fourth quarter of 2001 to the fourth quarter of 2005, the
residential investment component of real GDP rose at an average annual
rate of nearly 8 percent. Similarly, consumers responded to the
increases in the value of their assets by continuing to spend freely.
Saving rates, which had been declining since the early 1980s, fell to
about 2 percent during the two years before the recession.
This spending was facilitated by low interest rates and easy credit,
with household borrowing rising faster than incomes.

The Downturn

House prices began to drop in some markets in 2006, and then
nationally beginning in 2007. This process was gradual at first, with
prices measured using the Loan Performance house price index declining
just 3\1/2\ percent nationally between January and June 2007. Lenders
had lent aggressively during the boom, often providing mortgages whose
soundness hinged on continued house price appreciation. As a result,
the comparatively modest decline in house prices threatened large
losses on subprime residential mortgages (the riskiest class of
mortgages), as well as on the slightly higher-quality ``Alt-A''
mortgages. As the availability of mortgage credit tightened, the
downward pressure on real estate prices intensified. National house
prices declined 6 percent between June and December 2007.
The negative feedback between credit availability and the housing
market weighed on household and business confidence, restraining
consumer spending and business investment. Although residential
construction led the slowdown in real activity through 2007, by early
2008 outlays for consumer goods and services and business equipment
and software had decelerated sharply, and total employment was
beginning to decline. Real gross domestic product (GDP) fell slightly
in the first quarter of 2008.
In February 2008, Congress passed a temporary tax cut. Figure 2-2
shows real after-tax (or disposable) income and consumer spending
before and after rebate checks were issued. Consumption was maintained
despite a tremendous decline in household wealth over the same period.
Total household and nonprofit net worth declined 9.1 percent between
June 2007 and June 2008. Microeconomic studies of consumer behavior in
this episode confirm the role of the tax rebate in maintaining
spending (Broda and Parker 2008; Sahm, Shapiro, and Slemrod 2009).
The fact that real GDP reversed course and grew in the second quarter
of 2008 is further tribute to the helpfulness of the policy. But, in
part because of the lack of robust, sustained stimulus, growth did not
continue.
Financial institutions had invested heavily in assets whose values
were tied to the value of mortgages. For many reasons--the opacity of
the instruments, the complexity of financial institutions' balance
sheets and their ``off-balance-sheet'' exposures, the failure of credit-
rating agencies to accurately identify the riskiness of the assets,
and poor regulatory oversight--the extent of the institutions' exposure
to mortgage default risk was obscured. When mortgage defaults rose,
the result was unexpectedly large losses to many financial
institutions.
In the fall of 2008, the nature of the downturn changed dramatically.
More rapid declines in asset prices generated further loss of
confidence in the ability of some of the world's largest financial
institutions to honor



their obligations. In September, the Lehman Brothers investment bank
declared bankruptcy, and other large financial firms (including
American International Group, Washington Mutual, and Merrill Lynch)
were forced to seek government aid or to merge with stronger
institutions. What followed was a rush to liquidity and a cascading of
retrenchment that had many of the features of a classic financial
panic.
Risk spreads shot up to extraordinary levels. Figure 2-3 shows both
the TED spread and Moody's BAA-AAA spread. The TED spread is the
difference between the rate on short-term loans among banks and a safe
short-term Treasury interest rate. The BAA-AAA spread is the
difference between the interest rates on high-grade and medium-grade
corporate bonds. Both spreads rose dramatically during the heart of the
panic.
Indeed, one way to put the spike in the BAA-AAA spread in perspective
is to note that the same spread barely moved during the Great Crash of
the stock market in 1929, and rose by only about half as much during
the first wave of banking panics in 1930 as it did in the fall of
2008.
The same loss of confidence shown by the rise in credit spreads
translated into declining asset prices of all sorts. The S&P 500
declined 29 percent in the second half of 2008. Real house prices
tumbled another 11 percent over the same period (see Figure 2-1). All
told, household and



nonprofit net worth declined 20 percent between December 2007 and
December 2008, or by about $13 trillion. Again, a useful way to
calibrate the size of this shock is to note that in 1929, household
wealth declined only 3 percent--about one-seventh as much as in 2008.
This is another indication that the shocks hitting the U.S. economy
in 2008 were enormous.
The decline in wealth had a severe impact on consumer spending. This
key component of aggregate demand, which accounts for roughly 70
percent of GDP and is traditionally quite stable, declined at an
annual rate of 3.5 percent in the third quarter of 2008 and 3.1
percent in the fourth quarter. Some of this large decline may have
also reflected the surge in uncertainty about future incomes. Not only
did asset prices fall sharply, leading to the decline in wealth; they
also became dramatically more volatile. The standard deviation of
daily stock returns in the fourth quarter, for example, was 4.3
percentage points, even larger than in the first months of the Great
Depression.
The financial panic led to a precipitous decline in lending. Bank
credit continued to rise over the latter portion of 2008, as
households and firms that had lost access to other forms of credit
turned to banks. However, bank loans declined sharply in the first
and second quarters of 2009 as banks tightened their terms and
standards. Other sources of credit showed even more substantial
declines. One particularly important market is that for commercial
paper(short-term notes issued by firms to finance key operating costs
such as payroll and inventory). The market for lower-tier nonfinancial
(A2/P2) commercial paper collapsed in the fall of 2008, with the
average daily value of new issues falling from $8.0 billion in the
second quarter of 2008 to $4.3 billion in the fourth quarter. In
addition, securitization of automobile loans, credit card receivables,
student loans, and commercial mortgages ground to a halt.
This freezing of credit markets, together with the decline in wealth
and confidence, caused consumer spending and residential investment to
fall sharply. Real GDP declined at an annual rate of 2.7 percent in
the third quarter of 2008, 5.4 percent in the fourth quarter, and 6.4
percent in the first quarter of 2009. Industrial production, which had
been falling steadily over the first eight months of 2008, plummeted
in the final four months--dropping at an annual rate of 18 percent.
Many industries were battered by the financial crisis and the
resulting economic downturn. The American automobile industry was hit
particularly hard. Sales of light motor vehicles, which had exceeded
16 million units every year from 1999 to 2007, fell to an annual rate
of only 9.5 million in the first quarter of 2009. Employment in the
motor vehicle and parts industry declined by 240,000 over the 12
months through January 2009. Two domestic manufacturers, General
Motors (GM) and Chrysler, required emergency loans in late December
2008 and early January 2009 to avoid disorderly bankruptcy.
The most disturbing manifestation of the rapid slowdown in the economy
was the dramatic increase in job loss. Over the first months of 2008,
job losses were typically between 100,000 and 200,000 per month. In
October, the economy lost 380,000 jobs; in November, 597,000 jobs. By
January, the economy was losing jobs at a rate of 741,000 per month.
Commensurate with this terrible rate of job loss, the unemployment
rate rose rapidly--from 6.2 percent in September 2008 to 7.7 percent in
January 2009. It then continued to rise by roughly one-half of a
percentage point per month through the winter and spring; it reached
9.4 percent in May, and ended the year at 10.0 percent.

