Nobel Laureates on Fixing the Economy

As grim financial predictions dominate the news, it seems everyone is scrambling to become an expert on the economy. With the presidential election right around the corner, the pressure to craft a coherent narrative on the country's financial woes is especially high in Washington. It's been called a perfect storm; the combination of volatile markets, looming energy crises and high-stakes politics has delivered a moment of national focus, with more than 89 percent of the country believing that a fundamental shift is needed in how America runs itself.

But a shift to what? Both John McCain and Barack Obama have presented a series of ambitious economic packages that have further polarized both sides of the aisle, as well as Wall Street and Main Street. Perhaps the only matter universally agreed upon is that the next president—whoever he may be—will face a daunting set of fiscal challenges and a dramatically reduced set of resources with which to confront them.

To make sense of those challenges, NEWSWEEK invited winners of the Nobel Prize in Economic Sciences to explain how they would advise the next president in crafting and prioritizing his economic-recovery efforts. Excerpts:

Paul Krugman, a professor of economics at Princeton University since 2000, was awarded the Nobel Prize in 2008 for his work on international trade patterns. A twice-weekly columnist in The New York Times and former columnist in Fortune Magazine and Slate, he served on the U.S. Council of Economic Advisers from 1982 to 1983.
The idea that a new president should emulate Franklin Delano Roosevelt's first 100 days—a blizzard of activity to address a national crisis—has become a cliché. But this time it's exactly right. Assuming that this election goes the way almost all projections say it will, with Barack Obama taking the White House and Democrats greatly reinforcing their control of Congress, there should be rapid and radical action on at least three fronts.

First, the economy will almost surely be in a nasty recession by January. As soon as possible, the administration and Congress should fight this recession by putting in place a major fiscal-stimulus plan, this time centered on spending rather than tax cuts—aid to stressed state and local governments, expanded and extended unemployment benefits, and some serious public-works spending. The goal is to do well while doing good—to provide much needed help to individuals and help repair our frayed infrastructure, while at the same time supporting demand and employment.

Second, the administration should press rapidly forward on financial regulation. I hope—hope—that by January the financial rescue efforts already underway will have relieved the worst of the credit crunch. But even if they have, that's only the first step. We need much-expanded regulation to protect against a return of the financial crisis; if financial institutions need to be rescued like banks, they need to be regulated like banks, with the key things being capital requirements and oversight.

Third, now is the time for health-care reform. Some people say that the health-care issue should wait, but I disagree. The economic crisis has driven home the insecurity created by our current system, under which the misery of Americans who lose their jobs is often compounded by the loss of health insurance, as well. If elected, Obama should try to emulate LBJ, who signed Medicare into law less than 10 months after his 1964 victory.

Is this a wildly ambitious agenda? Yes—but these are wild times, and the country is ready for change. I'll give Obama a bit more than a 100 days—say, six months—but he should move fast. Like the crisis of the 1930s, the current crisis offers an opportunity to reform our system in fundamental ways.

A. Michael Spence, a senior fellow at the Hoover Institution and professor emeritus at Stanford University's business school, was awarded the Nobel Prize in 2001 for his work on markets with asymmetric information. From 1991 to 1997, he was chairman of the National Research Council Board on Science, Technology and Economic Policy.
The next administration will have a full plate. It will need to continue to inject capital into the financial system and take measures to ensure the functioning of the payments system and short-term credit markets. It will also need to return to the mortgages and reset terms, avoid a flood of foreclosures, all of this for efficiency, equity and political reasons. It will then need to inject a fiscal stimulus while communicating a plan to return the budget deficit to more sustainable levels in the medium run. It will need to coordinate policies with other major economies to avoid unintended and unwanted volatility in capital flows searching for the safest haven. It will need to structure its ownership and substantial control of the financial sector in such a way as to make it possible for private capital to reenter as the [industry's] damaged balance sheets get better and the visibility/transparency improves. Postcrisis it will need to thoroughly examine the systemic failures with a view to redesigning the regulatory oversight of the sector.

Priorities will have to be set on the fly as conditions shift, often rapidly as we have seen, in the economy and the financial sector. The overriding priority should be to have a top-flight team in Treasury, led by a secretary who, like Secretary Henry Paulson, has experience and stature in the financial sector.

Joseph E. Stiglitz, a professor at Columbia University, was also awarded the Nobel Prize in 2001 for his work on the economics of information. He was chief economist of the World Bank and chair of President Clinton ' s Council of Economic Advisers.
The next president takes office at a challenging time (to put it mildly) for the economy. He will inherit an economy in recession, a country facing a growing divide between rich and poor, a health-care system in which we spend more money to get poorer results than any other advanced economy and a society with an oil addiction that has only grown worse over time. The massive debt and deficit he will inherit will mean that the resources to attack these problems will be very limited.

