The Post-Crisis Macroeconomic Reality
Transcript of The Post-Crisis Macroeconomic Reality
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The Post-Crisis Macroeconomic Reality
Wealth Inequality, GDP Stagnation,
Disinflation, and Low Interest Rates
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Its Not Over Till Its Over
Larry Summers, November 2013
Open question on our situation:
Does the current state of the U.S. and world economy represent
a new normal or a continuation of the 2007-2009 financial
crisis?
In other words: How can we confidently know the financial crisis
is over?
Knowing whether or not the crisis is over is important because it
directly impacts our choice of monetary and fiscal policies.
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Its Over
Most all macroeconomic indicators have vastly
improved over where they stood in 1Q2009.
There is no sense of panic in the financial markets
and broader economy.
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Its Not Over
Key economic growthindicators are significantly
lower than where they were projected to be six
years after the crisis (assuming a full recovery).
The real interest rate remains negative.
The U.S. Federal Reserve balance sheet remains
burdened with $4.4 trillion-worth of bailouts and
quantitative easing.
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Even if there is no definitive answer to the
question of whether or not the financial crisis is
over, can we at least develop a modelthat
describes (or explains) the current state of the
economy?
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A Model of the Current State of the U.S. Economy
High wealth and income inequality
Stagnant GDP growth (0-3%)
Decreased aggregate demand
Low long-term interest rates (0-2%)
Investors reach for yield, drive up
asset values
US Treasuries serve as international
safe haven investment
Increasingly aging population favors
fixed-income investments
Fed uses low-interest rate policies
to stimulate growth
Fiscal policy austerityReduced credit expansion
by financial sector
Increased economic instability 6
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A Cyclical Version of the Same Model
Long-Term IncomeInequality
Low GDP Growth
Low InflationExpectations
PersistentMonetary Easing
Asset ValueBubbles
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5
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Key Players in the Model
Long-Term IncomeInequality
Low GDP Growth
DisinflationaryPressures
(< 2% Inflation)
Persistent
Monetary Easing
(Negative RealInterest Rates)
Asset ValueBubbles
Central Bankers
Workers/Consumers
Investors
Managers
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34
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Potential for
Liquidity Trap
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Macroeconomic Evidence
Supporting the Cyclical Model
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The macroeconomic evidence supporting the
model is straightforward and uncontroversial.
The controversy lies in the models arrows of
causality, which likely hide critical assumptions.
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Evidence: 1
Source: Elise Gould, Why Americas Workers Need Faster Wage Growth And What We Can Do About It (2014, EPI Briefing Paper)
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Evidence: 1
Source: Fabrizio Perri, Inequalities, Recessions and Recoveries (2013, FRB Minneapolis Annual Report Essay)
The Y Axis represents the ratio of the top 5% of income earners and the median income; market income represents all
income sources (wages, salaries, rents, dividends, interest); disposable income represents market income plus transfer
payments minus tax liabilities.
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Evidence: 2
Source: Steve Keen, End This Depression? Never (published in Business Spectator, 26 November 2013)
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Evidence: 2
Source: Buttonwood, Trends in Low Places (18 November 2014, The Economist)
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Evidence: 2
Borrowed from: Laurence H. Summers, Reflections on the New Secular Stagnation Hypothesis,
in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press)
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Evidence: 2
Source: The Budget And Economic Outlook 2015 2025, Congressional Budget Office, January 2015
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Evidence: 2
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Source: Josh Zumbrun, The U.S. Economy Will Soon See Its Best Years in a Decade, Forecasters Say, Wall Street Journal, 2 Feb. 2015
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Drivers of GDP Stagnation
Shortfalls in Supply:
Slowing productivity growth (technological innovation reverting to itshistorical norm)[1,3,5,6]
Slowing labor force growth (aging population)[1,2,3,4,5]
Shortfalls in Demand:
Reduced middle class purchasing power (increasing income/wealth
inequality)[1,2]
Reduced aggregate purchasing power (transfer of production from high-
wage countries to the low-wage, low-consumption developing world)[2]
Reduced government debt and deficit spending (austerity is
fashionable)[1]
Increased household deleveraging versus consumption[2]Sources: C. [1]Teulings & R. Baldwin, Introduction, in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press);
[2] Steve Keen, End This Depression? Never (published in Business Spectator, 26 November 2013); [3] Paul Krugman,
Secular Stagnation, Coalmines, Bubbles, and Larry Summers (16 November 2013, The New York Times); [4] No Country
for Young People (22 November 2014, The Economist); [5]James Pethokoukis, Future economic growth will likely be slow