Wall Street and Main Street

As described in more detail later, policymakers have focused much of
their response to the crisis on stabilizing the financial system. Many
Americans are troubled by these policies. Because to a large extent it
was the actions of credit market participants that led tothecrisis,
people ask why policymakers should take actions focused on restoring
credit markets.
The basic reason for these policies is that the health of credit
markets is critically important to the functioning of our economy.
Large firms use commercial paper to finance their biweekly payrolls
and pay suppliers for materials to keep production lines going. Small
firms rely on bank loans to meet their payrolls and pay for supplies
while they wait for payment of their accounts receivable. Home
purchases depend on mortgages; automobile purchases depend on car
loans; college educations depend on student loans; and purchases of
everyday items depend on credit cards.
The events of the past two years provide a dramatic demonstration of
the importance of credit in the modern economy. As the President said
in his inaugural address, ``Our workers are no less productive than
when this crisis began. Our minds are no less inventive, our goods and
services no less needed.'' Yet developments in financial markets--rises
and falls in home and equity prices and in the availability of
credit--have led to a collapse of spending, and hence to a precipitous
decline in output and to unemployment for millions.
Numerous academic studies before the crisis had also shown that the
availability of credit is critical to investment, hiring, and
production. One study, for example, found that when a parent company
earns high profits and so has less need to rely on credit, the
additional funds lead to higher investment by subsidiaries incompletely unrelated lines of business (Lamont 1997). Another found that when a
small change in a firm's circumstances frees up a large amount of funds
that would otherwise have to go to pension contributions, the result is
a large change in spending on capital goods (Rauh 2006). Other studies
have shown that when the Federal Reserve tightens monetary policy,
small firms, which typically have more difficulty obtaining financing,
are hit especially hard (Gertler and Gilchrist 1994), and firms without
accessto public debt markets cut their inventories much more sharply
than firms that have such access (Kashyap, Lamont, and Stein 1994).
Research before the crisis had also found that financial market
disruptions could affect the real economy. Ben Bernanke, who is now
Chairman of the Federal Reserve, demonstrated a link between the
disruption of lending caused by bank failures and the worsening of the
Great Depression (Bernanke 1983). A smaller but more modern example is
provided by the impact of Japan's financial crisis in the 1990s on the
United States: construction lending, new construction, and construction
employment were more adversely affected in U.S. states where
subsidiaries of Japanese banks had a larger role, and thus where credit
availability was more affected by the collapse of Japan's bubble (Peek
and Rosengren 2000). That a financial disruption in a trading partner
can have a detectable adverse impact on our economy through its impact
on credit availability suggests that the effect of a full-fledged
financial crisis at home would be enormous--an implication that, sadly,
has proven to be correct.
Finally, microeconomic evidence from the recent crisis also shows the
importance of the financial system to the real economy. For example,
firms that happened to have long-term debt coming due after the crisis
began, and thus faced high costs of refinancing, cut their investment
much more than firms that did not (Almeida et al. 2009). Another study
found that a majority of corporate chief financial officers surveyed
reported that their firms faced financing constraints during the
crisis, and that the constrained firms on average planned to reduce
investment spending, research and development, and employment sharply
compared with the unconstrained firms (Campello, Graham, and Harvey
2009).
In short, the goal of the policies to stabilize the financial system
was not to help financial institutions. The goal was to help ordinary
Americans. When the financial system is not working, individuals and
businesses cannot get credit, demand and production plummet, and job
losses skyrocket. Thus, an essential step in healing the real economy
is to heal the financial system. The alternative of letting financial
institutions suffer the consequences of their mistakes would have led
to a collapse of credit markets and vastly greater suffering for
millions and millions of Americans.
The policies to rescue the financial sector were, however, costly,
and often had the side effect of benefiting the very institutions whose
irresponsible actions contributed to the crisis. That is one reason
that the President has endorsed a Financial Crisis Responsibility Fee
on the largest financial firms to repay the Federal Government for its
extraordinary actions. As discussed in Chapter 6, the Administration
has also proposed a comprehensive plan for financial regulatory
reform that will help ensure that Wall Street does not return to the
risky practices that were a central cause of the recent crisis.

The Unprecedented Policy Response

Given the magnitude of the shocks that hit the economy in the fall of
2008 and the winter of 2009, the downturn could have turned into a
second Great Depression. That it has not is a tribute to the
aggressive and effective policy response. This response involved the
Federal Reserve and other financial regulators, the Administration,
and Congress. The policy tools were similarly multifaceted, including
monetary policy, financial market interventions, fiscal policy, and
policies targeted specifically at housing.

Monetary Policy

The first line of defense against a weak economy is the interest rate
policy of the independent Federal Reserve. By increasing or decreasing
the quantity of reserves it supplies to the banking system, the
Federal Reserve can lower or raise the Federal funds rate, which is
the interest rate at which banks lend to one another. The funds rate
influences other interest rates in the economy and so has important
effects on economic activity. Using changes in the target level of the
funds rate as their main tool of counter-cyclical policy, monetary
policymakers had kept inflation low and the real economy remarkably
stable for more than two decades.
The Federal Reserve has used interest rate policy aggressively in the
recent episode. The target level of the funds rate at the beginning of
2007 was 5\1/4\ percent. The Federal Reserve cut the target by 1
percentage point over the last four months of 2007 and by an
additional 2\1/4\ percentage points over the first four months of 2008.
After the events of September, it cut the target in three additional
steps in October and December, bringing it to its current level of 0
to \1/4\ percent.
Conventional interest rate policy, however, could do little to deal
with the enormous disruptions to credit markets. As a result, the
Federal Reserve has used a range of unconventional tools to address
those disruptions directly. For example, in March 2008, it created
the Primary Dealer Credit Facility and the Term Securities Lending
Facility to provide liquidity support for primary dealers (that is,
financial institutions that trade directly with the Federal Reserve)
and the key financial markets in which they operate. In October 2008,
when the critical market for commercial paper threatened to stop
functioning, the Federal Reserve responded by setting up the
Commercial Paper Funding Facility to backstop the market.
Once the Federal Reserve's target for the funds rate was effectively
lowered to zero in December 2008, there was another reason to use
unconventional tools. Nominal interest rates generally cannot fall
below zero: because holding currency guarantees a nominal return of
zero, no one is willing to make loans at a negative nominal interest
rate. As a result, when the Federal funds rate is zero, supplying more
reserves does not drive it lower. Statistical estimates suggest that
based on the Federal Reserve's usual response to inflation and
unemployment, the subdued level of inflation and the weak state of the
economy would have led the central bank to reduce its target for the
funds rate by about an additional 5 percentage points if it could have
(Rudebusch 2009).
This desire to provide further stimulus, coupled with the inability
to use conventional interest rate policy, led the Federal Reserve to
undertake large-scale asset purchases to reduce long-term interest
rates. In March 2009, the Federal Reserve announced plans to purchase
up to $300 billion of long-term Treasury debt; it also announced plans
to increase its purchases of the debt of Fannie Mae, Freddie Mac, and
the Federal Home Loan Banks (the government-sponsored enterprises, or
GSEs, that support the mortgage market) to up to $200 billion, and its
purchases of agency (that is, Fannie Mae, Freddie Mac, and Ginnie Mae)
mortgage-backed securities to up to $1.25 trillion.
Finally, the Federal Reserve has attempted to manage expectations by
providing information about its goals and the likely path of policy.
Officials have consistently stressed their commitment to ensuring that
inflation neither falls substantially below nor rises substantially
above its usual level. In addition, the Federal Reserve has repeatedly
stated that economic conditions ``are likely to warrant exceptionally
low levels of the Federal funds rate for an extended period.'' To the
extent this statement provides market participants with information
they did not already have, it is likely to keep longer-term interest
rates lower than they otherwise would be.
One effect of the Federal Reserve's unconventional policies has been
an enormous expansion of the quantity of assets on the Federal
Reserve's balance sheet. Figure 2-4 shows the evolution of Federal
Reserve asset holdings since the beginning of 2007. One can see both
that asset holdings nearly tripled between January and December 2008
and that there was a dramatic move away from short-term Treasury
securities.



The flip side of the large increase in the Federal Reserve's asset
holdings is a large increase in the quantity of reserves it has
supplied to the financial system. Some observers have expressed
concern that the large expansion in reserves could lead to inflation.
In this regard, two key points should be kept in mind. First, as
already described, most statistical models suggest that the Federal
Reserve's target interest rate would be substantially lower than it
is today if it were not constrained by the fact that the Federal funds
rate cannot fall below zero. As a result, monetary policy is in fact
unusually tight given the state of the economy, not unusually loose.
Second, the Federal Reserve has the tools it needs to prevent the
reserves from leading to inflation. It can drain the reserves from the
financial system through sales of the assets it has acquired or other
actions. Indeed, despite the weak state of the economy, the return of
credit market conditions toward normal is leading to the natural
unwinding of some of the exceptional credit market programs. Another
reliable way the Federal Reserve can keep the reserves from creating
inflationary pressure is by using its relatively new ability to raise
the interest rate it pays on reserves: banks will be unwilling to lend
the reserves at low interest rates if they can obtain a higher return
on their balances held at the Federal Reserve.