We will almost surely be going into a deep recession—the longest since the Great Depression. The immediate focus will be how to prevent it from getting worse. Inevitably, unemployment will grow, but more and more will find their benefits expire before they find another job—some 700,000 or so are likely to be in this position in the next few weeks. Pumping money into the banks was critical, but trickle-down economics doesn't work; by itself it's not enough. States are facing massive shortfall in revenues, and without aid, they have to start laying off workers. Foreclosures are likely to continue apace, as house prices continue to fall as a result of the bursting of the bubble.

To recover, however, we need more; investments in infrastructure and technology. Green investments on alternative-energy sources and public-transport systems can help wean us off our oil dependence. But recovery is not enough: we need to prevent a recurrence. We need new regulations and a new regulatory framework—one that can not only protect us against risks of bad lending, but against the risk of a president who doesn't understand the role of regulation in a modern economy.

To get the resources to attack these daunting problems means that we will have to raise taxes, at least on upper-income Americans, and use all of our resources wisely. There are two major sources of waste in our economy: the first is in the military, where spending has been unbridled—including on weapons that don't work designed to fight enemies that don't exist. We could have more security with a smaller military budget. The second is in health care. We have been aware of the problems for years, but vested interests have resisted change. Matters have become worse in the last eight years—the paradox of more uninsured and more spending. Reforming the health care system is essential to the health of our society, but also to the health of our economy.

This is, admittedly, an ambitious agenda. But we have no choice, if we wish to preserve and enhance our standard of living. Such a program will both increase output in the short run and help growth in the long run.

Edward C. Prescott is a senior monetary adviser at the Federal Reserve Bank of Minneapolis and a professor of economics at the W.P. Carey School of Business at Arizona State University. He was awarded the Nobel Prize in 2004 for his work on dynamic macroeconomics.
No matter who wins office, the temptation will be to change as many rules as possible, as quickly as possible. This is usually the inclination of an incoming president, but this will be especially true given the current financial turmoil and the perceived urgency to "do something!" However, I would remind the next president that changing the rules of the game too dramatically can have unintended consequences, which are often suboptimal. Indeed, even hinting that rules will be changed can alter expectations and change behavior.

This is especially true on the issue of taxes. There is no more important issue on which a president can affect the economy than the question of taxation. Recent research has revealed that tax rates are the key factor in determining the economic health of developed nations. Ingenuity, risk-taking and productivity are the engines of economic growth, and all are dependent on properly aligned incentives. High tax rates are the surest way to squash those incentives and stall that engine.

Another key issue that the next president will face is the call for health-care reform. Again, I would caution the next president to consider measures that will help unleash Americans' creativity and make the system more efficient. We've already developed less expensive walk-in clinics, and a market is developing for cheaper and better home health care for the elderly. And we've done these things without government directives. More regulations, price controls and too much government oversight will result in less efficient outcomes.

Third, I would advise the next president not to equate the current financial turmoil with the onset of another Great Depression. Yes, credit markets matter: firms need ready funds, banks need to trust each other, and investors need the confidence on which all capital markets depend. But that's why we have a central bank, and that's why the Federal Reserve—along with the Treasury Department and central banks around the world—has taken its extraordinary measures. This is what lenders of last resort are supposed to do. Let them do their job. The real economy will survive this episode.

One final note: we expect too much of our presidents when it comes to the economy, and they are often too happy to oblige that expectation. The American people don't need a president to manage their business but rather to manage the rules. Here's hoping for a steady hand.

Eric Maskin has been a professor of social science at the Institute for Advanced Study in Princeton, N.J., since 2000. He was awarded the Nobel Prize in 2007 for his work on mechanism design theory.
I'd advise the next president to learn to distinguish between markets that do not call for government intervention and those that do. Many markets work best with little or no outside interference. But others—especially those subject to big "externalities"—need a helping hand. The credit market is in this second category.

When a bank calls in a loan, it obviously hurts the customer in question. But it also adversely affects other banks that have lent to this borrower. They are now less likely to be repaid, and so can't as readily lend to their own customers. We say the original bank exerts an externality—a secondary effect that it doesn't take account of—on these other banks. As long as everyone continues lending, all is well. But if some banks stop doing so—perhaps because a number of customers have defaulted—they may force other banks to call in their loans, too. The chain reaction so generated could end up paralyzing the credit market altogether. Sound familiar?

Yet, government can save the day. By infusing money into some banks, it allows them to begin lending again. With a big enough infusion, the chain reaction reverses, and ultimately the market is restored to health—at which point the government presumably gets its investment back.