San Francisco Fed (15 February 2015, American Enterprise Institute); [6]J. Fernald & B. Wang, The Recent Rise
and Fall of Rapid Productivity Growth (9 February 2015, FRBSF Economic Letter)
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Hours Worked and Output Per Hour
(Productivity) are Decreasing or Stagnating
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Source: John Fernald and Bing Wang, The Recent Rise and Fall of Rapid Productivity Growth, FRBSF Economic Letter, 9 Feb. 20 15
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Evidence: 3
Source: The Budget And Economic Outlook 2015 2025, Congressional Budget Office, January 2015
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Evidence: 3
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Source: Eric Morath, Inflation Well Short of Feds 2% Target, Wall Street Journal, 2 Feb. 2015
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Evidence: 3
Calculated from a model published in: Inflation Expectations, Real Rates, and Risk Premia: Evidence
from Inflation Swaps (Haubrich, Pennacchi, & Ritchken, 2012; Federal Reserve Bank of Cleveland)
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Evidence: 3
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Source: The dangers of deflation: the pendulum swings to the pit, The Economist, 25 October 2014
World Inflation Targets
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Drivers of Deflation
Supply-side:
Increasing globalization of market capitalism after fall of Soviet Union[2,3]
The rise of the Internet and other information technology (IT) innovations[3]
A new international monetary system based on a shared commitment by central
bankers to prevent inflation and keep prices stable[3]
Global manufacturing overcapacity flooding markets with a glut of goods[1,2,4]
Falling commodity and oil prices[6]
Demand-side:
Debt-deflation following the bursting of a credit bubble (i.e., following a balance-
sheet recession)[4]
Wage stagnation (job security trumps upward wage pressure)[6]
Other: Excessive quantitative easing (QE) policies worldwide[5]
Sources: [1] M. J. Mandel, The Threat of Deflation (BusinessWeek, 10 November 1997); [2] A. Sullivan, Fear of Falling? Relax,
Global Deflation Might Be Good For You (New York Times, 30 January 1999); [3] C. J. Farrell, Deflation: What Happens When Prices
Fall (2004); [4] B. Bernanke, Deflation: Making Sure It Doesnt Happen Here (Remarks at the National Economists Club,
21 November 2002); [5]A. Evans-Pritchard, The nagging fear that QE itself may be causing deflation (The Telegraph, 4 June 2014);
[6] A.S. Blinder & J. L. Yellen, The Fabulous Decade: Macroeconomic Lessons from the 1990s (2001)
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Evidence: 4
Source: Paul Krugman, Four Observations on Secular Stagnation, in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press)
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Evidence: 4
Borrowed from: Laurence H. Summers, Reflections on the New Secular Stagnation Hypothesis,
in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press)
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Evidence: 4
Source: Josh Zumbrun, A Whiff of Secular Stagnation in Budget Forecasts, Wall Street Journal, 3 Feb. 2015
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Evidence: 4
Source: Josh Zumbrun, A Whiff of Secular Stagnation in Budget Forecasts, Wall Street Journal, 3 Feb. 2015
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Drivers of Low Real Interest Rates(i.e., high U.S. bond prices)
Bond investors pessimistic expectations:
Growth of U.S. economy slowing
Growth of world economy (China, Europe, Japan) slowing
U.S./world inflation will remain low
Central bank forward guidance has committed to low long-termnominal interest rates
Central banks maintain accommodative policies (i.e., target lownominal interest rates) to boost employment & GDP numbers
Excess rate of household savings (excess supply of potential loans)
Declining level of business investment (decreased demand forpotential loans)
General excess liquidity in system resulting from QE-type policiesBased on : O. Blanchard, D. Furceri, & A. Pescatori, A prolonged period of low real interest rates?
in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press);
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The Feds Contribution to Low Real Interest Rates
Borrowed from: N. Michel & S. Moore, Quantitative Easing, the Feds Balance Sheet, and Central Bank Insolvency (2014, Heritage Foundation)
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Persistently Low Real Interest Rates Are Bad
for Multiple Reasons
Low real interest rates undermine monetary policy: if real interest
rates are low during normal times, adverse macroeconomic shocks
may require negative real interest rates to restore full employment
however, negative real interest rates will undermine the
effectiveness of monetary policy in a low inflation environment. Low real and nominal interest rates undermine the financial stability
of the overall economy.
Low real interest rates increase the cost of new household
borrowing under deflationary conditions
Low real interest rates increase the financial burden of current
household debt under deflationary conditionsSources: C. Teulings & R. Baldwin, Introduction, in Secular Stagnation: Facts, Causes and Cures (2014, CEPR Press);
B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002
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Evidence: 5
Source: Screenshot from Yahoo! Finance (01 December 2014, 6:19 am EST)
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How Did the Model Look Before
the Crisis?