Financial Rescue

Efforts to stabilize the financial system have been a central part of
the policy response. As just discussed, even before the financial
crisis in September 2008, the Federal Reserve was taking steps to ease
pressures on credit markets. The events of the fall led to even
stronger actions. On September 7, Fannie Mae and Freddie Mac were
placed in conservatorship under the Federal Housing Finance Agency to
prevent a potentially severe disruption of mortgage lending. On
September 16, concern about the potentially catastrophic effects of a
disorderly failure of American International Group (AIG) caused the
Federal Reserve to extend the firm an $85 billion line of credit. On
September 19, concerns about the possibility of runs on money-market
mutual funds led the Treasury to announce a temporary guarantee
program for these funds.
On October 3, Congress passed and President Bush signed the Emergency
Economic Stabilization Act of 2008. This Act provided up to $700
billion for the Troubled Asset Relief Program (TARP) for the purchase
of distressed assets and for capital injections into financial
institutions, although the second $350 billion required presidential
notification to Congress and could be disallowed by a vote of both
houses. The initial $350 billion was used mainly to purchase preferred
equity shares in financial institutions, thereby providing the
institutions with more capital to help them withstand the crisis.
At President-Elect Obama's request, President Bush notified Congress
on January 12, 2009 of his plan to release the second $350 billion of
TARP funds. With strong support from the incoming Administration, the
Senate defeated are solution disapproving the release.
These funds provided policy-makers with critical resources needed to
ensure financial stability.
On February 10, 2009, Secretary of the Treasury Timothy Geithner
announced the Administration's Financial Stability Plan. The plan
represented a new, comprehensive approach to the financial rescue
that sought to tackle the interlocking sources of instability and
increase credit flows. An overarching theme was a focus on
transparency and accountability to rebuild confidence in financial
markets and protect taxpayer resources.
A key element of the plan was the Supervisory Capital Assessment
Program (or ``stress test''). The purpose was to assess the capital
needs of the country's 19 largest financial institutions should
economic and financial conditions deteriorate further. Institutions
that were found to need an additional capital buffer would be
encouraged to raise private capital and would be provided with
temporary government capital if those efforts did not succeed. This
program was intended not just to examine the capital positions of the
institutions and ensure that they obtained more capital if
needed, but also to strengthen private investors' confidence in the
soundness of the institutions' balance sheets, and so strengthen the
institutions' ability to obtain private capital.
Another element of the plan was the Consumer and Business Lending
Initiative, which was aimed at maintaining the flow of credit. In
November 2008, the Federal Reserve had created the Term Asset-Backed
Securities Loan Facility to help counteract the dramatic decline in
securitized lending. In the February announcement of the Financial
Stability Plan, the Treasury greatly expanded the resources of the
not-yet-implemented facility. The Treasury increased its commitment to
$100 billion to leverage up to $1 trillion of lending for businesses
and households. By facilitating securitization, the program was
designed to help unfreeze credit and lower interest rates for auto
loans, credit card loans, student loans, and small business loans
guaranteed by the Small Business Administration (SBA).
A third element of the plan was a Treasury partnership with the
Federal Deposit Insurance Corporation and the Federal Reserve to
create the Public-Private Investment Program. A central purpose was to
remove troubled assets from the balance sheets of financial
institutions, thereby reducing uncertainty about their financial
strength and increasing their ability to raise capital and hence their
willingness to lend. Partnership with the private sector served two
important objectives: it leveraged scarce public funds, and it used
private competition and incentives to ensure that the government did
not overpay for assets.
There were two other key components of the Financial Stability Plan.
One was a wide-ranging program to reduce mortgage interest rates and
help responsible homeowners stay in their homes. These policies are
described later in the section on housing policy. The other component
was a range of measures to help small businesses. Many of these were
included in the American Recovery and Reinvestment Act and are
discussed in the section on fiscal stimulus.
Failure of the two troubled domestic automakers (GM and Chrysler)
threatened economy-wide repercussions that would have been magnified
by related problems at the automakers' associated financial
institutions (GMAC and Chrysler Financial). To avoid these
consequences, the Bush Administration set up the Auto Industry
Financing Program within the TARP. This program extended $17.4 billion
in funding to the two companies in late December 2008 and early
January 2009. The program also extended $7.5 billion in funding to the
two auto finance companies around the same time. Upon taking office,
the Obama Administration required the automakers to submit plans for
restructuring and a return to viability before additional funds were
committed. To sustain the industry during this planning process, the
Treasury established the Warranty Commitment Program to reassure
consumers that warranties of the troubled firms would behonored.
It also initiated the Auto Supplier Support Program to maintain
stability in the auto supply base.
Over the spring of 2009, the Administration's Auto Task Force worked
with GM and Chrysler to produce plans for viability. In the case of
Chrysler, the task force determined that viability could be achieved
by merging with the Italian automaker Fiat. For GM, the task force
determined that substantial reductions in costs were necessary and
charged the company with producing a more aggressive restructuring
plan. For both companies, a quick, targeted bankruptcy was judged to
be the most efficient and successful way to restructure. Chrysler
filed for bankruptcy on April 30, 2009; GM, on June 1. In addition to
concessions by all stakeholders, including workers, retirees,
creditors, and suppliers, the U.S. Government invested substantial
funds to bring about the orderly restructuring. In all, more than $80
billion of TARP funds had been authorized for the motor vehicle
industry as of September 20, 2009.