Such intervention comes, however, with an attendant risk. If banks anticipate government will come to the rescue should the credit market go badly awry, they may make loans that would otherwise be imprudent, e.g. subprime loans with little prospect of repayment. So a contingent bailout policy—implicit or explicit—must be coupled with some regulation of what banks can and cannot do. For example, a ban on lending to uncreditworthy customers might well make sense.

Our new president should not forget that unrestrained markets are remarkably successful at delivering many of our most-needed goods and services. But he must also understand the logic of externalities and why in markets like credit—where externalities are significant—a well-planned activist role for government could be vitally important.

Edmund Phelps was awarded the Nobel Prize in 2006 for his work on the tradeoffs between economic objectives. He currently directs the Center on Capitalism and Society at Columbia University.
There are good booms. For example, the Internet boom of the late '90s was a happy time and left lasting benefits. The latest housing boom was different. It buoyed employment, but it proved to be a massive malinvestment that left near-insolvent banks, a credit crunch and an emerging business slump. The debacle has revealed serious flaws in the banking and finance system, which the next president will have to confront head-on.

The absence of owner control over management in the big banks was costly. Bank heads were locked in a competition in which each one "reached for return" as needed to keep profits and share price on a par with rivals—no matter what the risk. Nowhere was there a way for shareowners to say "stop." To prevent that from happening, stronger corporate governance is needed. I would advise the next president to press Congress to legislate that the proposed base pay of CEOs be submitted to a shareholder vote and that bonuses be geared to long-term performance.

The lack of vision in bank management was another flaw. Bankers seemed unwilling to acknowledge and allow for the possibility that interest rates might rise back to more familiar levels and that housing prices (in real terms) were about 40 percent over historical norms. That unwillingness helped create the subprime crisis that's consumed much of the industry. True, the next president cannot legislate "strategic vision." But financial players, instead of communicating and analyzing in terms of a single future, could be required to work with two or three future hypotheticals that include best- and worst-case scenarios.

Finally, the great investment banks ceased to be an instrument of capitalism for the finance of business investment and innovation, and became agencies for "wealth management." It was economic policy that drew banks to mortgages, of course. The American dream became "home ownership" rather than a successful career. To redress the balance, the next president should press Congress to provide businesses with additional subsidies to help them invest, comparable to the subsidies it provides households—through Fanny Mae and Freddie Mac—to buy homes.

If America is to continue to be the place where ordinary people find stimulation, challenge, novelty and fulfillment, our business sector will need more dynamism and inclusion than it has shown lately. This will require a restructuring of the financial sector to serve business innovation. The tiny band of "angel investors" and venture capitalists can't do it all. Also, the next administration must act to stimulate jobs for the disadvantaged, many of whom are now in prison. I have long advocated that a subsidy be paid to each firm employing low-wage workers as a way of raising their pay and stimulating their employment. Barack Obama's planned hiring subsidy is a step in that direction. But we have miles to go to get back on the track for dynamism and inclusion.

Update: After this story was published, we received a response from a seventh Nobel-winning economist, who had been traveling and was therefore initially unable to contribute his essay.

Sir Clive W.J. Granger was awarded the Nobel Prize in 2003 for his work on economic time series. Born in Wales, he has been a professor of economics at the University of California, San Diego since 1974.
Most economic recessions can only be broken by a change in opinion or attitude by the majority of the participants such as investors, buyers, or speculators. Any major figure, particularly a president, could influence the thinking of "investors" at certain critical moments. Such a change has to involve a new idea that sounds sensible and has wide acceptance. The $700 billion bail-out proposed by Congress did not pass the simple acceptance tests, but the "British" suggestion introduced by British Prime Minister Gordon Brown is performing well and getting wide attention.

The next president could state, for example, that his administration is implementing something like the British proposal, which clearly makes some common sense [even if unclear economics] and is being introduced by several other countries. The cost is less than previous schemes and is designed to be reversible in four or five years if successful. The money is going exactly where it is most needed! Should the Brown plan be widely accepted and acted on, we will still all face a few weeks or possibly even months of uncertainty before the world's economies get back on a sound trajectory.

Concerning [worries that] government spending would be too great: it would be less than continuing the Iraq war for a few years and much less than going to war with Iran, which is so casually debated. The costs should certainly be kept watch over and publicized.

Placing funds directly into banks also sounds like a plausible proposal. If it does not work we will have to survive a few more uncomfortable weeks before another plausible idea arises.
Finally, in my opinion, the new president should concentrate his energies on getting workers back to work and strengthening inustry, once the credit markets are working well.