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The model looked much the same prior to the
crisis, with one fundamentally important
difference: commercial credit bubbles (6).
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The Great Moderation: 1985 - 2007
Long-Term IncomeInequality
Strong GDPGrowth Despite
Low Wages
PeriodicInflationaryPressures
Periodic MonetaryTightening
Asset ValuesSteadily Rise
Central BankersWorkers/Consumers
Investors/
Financial Markets
Managers
Cheap Credit,
Lax Loan Standards
Commercial Banks
6
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Fulmers Hypothesis: During the Great
Moderation, aggregate purchasing power
derived from the credit bubbles masked the
low-growth effects of long-term income/wealthinequality, which became visible only after the
credit bubbles burst.
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The Financial Crisis: 2007 - 2009
Long-Term IncomeInequality
GDP GrowthSeverely Slows
StrongDisinflationary
Pressures
Interest Rates HitZero-Lower Bound
(ZLB)
Asset ValueBubble
Central BankersWorkers/Consumers
Investors/
Financial Markets
Managers
Credit Bubble
Bursts
Commercial Banks
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Households Replace
Spending with Deleveraging
Central Bank Adopts Aggressive
Policy to Stimulate Demand
Investors Stay in Cash
Or Buy Paper Assets
Managers Reluctant
to Hire & Increase Wages
Central Bank Lacks
Credible Means of Increasing
Inflation ExpectationsLiquidity Trap
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A Liquidity Trap Drives and Is Driven By
Deflation
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Source: Paul Krugman, Fear of a Quagmire? New York Times, 24 May 2003
What if the economy is in such a deep malaise that pushing interest
rates all the way to zero isn't enough to get the economy back to full
employment? Then you're in a liquidity trap: additional cash pumped
into the economy -- added liquidity -- sits idle, because there's no
point in lending money out if you don't receive any reward.Andmonetary policy loses its effectiveness.
Once an economy is caught in such a trap, it's likely to slide into
deflation -- and nasty things begin to happen. Falling prices induce
people to postpone their purchases in the expectation that prices willfall further, depressing demand today.
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A Liquidity Trap Is a Central Bank
Credibility Problem
We normally say that an increase in the money supply leads to an
equal proportional increase in the price level But thats not actually
right. What a model with all the is dotted and ts crossed actually says
is that the CPI doubles if you double the current money supply and
all future expected money supplies.
[But]once you realize that central banks may not be able to move
expectations about future money supplies, it becomes a real
possibility that the economy will be in a liquidity trap: if interest rates
are near zero, money printed now just gets hoarded, and monetarypolicy has no traction on the real economy.
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Source: Paul Krugman, Macro policy in a liquidity trap (wonkish), New York Times, 15 November 2008
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A Liquidity Trap May Be Masked by
Credit Bubbles
Without all that increase in household debt [during the Great
Moderation: 1985 - 2007], interest rates would presumably have
to have been considerably lowermaybe negative. In other
words, you can argue that our economy has been trying to get
into the liquidity trap for a number of years, and that it onlyavoided the trap for a while thanks to successive [credit]
bubbles.
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Source: Paul Krugman, Secular Stagnation, Coalmines, Bubbles, and Larry Summers, New York Times, 16 November 2013
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An Entrenched Liquidity Trap Is Called
Secular Stagnation
Secular stagnation is the proposition that periods like the last
five-plus years, when even zero policy interest rates arent
enough to restore full employment, are going to be much more
common in the future than in the past that the liquidity trap is
becoming the new normal.
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Source: Paul Krugman, Three Charts on Secular Stagnation, New York Times, 7 May 2014
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Secular Stagnation Is a Demand-Side
Phenomenon: Krugman
Secular stagnation is the claim that underlying changes in the
economy, such as slowing growth in the working-age population,
have made episodes like the past five years in Europe and the
US, and the last 20 years in Japan, likely to happen often. That is,
we will often find ourselves facing persistent shortfalls of
demand, which cant be overcome even with near-zero interest
rates. But if we have a persistent shortfall in demand, what
we need is measures to boost spending higher inflation,
maybe sustained spending on public works (and less concernabout debt because interest rates will be low for a long time).
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Source: Paul Krugman, What Secular Stagnation Isnt, New York Times, 27 October 2014
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Secular Stagnation Is a Demand-Side
Phenomenon: Summers
Secular stagnation in my version, like that of Alvin Hansen, the
economist who coined the term in the 1930s, has emphasized
the difficulty of maintaining sufficient demand to permit
normal levels of output. But with a high propensity to save, a
lowpropensity to invest and low inflation, this has been
impossible.