Fiscal Stimulus

The signature element of the Administration's policy response to the
crisis was the American Recovery and Reinvestment Act of 2009 (ARRA).
The President signed the Recovery Act in Denver on February 17, just
28 days after taking office. At an estimated cost of $787 billion, the
Act is the largest countercyclical fiscal action in American history.
It provides tax cuts and increases in government spending equivalent
to roughly 2 percent of GDP in 2009 and 2\1/4\ percent of GDP in 2010.
To put those figures in perspective, the largest expansionary swing in
the budget during Franklin Roosevelt's New Deal was an increase in the
deficit of about 1\1/2\ percent of GDP in fiscal 1936. That expansion,
however, was counteracted the very next fiscal year by a contraction
that was even larger.
The fiscal stimulus was designed to fill part of the shortfall in
aggregate demand caused by the collapse of private demand and the
Federal Reserve's inability to lower short-term interest rates
further. It was part of a comprehensive package that included
stabilizing the financial system, helping responsible homeowners avoid
foreclosure, and aiding small businesses through tax relief and
increased lending. The President set as a goal for the fiscal stimulus
that it raise employment by 3\1/2\ million relative to what it
otherwise would have been.
Several principles guided the design of the stimulus. One was that it
be spread over two years, reflecting the Administration's view that
the economy would need substantial support for more than one year. At
the same time, the Administration also strongly supported keeping the
stimulus explicitly temporary. It was not to be an excuse to
permanently expand the size of government.
A second key principle was that the stimulus be well diversified.
Different types of stimulus affect the economy in different ways.
Individual tax cuts, for example, affect production and employment in
a wide range of industries by encouraging households to spend more on
consumer goods, while government investments in infrastructure
directly increase construction activity and employment. In addition,
underlying economic conditions affect the efficacy of fiscal policy in
ways that can be quantitatively important and sometimes difficult to
forecast. Likewise, different types of stimulus affect the economy with
different speeds. For instance, aid to individuals directly affected by
the recession tends to be spent relatively quickly, while new
investment projects require more time. Because of the need to provide
broad support to the economy over an extended period, the
Administration supported a stimulus plan that included a broad range of
fiscal actions.
A third principle was that emergency spending should aim to address
long-term needs. Some spending, such as unemployment insurance, is
aimed at helping those directly affected by the recession maintain a
decent standard of living. But government investment spending should
aim to create enduring capital investments that increase productivity
and growth.
The Recovery Act reflected those guiding principles. The
Congressional Budget Office (CBO) estimated that almost one-quarter of
the stimulus would be spent by the end of the third quarter of 2009,
and an additional half would be spent over the next four quarters (Congressional Budget Office 2009b). So far, the pace of the spending
and tax cuts has largely matched CBO's estimates.
The final package was very well diversified. Roughly one-third took
the form of tax cuts. The most significant of these was the Making
Work Pay tax credit, which cut taxes for 95 percent of working
families. Taxes for a typical family were reduced by $800 per couple
for each of 2009 and 2010. Another provision of the bill provided
roughly $14 billion for one-time payments of $250 to seniors,
veterans, and people with disabilities. The macroeconomic effects of
these payments are likely to be similar to those of tax cuts.
Businesses received important tax cuts as well. The most important of
these was an extension of bonus depreciation, which reduced taxes on
new investments by allowing firms to immediately deduct half the cost
of property and equipment purchases. One advantage of such temporary
investment incentives is that they can affect the timing of
investment, moving some investment from future years when the economy
does not have a deficiency of aggregate demand to the present, when it
does.
In addition, because the financial market disruptions had a
particularly paralyzing effect on the financial plans of small
businesses, the Act included additional measures targeted specifically
at those businesses. Tax cuts for small businesses included an
expansion of provisions allowing for the carryback of net operating
losses, a temporary 75 percent exclusion from capital gains taxes on
small business stock, and the ability to immediately expense up to
$250,000 of qualified investment purchases. In addition to reducing
taxes, these provisions improve cash flow at firms facing credit
constraints and provide extra incentives for individuals to invest in
small businesses. The Act also included measures to help increase
small business lending through the SBA. In particular, it raised to 90
percent the maximum guarantee on SBA general purpose and working
capital loans (the 7(a) program) and eliminated fees on both 7(a)
loans and loans for fixed-asset capital and real estate investment
projects (the 504 program).
Another important part of the stimulus consisted offiscal relief to
state governments. Because almost every state has a balanced-budget
requirement, the declines in revenues caused by the recession forced
states to cut spending or raise taxes, thereby further contracting
demand and magnifying the downturn. Federal fiscal relief can help
prevent these contractionary responses, helping to maintain critical
state services and state employment, prevent tax increases on families
already suffering from the recession, and cushion the fall in demand.
And because many states were already raising taxes and cutting
spending when the ARRA was passed, the effects were likely to occur
relatively quickly. The Act therefore included roughly $140 billion of
state fiscal relief.
The Recovery Act also included approximately $90 billion of support
for individuals directly affected by the recession. This support
serves two critical purposes. First, it provides relief from the
recession's devastating impact on families and individuals. Second,
because the recipients typically spend this support quickly, it
provides an immediate boost to the broader economy. Among the major
components of this relief were an extension and expansion of
unemployment insurance benefits, subsidies to help the unemployed
continue to obtain health insurance, and additional funding for the
Supplemental Nutritional Assistance Program. The Act also reduced
taxes on unemployment insurance benefits, the effect of which is
similar to an expansion of benefits.
Finally, the Recovery Act included direct government investment
spending. Because government investment raises output in the short run
both through its direct effects and by increasing the incomes and
spending of the workers employed on the projects, its output effects
are particularly large. In addition, because this type of stimulus is
spent less quickly than other types, it will play a vital role in
providing support to the economy after 2009. And by funding critical
investments, this spending will raise the economy's output even in the
long run.
The Act included funding both for traditional government investment
projects, such as transportation infrastructure and basic scientific
research, and for initial investments to jump-start private investment
in emerging new areas, such as health information technology, a smart
electrical grid, and clean energy technologies. The Act also included
tax credits for specific types of private spending, such as home weatherization and advanced energy manufacturing, which are likely to
have effects similar to direct government investment spending.
Altogether, roughly one-third of the budget impact of the Recovery Act
will take the form of these investments and tax credits.
Fiscal stimulus actions did not end with the passage and
implementation of the Recovery Act. In June 2009, the Administration
worked with Congress to set up the Car Allowance Rebate System (CARS).
Commonly known as the ``Cash for Clunkers'' program, CARS gave rebates
of up to $4,500 to consumers who replaced older cars and trucks with
newer, more fuel-efficient models. The program was in effect for July
and most of August. After the program's popularity led to quick
exhaustion of the original funding of $1 billion, the funding was
increased to $3 billion to allow more consumers to participate.
In November, the Worker, Homeownership, and Business Assistance
Act of 2009 cut taxes for struggling businesses and strengthened the
safety net forworkers. In particular, the Act extended the net
operating loss provisions of the Recovery Act that allowed small
businesses to count their losses this year against taxes paid in
previous years for an additional year, and expanded the benefit to
medium and large businesses. The Act also provided up to 20
additional weeks of unemployment insurance benefits for workers who
were reaching the end of their emergency unemployment benefits. In
December, an amendment to the Department of Defense Appropriations Act
of 2010 continued through the end of February 2010 the unemployment
insurance provisions of the Recovery Act, the November extension of
emergency benefits, and the COBRA subsidy program that helps
unemployed workers maintain their health insurance. It also expanded
the COBRA premium subsidy period from 9 to 15 months and extended the
increased guarantees and fee waivers for SBA loans.

Housing Policy
The economic and financial crisis began in the housing market, and an
important part of the policy response has been directed at that
market. The Administration initiated the Making Home Affordable
program (MHA) in March 2009. This program was designed to support low
mortgage rates, keep millions of homeowners in their homes, and
stabilize the housing market.
As described earlier, the Federal Reserve undertook large-scale
purchases of GSE debt and mortgage-backed securities in an effort to
reduce mortgage interest rates. At the same time, the Treasury
Department made an increased funding commitment to the GSEs. This
increased government support for the agencies also reduced their
borrowing costs and so helped lower mortgage interest rates.
Importantly, MHA also included a program to help households take
advantage of lower interest rates. The Home Affordable Refinance
Program helps families whose homes have lost value and whose mortgage
payments can be reduced by refinancing at historically low interest
rates. This program expanded the opportunity to refinance to borrowers
with loans owned or guaranteed by the GSEs who had a mortgage balance
up to 125 percent of their home's current value.
Another key component of MHA is the Home Affordable Modification
Program (HAMP), which is providing up to $75 billion to encourage loan
modifications. It offers incentives to investors, lenders, servicers,
and homeowners to encourage mortgage modifications in which all
stakeholders share in the cost of ensuring that responsible homeowners
can afford their monthly mortgage payments. To protect taxpayers, HAMP
focuses on sound modifications. No payments are made by the government
unless the modification lasts for at least three months, and all the
payments are designed around the principle of ``pay for success.'' All
parties have aligned incentives under the program to achieve
successful modifications at an affordable and sustainable level.
The Administration has supported additional programs to help the
housing sector. The Recovery Act included an $8,000 first-time
homebuyer's credit for home purchases made before December 1, 2009.
As with temporary investment incentives, this credit can help the
economy by changing the timing of decisions, bringing buyers into the
housing market who were not planning on becoming homeowners until after
2009 or were postponing their purchases in light of the distress in the
market. In November, this credit was expanded and extended by the
Workers, Homeownership, and Business Assistance Act of 2009.
The Recovery Act also gave considerable resources to the Neighborhood
Stabilization Program, a program administered by the Department of
Housing and Urban Development to stabilize communities that have
suffered from foreclosures and abandoned homes. The Administration
also provided assistance to state and local housing finance agencies
and their efforts to aid distressed homeowners, stimulate first-time
home buying, and provide affordable rental homes. These agencies had
faced a significant liquidity crisis resulting from disruptions in
financial markets.

The Effects of the Policies

The condition of the American economy has changed dramatically in the
past year. At the beginning of 2009, financial markets were
functioning poorly, house prices were plummeting, and output and
employment were in freefall. Today, financial markets have stabilized
and credit is starting to flow again, house prices have leveled off,
output is growing, and the employment situation is stabilizing.
Because of the depth of the economy's fall, we area long way from full
recovery, and significant challenges remain. But the trajectory of the
economy is vastly improved.
There is strong evidence that the policy response has been central to
this turnaround. The actions to stabilize credit markets have
prevented further destructive failures of major financial institutions
and helped maintain lending in key areas. The housing and mortgage
policies have kept hundreds of thousands of homeowners in their homes
and brought mortgage rates to historic lows. The speed of the
economy's change in direction has been remarkable and matches up well
with the timing of the fiscal stimulus. And both direct estimates as
well as the assessments of expert observers underscore the crucial
role played by the stimulus.

