Joshua Bates
Dr. Dumas
Econ 6352
6 December 2010
A Survey of the Crisis
Much has been made of what to do to prevent a financial catastrophe similar to the one that caused the ongoing “Great Recession.” Post passage of the recovery act, little attention seems to be paid to the fact that the economy is still in a prolonged state of high unemployment and low GDP growth. This question, until the recent announcement of further quantitative easing by the Federal Reserve, seemed to be already answered in the minds of policy makers and pundits alike; let stimulus work its magic, and pretend everything is alright. However, this is not the first severe downturn, nor the first financial crisis; perhaps history can illuminate a more proactive position for policy. On the other hand, perhaps history shows a dark road ahead, implying that no solution is the best solution and that the economy will recover in time. An outline of possible solutions will require a survey of the crisis and an examination of solutions, both implemented and potential with an eye towards what came before.
First the events leading up to the crisis must be chronicled before a sober analysis can be made. The St. Louis Federal Reserve financial crisis timeline begins in February of 2007, but in truth, the events that lay the framework for catastrophe were laid years earlier. Lax lending standards had been pervasive for years before the first nudge into the downward spiral, and made the financial system weak when that nudge finally came. According to Thomas Sowell’s The Housing Boom and Bust, “That nudge came as the Federal Reserve System, having lowered its own interest rates to an extremely low one percent, began slowly raising the interest rate back toward more normal levels in 2004” (57). These low interest rates made homes more attractive to potential buyers, both making it more affordable for well qualified buyers, and dropping higher valued houses into lower income price ranges. This increased demand spurred housing prices, but specialty loans such as the adjustable rate mortgage, a loan with a low fixed rate for the first few years and a floating rate after that, and interest only loans, loans which required only interest payments for the first few years, combined with little vetting on the part of bankers, allowed lower income customers to keep up with rising housing prices. 2006 would be a rude awakening to anyone who was dependent on their homes maintaining value for financial security.
As previously mentioned, the movement of interest rates in 2004, adversely affected housing prices later. What happened could have come straight from an economics textbook:
Then, just as unusually low interest rates had made monthly mortgage payments more affordable for more people, increasing the demand for houses and therefore their prices, conversely the rise of interest rates to more normal levels made monthly mortgage payments more expensive, and thereby reduced the demand for houses. (Sowell 58)
Now, all of the adjustable rate mortgages could move to higher rates, as well as interest only loans; those hanging by a thread before were foreclosed on, creating excess supply. It took two years of interest rate movement and foreclosures to work, but by 2006, housing prices began their freefall. Speculators got stuck holding the bag on high priced houses that could not be flipped for a profit, or even flipped at all, and they were foreclosed on, adding fuel to the housing price bonfire. Others just walked away; nobody wanted to pay for a mortgage on a house that had just lost hundreds of thousands of dollars worth of value. Still others had built a house of cards on home equity loans against the appreciated value of their homes, “Here too were people who were not trapped by circumstances beyond their control but who had simply chosen risky ways of getting money and lost” (Sowell 67). These busted home loans and housing prices would have been merely a local phenomenon, but for one thing, the mortgage bond market.
This is not the country’s first subprime problem; that is, the banking industry had a chance in the previous decade to learn how to loan money to people that could pay it back. That lesson would go unlearned, however, “[The banking industry] learned a complicated one: You can keep on making these loans, just don’t keep them on your books” (Lewis 24). These loans were repackaged into bonds, containing pieces of hundreds of different loans, each bond containing a different mix of high and low quality loans. These bonds were then broken into further tranches and recombined into collateralized debt obligations (CDO), a sort of mutual fund made up of several bits of mortgage bond. These were bought by investors big and small since they seemed like the perfect investment for everyone; young, high risk investors could purchase higher interest, riskier CDOs, and lower risk investors could get extremely safe tranches at low interest rates, assuming the risk estimates were correct. Unfortunately even the safer tranches may not have been so safe:
The dark magic of structured finance conjured many low-risk securities out of many risky securities. Like all dark magic, however, the conjuring came at a price because if you didn't get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined. (Tabarrok)
In any case, this left many exposed to a huge risk of mass defaults if the housing market ever collapsed, including the most recognized names on Wall Street. According to Michael Lewis, “By early 2005 all the big Wall Street investment banks were deep into the subprime game. Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley all had what they termed “shelves” for their subprime wares…” (Lewis 24). If they were not already, these firms would become household names when they collapsed.