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Source: Lawrence Summers, Bold Reform Is the Only Answer to Secular Stagnation, The Financial Times, 7 September 2014
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Evidence: 6
Borrowed from: D. Alpert, R. Hockett, & N. Roubini, The Way Forward (2011, New America Foundation)
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How Can We Boost GDP Growth?
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If it isnt socially or politically feasible to flatten
wealth and income inequality through harsh
redistributive policies, what other options exist
to boost purchasing power and spur GDPgrowth?
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Suggested Policies for Spurring GDP Growth
Supply -side structural strategies: Educate and improve the skills of the workforce
Improve companies capacity for innovation
Implement structural tax reforms
Bolster entitlement programs
Demand-side (Keynesian) strategies:
Continue to lower nominal interest rates (standard monetary
policy)
Temporarily raise the inflation target to lower real interest rates[2]
Increase public investment in infrastructure (fiscal policy)[1]
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Suggested Policies for Spurring GDP Growth (Contd)
Other approaches: Recognize that the growth era is over and seek to maintain a
steady-state economy[3]
Commit to higher inflation and simultaneously intervene in the
foreign-exchange markets to devalue the dollar[4]
Sources: [1]Larry Summers, Strategies for Sustainable Growth (5 January 2014, The Washington Post); [2] Why is Stagnation
Bubbly? (6 January 2014, The Economist);[3] Herman Daly, The Negative Natural Interest Rate and Uneconomic Growth (17
January 2014, The Daly News and blog entry on triplepundit.com); [4] Purchasing Power Disparity (14 January 2014, The Economist);
Glut Busters (15 May 2014, The Economist) [5]
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Conclusion
Its not over.
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Appendix
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Larry Summers Speech at the IMF Economic Forum (8 November 2013)
Observation #1:
Economy four years after the crisis:
While panic was averted, the share of adults working today is basically the same as it was four years ago, and GDP has fallenfurther behind 2009 potential.
Observation #2:
Economy prior to the crisis:
There was too much easy money, too much borrowing, too much wealth, yet inflation was entirely quiescent. Thus, somehow
even a great [credit] bubble wasnt enough to produce any excess in aggregate demand .
Explanation that might fit both observations (Summers hypothesis):
The short-term real interest rate consistent with full employment had fallen to -2 or -3% sometime in the middle of the last
decade. In that case, even with artificial stimulus to demand from financial imprudence, you would not see excess demand.
Moreover, even with a resumption of normal credit conditions, you would have difficulty getting back to full employment.
Policy Challenge Going Forward:
While its been demonstrated that monetary policy can contain panics when the interest rate is at zero; and while its also been
demonstrated presumptively that monetary policy can affect a range of asset prices to support demand when the interest rate is
zeroit may be a very difficult situation when natural and equilibrium interest rates have fallen significantly below zero
because it becomes much more difficult to make long-term use of extraordinary [monetary policy] measures.
Final Lesson:
We need to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor
of economic activities, holding our economies back below their potential.
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Policies for Combating Deflation
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H th F d l R C P t
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How the Federal Reserve Can Prevent
Deflation
During normal times, do not try to pushinflation to zerorather, a maintain a bufferzone of perhaps 1 -3% per year.
Use supervisory and regulatory powers toensure banks are well capitalized and thefinancial markets are functioning smoothly.
When inflation is already low, actpreemptively and aggressively to furtherlower interest rates.
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Source: B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002
H th F d l R C C
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How the Federal Reserve Can Cure
Deflation
Print money & distribute [very unlikely].
Purchase short-term U.S. Treasury securities (traditional open-
market operations)
Make large-scale asset purchases (LSAPs) (quantitative easing (QE))
Long-term U.S. Treasury securities
U.S. agency-backed securities
Purchase foreign government debt
Offer low- or zero-interest-rate loans to banks, with a range of
private assets deemed eligible as collateral. Intervene on currency markets to depreciate the U.S. dollar
[unlikely since it contradicts U.S. Treasury policy].
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Source: B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002;
N. Michel & S. Moore, Quantitative Easing, The Feds Balance Sheet, and Central Bank Insolvency (Heritage Foundation, 14 August 2014)
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How Fiscal Policy Can Cure Deflation
A broad-based tax cut
Increase government spendingSource: B. Bernanke, Deflation: Making Sure It Doesnt Happen Here, remarks at the National Economists Club, 21 November 2002