The Financial Sector

Given the powerful impact of the financial sector on the real economy,
a necessary first step to recovery of the real economy was recovery of
the financial sector. And the financial sector has unquestionably
begun to recover. Figure 2-5 extends the graph of the TED spread and
the BAA-AAA spread shown in Figure 2-3 through December 2009. After
spiking to unprecedented levels in October 2008, the TED spread fell
rapidly over the next two months but remained substantially elevated
at the beginning of 2009. It then declined gradually through August
and is now at normal levels. This key indicator of the basic
functioning of credit markets suggests substantial financial recovery.
The BAA-AAA spread remained very high through April but then fell
rapidly from April to September. This spread, which normally rises
when the economy is weak because of higher corporate default risks,
is now at levels comparable to those at the beginning of the recession
and below its levels in much of 1990-91 and 2002-03. Thus, the current
level of the spread appears to reflect mainly the weak state of the
economy rather than any specific difficulties in credit markets.



Another broad indicator of the health of the financial system is the
level of stock prices, which depend both on investors' expectations of
future earnings and on their willingness to bear risk. Figure 2-6 shows
the behavior of the S&P 500 stock price index since January 2006. This
series declined by 18 percent from its peak in October 2007 through the
end of August 2008, fell precipitously in September, and continued to
fall through March 2009 as the economy deteriorated sharply and
investors became extremely fearful. The stabilization of the economy
and the restoration of more normal workings of financial markets have
led to a sharp turnaround in stock prices. As of December 31, 2009, the
S&P 500 was 65 percent above its low in March. As with the BAA-AAA
spread, the current level of stock prices relative to their
pre-recession level appears to reflect the weaker situation of the real
economy rather than any specific problems with financial markets or
investors' willingness to bear risk.



These indicators show that financial markets have evolved toward
normalcy, which was a necessary step in stopping the economic
freefall. But for the economy to recover fully, that is not enough:
credit must be available to sound borrowers. On this front, the
results are more mixed. Some sources of credit are coming back
strongly, but others remain weak.
As described in more detail later, one critical market where policies
have succeeded in lowering interest rates and maintaining credit flows
is the mortgage market. Another market that has recovered
substantially is the market for commercial paper. In late 2008 and
early 2009, this market was functioning in large part because of the
direct intervention of the Federal Reserve. By mid-January, the
Federal Reserve's Commercial Paper Funding Facility (CPFF) was holding
$350 billion of commercial paper. As credit conditions have
stabilized, however, firms have been able to place their commercial
paper privately on better terms than through the CPFF, and levels of
commercial paper outstanding have remained stable even as the Federal
Reserve has reduced its holdings to less than $15 billion.
Nonetheless, quantities of commercial paper outstanding remain well
below their pre-crisis levels.
Another crucial source of credit that has stabilized is the market
for corporate bonds. As risk spreads have fallen, corporations have
found it easier to obtain funding by issuing longer-term bonds than by
issuing such instruments as commercial paper. As a result, corporate
bond issuance, which fell sharply in the second half of 2008, is now
running above pre-crisis levels.
An important financial market development occurred in response to the
stress test conducted in the spring. This comprehensive review of the
soundness of the Nation's 19 largest financial institutions, together
with the public release of this information, strengthened private
investors' confidence in the institutions. Partly as a result, the
institutions were able to raise $55 billion in private common equity,
improving their capital positions and their ability to lend.
The fact that financial institutions are increasingly able to raise
private capital is reducing their need to rely on public capital. Only
$7 billion of TARP funds have been extended to banks since January 20,
2009. Many financial institutions have repaid their TARP funds, and
the expected cost of the program to the government has been revised
down by approximately $200 billion since August 2009.
Policy initiatives have also had a clear impact on small business
lending. Figure 2-7 shows the amount of SBA-guaranteed loans that have
been made since October 2006. SBA loan volume experienced its first
significant decrease in September and October 2007; following the
failure of Lehman Brothers in September 2008, it fell by more than
half. The recovery in small business lending coincided with the
passage of the Recovery Act in February 2009. In the months between
Lehman's fall and passage of the Recovery Act, average monthly loan
volume was $830 million; immediately after passage, loan volume began
to steadily recover and averaged $1.3 billion per month through
September 2009. In September, loan volume reached $1.9 billion, which
was the highest level since August 2007; this has since been exceeded
by November 2009's monthly loan volume of



$2.2 billion. In total, between February and December 2009 the SBA
guaranteed nearly $15 billion in small business lending.
Nonetheless, overall credit conditions have not returned to normal.
Many small business owners report continued difficulties in obtaining
credit. In addition, the severity of the downturn is leading to
elevated rates of failure of small banks, potentially disrupting their
lending to small businesses and households. The market for asset-backed
securities is also far from fully recovered. As a result, it is often
hard for banks and other lenders to package and sell their loans, which
forces them to hold a greater fraction of the loans they originate and
thus limits their ability to lend.
One important source of data on credit availability is the Federal
Reserve's Senior Loan Officer Opinion Survey on Bank Lending
Practices. The survey, conducted every three months, examines whether
banks are tightening lending standards, loosening them, or keeping
them basically unchanged. The October 2008 survey found that the
overwhelming majority of banks were tightening standards. This
fraction has declined steadily, and by October 2009 less than 20
percent were reporting that they were tightening standards for
commercial and industrial loans, though none reported loosening
standards. Thus, credit conditions remain tight.

Housing

As described earlier, policymakers have taken unprecedented actions
to maintain mortgage lending. One result has been a major shift in the
composition of mortgage finance. In 2006, private institutions
provided 60 percent of liquidity while the GSEs, the Federal Housing
Agency (FHA), and the Veterans Administration (VA) provided the
remaining 40 percent. As home prices began to decline nationally in
2007, private financing for mortgages began to dry up. As of November
2009, the mortgages guaranteed by the GSEs, FHA, and the VA accounted
for nearly all mortgage originations. About 22 percent of mortgage
originations are guaranteed by FHA or VA, up from less than 3 percent
in 2006. About 75 percent of mortgage originations are guaranteed by
the GSEs, up from less than 40 percent in 2006.
As Figure 2-8 shows, mortgage rates fell to historic lows in 2009--consistent with the government's increased funding commitment to
Fannie Mae and Freddie Mac and the Federal Reserve's purchases of
mortgage-backed securities. These low mortgage rates support home
prices and thus benefit all homeowners. More directly, households that
have refinanced their mortgages at the lower rates have obtained
considerable savings. These savings have effects similar to tax cuts,
improving households' financial positions and encouraging spending on
other goods. With the help of the Home Affordable Refinance Program,
approximately 3 million borrowers have refinanced, putting more than
$6 billion of purchasing power at an annual rate into the hands of
households.



In addition, the Home Affordable Modification Program has been
successful in encouraging mortgage modifications. When the program was
launched, the Administration estimated that it could offer help to as
many as 3 million to 4 million borrowers through the end of 2012. On
October 8, 2009, the Administration announced that servicers had begun
more than 500,000 trial modifications, nearly a month ahead of the
original goal. As of November, the monthly pace of trial modifications
exceeded the monthly pace of completed foreclosures. Of course, not
all trial modifications will become permanent, but the Administration
is making every effort to ensure that as many sound modifications as
possible do.
One important result of the policies aimed at the housing market and
of the broader policies to support the economy is that the housing
market appears to have stabilized. National home price indexes have
been relatively steady for the past several months, as shown in Figure
2-9. The Federal Housing Finance Agency purchase-only house price
index, which is constructed using only conforming mortgages (that is,
mortgages eligible for purchase by the GSEs), has changed little since
late 2008. The LoanPerformance house price index, another closely
watched measure that uses conforming and nonconforming mortgages with
coverage of repeat sales transactions for more than 85 percent of the
population, rose 6 percent between March and August 2009 before
declining slightly in recent months. In addition, the pace of sales of
existing single-family homes has increased substantially. Sales in the
fourth quarter of 2009 were 29 percent above their low in the first
quarter of 2009 and comparable to levels in the first half
of 2007.
Finally, there are signs of renewed building activity. After falling
81 percent from their peak in September 2005 to their low in January
2009, single-family housing permits (a leading indicator of housing
construction) rose 49 percent through December 2009. Similarly, after
falling for 14 consecutive quarters, the residential investment
component of real GDP rose in the third and fourth quarters of 2009.
Inventories of vacant homes for sale remain at high levels, and many
vacant homes are being held off the market and will likely be put up
for sale as home prices increase. This overhang may lead to some
additional price declines, although prices are unlikely to fall at the
same rate as they did during the crisis. Thus, the recovery of the
housing sector is likely to be slow. Of course, we should neither
expect nor want the housing market to return to its pre-crisis
condition. In the long run, as discussed in more detail in Chapter 4,
neither the extraordinarily high levels of housing construction and
price appreciation before the crisis nor the extraordinarily low levels
of construction and the rapid price declines during the crisis are
sustainable.