By February of 2007, the ball was already moving towards calamity; while it is likely not true that nothing could be done to stop it, certainly nothing was effective. One action that seems to be currently left out of the debate is the Economic Stimulus Act of 2008, enacted in February of that year. According to the Consumerist, the stimulus took “the form of instant cash bonuses: $800 for individuals and $1600 for married couples” (Consumerist.com). The initial outlook of the stimulus looked promising; previously this style of stimulus seemed to work in 2001. Per the New York Times, ”The tax rebates granted after the 2001 recession —which amounted to an average of $500 per eligible household — proved surprisingly effective, because people spent most of the money rather than salting it away in savings or using it to pay down credit card debt” (“How to Rev Up a Slowing Economy”). However, there were early naysayers, and this attempt would eventually be swamped by the collapse to come. The administration was not the only policy maker working on the problems.
Even before the Bush stimulus, the Federal Reserve began damage control. September 18, 2008, according to the St. Louis Federal Reserve Timeline, “The FOMC votes to reduce its target for the federal funds rate 50 basis points to 4.75 percent. The Federal Reserve Board votes to reduce the primary credit rate 50 basis points to 5.25 percent.” This began a steep drop in the federal funds rate, the rate at which banks loan money to each other, to near zero percent levels still being experienced at the time of this writing. These rate changes, along with open market actions and unprecedented lending practices would lead one to conclude that monetary policy was expansionary. Certainly at the time it was believed to be loose and many pundits continue to believe. In any case, it was not enough to reduce the damage done by lax lending practices, mortgage securitization and the increased demand caused in part by extended periods of low rates previously. September of 2008 was already on the way. Up until September of 2008, the economy was dragging along, having difficulty absorbing a minor financial issue and relatively mild recession. To start, two large government-sponsored enterprises, Fannie Mae and Freddie Mac, entered into government conservatorship. This helped to spark Bank of America’s purchase of Merrill Lynch, Lehman Brothers’ bankruptcy, the closing of Washington Mutual Bank, the bailout of American International Group and Wachovia’s cessation of banking operations. Although Countrywide Financial and Bear Stearns failed earlier in the year, they did not have the same effect as these closings. This eventually caused the Emergency Economic Stabilization Act of 2008 to be passed, establishing the Troubled Asset Relief Program; this program became a hub of funds to bail out first banks but later General Motors. With all this excitement going on, it was the perfect time to elect a new president.
President Obama went to work right away at stimulating aggregate demand. The most notable action was the February 17, 2009 passage of the American Recovery and Reinvestment Act of 2009 (ARRA), better known as the stimulus bill; this would come to be one of the more controversial actions in the aftermath of the crash. The new administration also took several actions to pacify financial markets, the most heavily touted of which was the bank stress tests. There were also programs designed to prevent foreclosure and lure in new home buyers. Every lever of policy seemed to be set to full throttle, however, the economy did not seem to be getting much better, and in some places maybe even a little worse. Perhaps history has something to say about this.
Carmen Reinhart and Kenneth Rogoff had a similar idea, and decided to devote much research to the subject of financial crisis. Their conclusion is that during the boom times, policy makers suffer from what they cleverly term as “This time is different syndrome.” According to the authors, the cause is a overstatement of the soundness of current policy:
It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. The current boom, unlike the many booms that preceded the catastrophic collapses of the past (even in our country), is built on sound fundamentals, structural reforms, technological innovation, and good policy. (Reinhart 15)
Their conclusion seems to suggest that we look to history, not always to determine how to prevent crisis altogether, but to determine how best to deal with crises when and where they arise. Further evidence for the need for solutions instead of vaccination appear later in the book, with the indication that, “thus far, no major country has been able to graduate from banking crises” (Reinhart 147). As a bit of anecdotal evidence, it seems clear from the description of the current crisis that it would have been difficult to legislate against the intricate workings of the events that went into the crisis before it happened. Certainly the next financial crisis will take a form completely alien to current theory in finance, and perhaps even economics.
