Editors' Summary

The brookings panel on economic activity held its eighty-seventh conference in Washington, D.C., on April 2 and 3, 2009. The conference occurred barely six months after the collapse of the investment bank Lehman Brothers, an event often used to date the transition from a largely conventional cyclical downturn, characterized by a strained financial system and mild recession, to a full-blown financial and economic crisis. In keeping with the Brookings Papers' tradition of providing timely analysis of current economic events, three of the papers in this volume address the role of various factors in the initial downturn and the ensuing crisis, including the response of policymakers, the behavior of bond markets, and the role played by the oil market. The two remaining papers examine the impact of tax cuts on government spending, and the role of corruption in undermining popular support for market-oriented policies.

In the first paper in this issue, Phillip Swagel provides an insider's account of the policy debates as they unfolded in real time during his tenure as assistant secretary of the Treasury for economic policy in the last two years of the Bush administration. Swagel's account is both a blow-by-blow history of the policy response to the crisis and a lesson in economic realpolitik. He documents that the Treasury under Secretary Henry Paulson was quite aware of the fragility of the financial system as early as 2006, and indeed, interagency work was well under way to develop a strategy for dealing with a crisis should one occur.

Swagel's narrative provides insight into the constraints on the policy process that were not immediately apparent to many commentators. In particular, policymakers at the Treasury and at the Federal Reserve were unable to pursue a number of useful policy proposals simply because they and other government agencies lacked appropriate legal authority. Although Congress could have granted that authority, this raised the even larger concern of political constraints, which were particularly important in the context of a profound lack of trust between the executive and legislative branches. A recurrent theme of the paper is the sheer difficulty of getting Congress to respond under anything less than crisis conditions—and possibly even then—which delayed and diluted the eventual policy response. Swagel also highlights a third, more practical constraint: time. Policymakers had to make decisions rapidly, often with too little information, as financial markets collapsed around them. He reserves some constructive criticism for the role played by many academic macroeconomists throughout the ensuing public debate: their editorializing, in his view, appeared largely uninformed by the various constraints, rendering their advocacy often unhelpful and occasionally even counterproductive. At the same time, however, he faults the Treasury for doing a poor job of making its case to a skeptical public.

In the second paper, John Campbell, Robert Shiller, and Luis Viceira present a thorough accounting of what has been learned from the first quarter-century of experience with inflation-indexed bonds in the United Kingdom and the first decade of experience in the United States. Yields on these bonds indicate a substantial and puzzling decline in long-term real interest rates from the 1990s through 2008. The volatility of these real rates was likewise unexpected, given that a key determinant, the marginal product of capital, can reasonably be presumed to be stable over time. Over the same period, movements in the prices of inflation-indexed bonds have come to be negatively correlated with movements in stock prices. The authors also find that seemingly very similar bonds can bear surprisingly different yields, with real U.S. and U.K. yields diverging at times by over 2 percentage points.

Having documented these facts, the authors set out to explain them. They begin with the expectations theory of the term structure—the view that long-term real yields reflect current and expected future short-term real interest rates. As expected short-term real rates vary, so too does this long-run expectation. Using a simple econometric model to proxy for expectations about current and future short-term rates, the authors succeed in replicating some of the observed changes in long-term inflation-indexed...