Overall Economic Activity

The direction of overall economic activity changed dramatically over
the course of 2009. Figure 2-10 shows the quarterly growth rate of real
GDP, the broadest indicator of national production. After falling at an
annual rate of 6.4 percent in the first quarter, real GDP declined at a
rate of just 0.7 percent in the second quarter. It then grew at a 2.2
percent rate in the third quarter and a 5.7 percent rate in the fourth.
Such a rapid turnaround in growth is remarkable. The improvement in
growth of 8.6 percentage points from the first quarter to the third
quarter (that is, the swing from growth at a -6.4 percent rate to
growth at a 2.2 percent rate) was the largest since 1983. Similarly,
the three-quarter improvement from the first quarter to the fourth of
12.1 percentage points was the largest since 1981, and the second
largest since 1958.
One limitation of these simple statistics is that they do not account
for the usual dynamics of the economy. A more sophisticated way to
gauge the extent of the change in the economy's direction is to
compare the path the economy has followed with the predictions of a
statistical model. There are many ways to construct a baseline
statistical forecast. The particular one used here is a vector
auto regression (or VAR) that includes the logarithms of real GDP
(in billions of chained 2005 dollars) and payroll employment (in
thousands,in the final month of the quarter), using four lags of
each variable



and estimated over the period 1990:Q1-2007:Q4. Because the sample
period ends in the fourth quarter of 2007, the co efficient estimates
used to construct the forecast are not influenced by the current
recession. Rather, they show the normal joint short-run dynamics of
real GDP and employment over an extended period. GDP and employment are
then forecast for the final three quarters of 2009 using the estimated
VAR and actual data through the first quarter of the year. The
resulting comparison of the actual and projected paths of the economy
shows the differences between the economy's actual performance and what
one would have expected given the situation as of the first quarter and
the economy's usual dynamics.\1\ Although the results presented here are
based on one specific approach to constructing the baseline projection,
other reasonable approaches have similar implications.

\1\ï¿½1AFor more details on this approach and the model-based approach
discussed later, see Council of Economic Advisers (2010).


This more sophisticated exercise also finds that the economy's
turnaround has been impressive. The statistical forecast based on the
economy's normal dynamics projects growth at a -3.3 percent rate in
the second quarter of 2009, -0.5 percent in the third, and 1.3 percent
in the fourth. In all three quarters, actual growth was substantially
higher than the projection. Figure 2-11 shows that as a result, the
level of GDP exceeded the projected level by an increasing margin: 0.7
percent in the second quarter, 1.4 percent in the third quarter, and
2.5 percent in the fourth.



The gap between the actual and projected paths of GDP provides a
rough way to estimate the effect of economic policy. The most obvious
sources of the differences are the unprecedented policy actions.
However, the gap reflects all unusual influences on GDP. For example,
the rescue actions taken in other countries (described in Chapter 3)
could have played a role in better American performance. At the same
time, the continuing stringency in credit markets is likely lowering
output relative to its usual cyclical patterns. Thus, while some
factors work in the direction of causing the comparison of the
economy's actual performance with its normal behavior to overstate the
contribution of economic policy actions, others work in the opposite
direction.
One way to estimate the specific impact of the Recovery Act is to use
estimates from economic models. Mainstream estimates of economic
multipliers for the effects of fiscal policy can be combined with
figures on the stimulus to date to estimate how much the stimulus has
contributed to growth. (For the financial and housing policies, this
approach is not feasible, because the policies are so unprecedented
that no estimates of their effects are readily available.) When this
exercise is performed using the multipliers employed by the Council of
Economic Advisers (CEA), which are based on mainstream economic models,
the results suggest a critical role for the fiscal stimulus. They
suggest that the Recovery Act contributed approximately 2.8
percentage points to growth in the second quarter, 3.9 percentage
points in the third, and 1.8 percentage points in the fourth. As a
result, this approach suggests that the level of GDP in the fourth
quarter was slightly more than 2 percent higher than it would have
been in the absence of the stimulus.
Knowledgeable outside observers agree that the Recovery Act has
increased output substantially relative to what it otherwise would
have been. For example, in November 2009, CBO estimated that the Act
had raised the level of output in the third quarter by between 1.2 and
3.2 percent relative to the no-stimulus baseline (Congressional Budget
Office 2009a). Private fore-casters also generally estimate that the
Act has raised output substantially.
A final way to look for the effects of the rescue policies on GDP is
in the behavior of the components of GDP. Figure 2-12 shows the
contribution of various components of GDP to overall GDP growth in
each of the four quarters of 2009. One area where policy's role seems
clear is in business investment in equipment and software. A key source
of the turnaround in GDP is the change in this type of investment from
a devastating 36 percent annual rate of decline in the first quarter to
a 13 percent rate of increase by the fourth quarter. Two likely
contributors to this change were the investment incentives in the
Recovery Act and the many measures to stabilize the financial system
and maintain lending. Similarly, the housing and financial



market policies were surely important to the swing in the growth of
residential investment from a 38 percent annual rate of decline in
the first quarter to increases in the third and fourth quarters.
Two other components showing evidence of the policies' effects are
personal consumption expenditures and state and local government
purchases. The Making Work Pay tax credit and the aid to individuals
directly affected by the recession meant that households did not have
to cut their consumption spending as much as they otherwise would
have, and the Cash for Clunkers program provided important incentives
for motor vehicle purchases in the third quarter. Consumption was
little changed in the first two quarters of 2009 and then rose at a
healthy 2.8 percent annual rate in the third quarter--driven in
considerable part by a 44 percent rate of increase in purchases of
motor vehicles and parts--and at a 2.0 percent rate in the fourth
quarter. And, despite the dire budgetary situations of state and local
governments, their purchases rose at the fastest pace in more than
five years in the second quarter and were basically stable in the
third and fourth quarters. This stability almost surely could not have
occurred in the absence of the fiscal relief to the states.
The figure also shows the large role of inventory investment in
magnifying macroeconomic fluctuations. When the economy goes into a
recession, firms want to cut their inventories. As a result, inventory
investment moves from its usual slightly positive level to sharply
negative, contributing to the fall in output. Then, as firms moderate
their inventory reductions, inventory investment rises--that is,
becomes less negative--contributing to the recovery of output.
Finally, the turnaround in the automobile industry has been
substantial. The Cash for Clunkers program appears to have generated a
sharp increase in demand for automobiles in July and August 2009
(Council of Economic Advisers 2009). Sales of light motor vehicles
averaged 12.6 million units at an annual rate during these two months,
up from an annual rate of 9.6 million units in the second quarter.
Although some observers had hypothesized that the July and August sales
boost would be offset by a corresponding loss of sales in the months
immediately following, sales in September (9.2 million at an annual
rate) roughly matched the pace of sales in the first half of 2009, and
sales subsequently rebounded to a 10.8 million unit annual pace in the
fourth quarter. Employment in motor vehicles and parts hit a low of
633,300 in June 2009 and has increased modestly since then. In December
2009, employment was 655,200.
Both GM and Chrysler proceeded through bankruptcy in an efficient
manner, and the new companies emerged far more quickly than outside
experts thought would be possible. The companies are performing in
line with their restructuring plans, and in November 2009, GM
announced its intention to begin repaying the Federal Government
earlier than originally expected. It made a first payment of $1
billion in December.

The Labor Market
The ultimate goal of the economic stabilization and recovery
policies is to provide a job for every American who seek sone. The
recession's impact on the labor market has been severe: employment in
December 2009 was 7.2 million below its peak level two years earlier,
and the unemployment rate was 10 percent. Moreover, although real GDP
has begun to grow, employment losses are continuing.
Nonetheless, there is clear evidence that the labor market is
stabilizing. Figure 2-13 shows the average monthly job loss by quarter
since 2006. Average monthly job losses have moderated steadily, from a
devastating 691,000 in the first quarter of 2009 to 428,000 in the
second quarter, 199,000 in the third, and 69,000 in the fourth. The
change in the average monthly change in employment from the first
quarter to the third was the largest over any two-quarter period since
1980, and the change from the first to the fourth quarter was the
largest three-quarter change since 1946. Given what we now know about
the terrible rate of job loss over the winter,it would have been very
difficult for the labor market to stabilize more rapidly than it has.



One can again use the VAR described earlier to obtain a more refined
estimate of how the behavior of employment has differed from its usual
pattern. This statistical procedure implies that given the economy's
behavior through the first quarter of 2009 and its usual dynamics, one
would have expected job losses of about 597,000 per month in the second
quarter, 513,000 in the third quarter, and 379,000 in the fourth.
Thus, actual employment as of the middle of the second quarter (May)
was approximately 300,000 higher than one would have projected given
the normal behavior of the economy; as of the middle of the third
quarter (August), it was about 1.1 million higher; and as of the middle
of the fourth quarter (November), it was about 2.1 million higher.
As with the behavior of GDP, the portion of this difference that is
attributable to the Recovery Act and other policies cannot be isolated
from the portion resulting from other factors. But again, the
difference could either understate or overstate the policies'
contributions.
As with GDP, economic models can be used to focus specifically on the
contributions of the Recovery Act. The results are shown in Figure
2-14. The CEA's multiplier estimates suggest that the Act raised
employment relative to what it otherwise would have been by about
400,000 in the second quarter of 2009, 1.1 million in the third
quarter, and 1.8 million in the fourth quarter. Again, these estimates
are similar to other assessments. For example, CBO's November report
estimated that the Act had raised



employment in the third quarter by between 0.6 million and 1.6
million, relative to what otherwise would have happened.
A more complete picture of the process of labor market healing can be
obtained by looking at labor market indicators beyond employment.
Table 2-1 shows some of the main margins along which labor market
recovery occurs. The margins are listed from left to right in the
rough order in which they tend to adjust coming out of a recession.
One of the first margins to respond is productivity--when demand begins
to recover or moderates relative to the previous rate of decline,
firms initially produce more with the same number of workers. Another
early margin is initial claims for unemployment insurance--fewer
workers are laid off. A somewhat later margin is the average
workweek--firms start increasing production by increasing hours. The
usual next step is temporary help employment--when firms decide to
hire, they often begin with temporary help. Eventually total
employment responds. The unemployment rate usually lags employment
slightly because employment growth brings some discouraged workers
back into the labor force and because the labor force naturally grows
over time. The last item to adjust is usually the duration of
unemployment spells, as workers who have been unemployed for extended
periods finally find jobs.
The table shows that recovery from this recession is following the
typical pattern, with labor market repair evident along the margins
that typically respond early in a recovery. Productivity growth has
surged as GDP has begun to increase and employment has continued to
fall.



Initial unemployment insurance claims, which rose precipitously earlier
in the recession, have begun to decline at an increasing rate. Likewise,
the workweek has gone from shortening to lengthening, albeit slowly.
Temporary help employment has changed from extreme declines to
substantial increases. So far, total employment has shown a greatly
moderating decline but has not yet risen. The pace of increase in the
unemployment rate has slowed noticeably, but the unemployment rate has
not yet fallen on a quarterly basis. Finally, increases in the duration
of unemployment have not yet begun to moderate noticeably.
These data suggest that the labor market is beginning to move in the
right direction, but much work remains to be done. The country is not
yet seeing the substantial rises in total employment and declines in
the unemployment rate that are the ultimate hallmark of robust labor
market improvement. And, of course, even once all the indicators are
moving solidly in the right direction, the labor market will still
have a long way to go before it is fully recovered.
Signs of healing are also beginning to appear in the industrial
composition of the stabilization of the labor market. Figure 2-15
shows the average monthly change in each of eight sectors in each of
the four quarters of 2009. As one would expect of the beginnings of a
recovery from a severe



recession, the moderation in job losses has been particularly
pronounced in manufacturing and construction, two of the most
cyclically sensitive sectors. There has also been a sharp turnaround
in professional business services, driven largely by renewed
employment growth in temporary help services.
One area where the Recovery Act appears to have had a direct impact
on employment is in state and local government. Despite the enormous
harm the recession has done to their budgets, employment in state and
local governments has fallen relatively little. Indeed, employment in
state and local government, particularly in public education, rose in
the fourth quarter.

The Challenges Ahead

The financial and economic rescue policies have helped avert an
economic calamity and brought about a sharp change in the economy's
direction. Output has begun growing again, and employment appears
poised to do so as well. But even when the country has returned to a
path of steadily growing output and employment, the economy will be
far from fully recovered. Since the recession began in December 2007,
7.2 million jobs have been lost. It will take many months of robust
job creation to erase that employment deficit. For this reason, it is
important to explore policies to speed recovery and spur job creation.

Deteriorating Forecasts

This jobs deficit is much larger than the vast majority of observers
anticipated at the end of 2008. This is not the result of as low
economic turn around. On the contrary, as described above, the change
in the economy's direction has been remarkably rapid given the
economy's condition in the first quarter of 2009. Rather, the jobs
deficit reflects two developments.
The first developmentis theunanticipated severityofthe downturn in
the real economy in 2008 and early 2009. Table 2-2 shows consensus
forecasts from November 2008 through February 2009, along with
preliminary and actual estimates of real GDP growth. The table shows
that the magnitude of the fall in GDP in the fourth quarter of 2008
and the first quarter of 2009--driven in part by the unexpectedly
strong spread of the crisis to the rest of the world--surprised most
observers. The Blue Chip Consensus released in mid-December 2008
projected fourth quarter growth would be -4.1 percent and first
quarter growth would be -2.4 percent. The actual values turned out
to be -5.4 percent and -6.4 percent. The Blue Chip forecast
released in mid-January also projected a substantially smaller decline
in first quarter real GDP than actually occurred.

Part of the difficulty in forecasting resulted from large data
revisions. The official GDP figures available at the end of January
2009 indicated that real GDP had fallen by just 0.2 percent over the
four quarters of 2008; revised data now put the decline at 1.9 percent.
The Administration's economic forecast made in January 2009 and
released with the fiscal 2010 budget, like the private forecasts,
underestimated the speed of GDP decline in the first quarter. It also
underestimated average growth over the remaining three quarters of
2009. For the four quarters of 2009, the Administration forecast
overall growth of 0.3 percent; the actual value, according to the
latest available data, is 0.1 percent.
The second development accounting for the unexpectedly large jobs
deficit involves the behavior of the labor market given the behavior
of GDP. Table 2-2 also shows consensus forecasts for the unemployment
rate. These data indicate that as of December 2008, unemployment in
the fourth quarter of 2009 was forecast to be 8.1 percent,
dramatically less than the actual value of 10.0 percent. As of mid-
January 2009, unemployment was forecast to be 8.4 percent in the
fourth quarter. In its forecast made in January 2009, the
Administration unemployment forecast was similar to the consensus
forecast.
Some of the unanticipated rise in unemployment was the result of the
worse-than-expected GDP growth in 2008 and the beginning of 2009. CEA
analysis, however, also suggests that the normal relationship between
GDP and unemployment has fit poorly in the current recession. This
relationship, termed Okun's law after former CEA Chair Arthur Okun
who first identified it, suggests that a fall in GDP of 1 percent
relative to its normal trend path is associated with a rise in the
unemployment rate of about 0.5 percentage point after four quarters.
Figure 2-16 shows the scatter plot of the four-quarter change in real
GDP and the four-quarter change in the unemployment rate. The figure
shows that although the fit of Okun's law is usually good, the
relationship has broken down somewhat during this recession. The error
was concentrated in 2009, when the unemployment rate increased
considerably faster than might have been expected given the change in
real GDP. CEA calculations suggest that as of the fourth quarter of
2009, the unemployment rate was approximately 1.7 percentage points
higher than would have been expected given the behavior of real GDP
since the business cycle peak in the fourth quarter of 2007.
This unusual rise in the unemployment rate does not appear to result
from unusual behavior of the labor force. If anything, the labor force



appears to have contracted somewhat more than usual given the path of
the economy. Rather it reflects larger-than-typical falls in
employment relative to the decline in GDP. This behavior is consistent
with the tremendous increase in productivity during this episode,
especially over the final three quarters of 2009. Indeed, labor
productivity rose at a 6.9 percent annual rate in the second quarter
and at an 8.1 percent rate in the third quarter; if productivity rose
by a similar amount in the fourth quarter, as seems likely, the
increase will have been one of the fastest over three quarters in
postwar history.

The Administration Forecast

Looking forward, the Administration projects steady but moderate GDP
growth over the near and medium term. Table 2-3 reports the
Administration's forecast used in preparing the President's fiscal
year 2011 budget.



The Administration estimates that normal or potential GDP growth will
be roughly 2\1/2\ percent per year (see Box 2-1). Because projected GDP
growth is only slightly stronger than potential growth, relatively
little decline is projected in the unemployment rate during 2010.
Indeed, it is possible that the rate will rise for a while as some
discouraged workers return to the labor force, before starting to
generally decline. Consistent with this, employment growth is
projected to be roughly equal to normal trend growth of about 100,000
per month.
----------------------------------------------------------------------
Box 2-1: Potential Real GDP Growth

The Administration forecast is based on the idea that real GDP
fluctuates around a potential level that trends upward at a relatively
steady rate. Over the budget window, potential real GDP is projected
to grow at a 2.5 percent annual rate. Potential real GDP growth is a
measure of the sustainable rate of growth of productive capacity.
The growth rate of the economy over the long run is determined by its
supply side components, which include population, labor force
participation, the ratio of nonfarm business employment to household
employment, the length of the workweek, and labor productivity. The
Administration's forecast for the contribution of the growth rates of
these supply side factors to potential real GDP growth is shown in the
accompanying table.



Over the next 11 years, the working-age population is projected to
grow 1.0 percent per year, the rate projected by the Census Bureau. The
normal or potential labor force participation rate, which fell at a 0.3
percent annual rate during the past 8 years, is expected to continue
declining at that pace. The continued projected decline results from
the aging baby boom generation entering their retirement years. The
potential employment rate (that is, 1 minus the normal or potential
unemployment rate) is not expected to contribute to potential
GDP growth because no change is anticipated in the unemployment rate
consistent with stable inflation. The potential ratio of nonfarm
business employment to household employment is also expected to be
flat during the forecast horizon--consistent with its average behavior
in the long run. This would be a change, however, from its puzzling
0.5 percent annual rate of decline during the past business cycle. The
potential workweek is projected to edge down slightly (0.1 percent per
year). This is a slightly shallower pace of decline than over the past
50 years, when it declined 0.3 percent per year. Over the 11-year
projection interval, some firming of the workweek would be a natural
labor market accommodation to the anticipated decline in labor force
participation.
Potential growth of labor productivity is projected at 2.3 percent
per year, a conservative forecast relative to its measured product-side
growth rate (2.8 percent) between the past two business cycle peaks,
but close to an alternative income-side measure of productivity growth
(2.2 percent) during the same period. The ratio of real GDP to nonfarm
business output is expected to continue to subtract from overall growth
as it has over most long periods, because the nonfarm business sector
generally grows faster than other sectors, such as government,
households, and nonprofit institutions. Together, the sum of all of the
components is the growth rate of potential real GDP, which is 2.5
percent per year.
As Table 2-3 shows, actual real GDP is projected to grow more rapidly
than potential real GDP over most of the forecast horizon. The most
important reason for the difference is that the actual employment
rate is projected to rise as millions of workers who are currently
unemployed return to employment and so contribute to GDP growth.
-----------------------------------------------------------------------

Traditionally, the large amount of slack would be expected to put
substantial downward pressure on wage and price inflation. For this
reason, inflation is projected to remain low in 2010. However, because
inflationary expectations remain well anchored, inflation is not
likely to slow dramatically or become negative (that is, turn into
deflation).
In 2011, slightly higher GDP growth of approximately 4 percent is
projected (again measured from fourth quarter to fourth quarter).
Consistent with this, stronger employment growth and a more
substantial decline in the unemployment rate are expected in 2011.
However, because GDP growth is still not projected to be as robust as
that following some other deep recessions, continued large output gaps
are anticipated. This will limit the upward movement of the inflation
rate toward a pace consistent with the Federal Reserve's long-term
target inflation rate of about 2 percent. Moreover, employment growth
is unlikely to be large enough to reduce the employment shortfall
dramatically in 2011.

Responsible Policies to Spur Job Creation

This large employment gap and the prospects that it is likely to
recede only slowly make a compelling case for additional measures to
spur private sector job creation. The Administration is therefore
exploring a range of possibilities and working with Congress to pass
measures into law.
Several principles are guiding this process. First, at a time when the
budget deficit is large and the country faces significant long-run
fiscal challenges, measures must be cost-effective. Second, given that
the employment consequences of the recession have been severe,
measures must focus particularly on job creation. And third, measures
must be tailored to the state of the economy: the policies that are
appropriate when an economy is contracting rapidly may not be the same
as those that are appropriate for an economy that is growing again but
operating below capacity.
Guided by these principles, the Administration has identified three
key priorities. One is a multifaceted program to jump-start job
creation by small businesses, which are critical to growth and have
been particularly harmed by the recession. Among the possible policies
in this area are investment incentives, tax incentives for hiring, and
additional steps to increase the availability of loans backed by the
Small Business Administration. These policies maybe particularly
effective at a time when the economy is growing--so that the question
for many firms is not whether to hire but when--and at a time when
credit availability remains an important constraint.
Initiatives to encourage energy efficiency and clean energy are
another priority. One proposal involves incentives for homeowners to
retrofit their homes for energy efficiency. Because in many cases the
effect of such incentives would be to lead homeowners to make cost-
saving investments earlier than they otherwise would have, they might
have an especially large impact. In addition, the employment effects
would be concentrated in construction, an area that has been
particularly hard-hit by the recession. The Administration has also
supported extending tax credits through the Department of Energy that
promote the manufacture of advanced energy products and providing
incentives to increase the energy efficiency of public and nonprofit
buildings.
A third priority is infrastructure investment. The experience of the
Recovery Act suggests that spending on infrastructure is an effective
way to put people back to work while creating lasting investments that
raise future productivity. For this reason, the Administration is
supporting an additional investment of up to $50 billion in roads,
bridges, airports, transit, rail, and water projects. Funneling some
of these funds through programs such as the Transportation Investment
Generating Economic Recovery (TIGER) program at the Department of
Transportation, which is a competitive grant program, could offer a
way to ensure that the projects with the highest returns receive top
priority.
Finally, it is critical to maintain our support for the individuals
and families most affected by the recession by extending the emergency
funding for such programs as unemployment insurance and health
insurance subsidies for the unemployed. This support not only cushions
the worst effects of the downturn, but also boosts spending and so
spurs job creation. Similarly, it is important to maintain support for
state and local governments. The budgets of these governments remain
under severe strain, and many are cutting back in anticipation of
fiscal year 2011 deficits. Additional fiscal support could therefore
have a rapid impact on spending, and would do so by maintaining crucial
services and preventing harmful tax increases.

Conclusion

The recession that began at the end of 2007 became the ``Great
Recession'' following the financial crisis in the fall of 2008. In the
wake of the collapse of Lehman Brothers in September, American
families faced devastating job losses, high unemployment, scarce
credit, and lost wealth. Late 2008 and 2009 will be remembered as a
time of great trial for American workers, businesses, and families.
But 2009 should also be remembered as a year when even more tragic
losses and dislocation did not occur. As terrible as this recession
has been, a second Great Depression would have been far worse. Had
policymakers not responded as aggressively as they did to shore up the
financial system, maintain demand, and provide relief to those
directly harmed by the downturn, the outcome could have been much more
dire.
As 2010 begins, there are strong signs that the American economy is
starting to recover. Housing and financial markets appear to have
stabilized and real GDP is growing again. The labor market also
appears to be healing, showing the expected early pattern of response
to output expansion.
With millions of Americans still unemployed, much work remains to
restore the American economy to health. It will take a prolonged and
robust GDP expansion to eliminate the large jobs deficit that has
opened up over the course of the recession. Only when the unemployment
rate has returned to normal levels and families are once again secure
in their jobs, homes, and savings will this terrible recession truly be
over.