Although the causes for financial crisis appear to be intricate and unique to the individual event, the leading indicators do not. Case in point is the current crisis; booming asset prices, in the form of the housing bubble, are a certain sign of trouble that appears to have been ignored. In addition the debt buildup seemed to confirm these potential problems. In fact, this crisis seems to have been imminently predictable, if not preventable:
We showed that standard indicators for the United States such as asset price inflation, rising leverage, large sustained current accounts deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis – indeed, a severe one. (Reinhart 223)
This provides two useful concepts; if this financial crisis conforms to historical precedent, then historical solutions can work here. Furthermore, if catastrophe is predictable then the blow can be cushioned in future, even if it cannot be prevented altogether.
Knowing the former, recommendations given by academics, pundits and policy makers alike can be reviewed for effectiveness. Firstly, one area where this crisis is unique is the state of the public debt; while the debt was high at the time of crisis, “The U.S. public debt buildup prior to the 2007 crisis was less than the [the five largest financial crises among developed nations since the Great Depression] average” (Reinhart 220). This means that deficit spending could perhaps have been a tool for dealing with the crisis; certainly with the large stimulus passed in early 2009, this fact was not lost on the administration. It was also not lost on the international community.
A quick look to the International Monetary Fund shows where the administration seems to be getting its advice. In an article titled “The Crisis through the Lens of History,” Charles Collyns recommends, “to act early, to act aggressively, and to act comprehensively to deal with financial strains.” Certainly there are questions as to whether this advice was taken to heart; according to CNN, the National Bureau of Economic Research marked the beginning of the recession in December of 2007 (Isidore). The first Bush stimulus as noted above did not come until February of 2008, and even then it was unable to stem the tide. However, stimulus plans, according to Collyns are a must in times of financial crisis, “With the effectiveness of monetary policy limited by financial disruptions, fiscal stimulus must play an important role to help maintain the momentum of the real economy and curtail negative feedbacks between the financial and real sectors.” The Obama stimulus plan, while coming as soon as he was able to pass it and much larger than the Bush stimulus, was by some accounts still too small. Referring to the ARRA, Paul Krugman opines that, “he offered an inadequate plan in order to win bipartisan support, then got nothing in return — and was forced to reduce the plan further so that Susan Collins could claim her pound of flesh” (“Obama messes up”). Another issue was the construction of the stimulus package. Richard Posner writes that, “No effort was made to target the stimulus on industries and areas of the country in which unemployment is greatest; it is those industries and those areas in which the employment effect of the stimulus would have been maximized” (“Stimulus: Pluses and Minuses”). These criticisms seem to imply that whatever the effectiveness of Collyns’s advice, the less than effective outcome of the stimulus plan may be attributed to execution, rather than poor precedent.
Whether the stimulus plan was the correct move at all still remains a point of contention. Thomas Sowell is one of the harsher critics of stimulus spending, quoting Schumpeter who wrote that, “the inaction of government, however reprehensible on humanitarian grounds, contributed to recovery at least by not hampering it.” Sowell even theorizes about how the stimulus may have even made the economic crisis worse:
In that atmosphere of uncertainty generated by unpredictable government policy experiments, people tend to hold on to their money. The velocity of circulation of money slowed down during the Great Depression, just as it has today. Massive government deficit spending did not stimulate private spending then, any more than it is stimulating it now.
Perhaps the most vocal critic of deficit spending is history itself. Reinhart and Rogoff indicate that, “Our extensive coverage of banking crises, however, says little about the much-debated issue of the efficacy of stimulus packages as a way of shortening the duration of the crisis and cushioning the downside of the economy as a banking crisis unfolds” (289-290). Thus as fiscal policy is at best a mixed bag, perhaps other policy levers might be played with.
Before proceeding to monetary policy, it might be helpful to investigate possible alternatives that can be easily pursued by the federal government. Reinhart and Rogoff compare advanced countries to emerging markets in times of financial crisis and find that these countries do better in employment than more developed nations:
Although there are well-known data issues involved in comparing unemployment rates across countries, the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress.
This seems to indicate that something like a temporary elimination of minimum wage laws or some other policy initiative designed to improve downward wage flexibility could be helpful. Flexibility in union collective bargaining agreements allowing the lowering of union wages in an effort to keep the maximum workers employed and the company afloat during recessionary times could also be pursued in future. Both of these policies sound like political impossibilities; perhaps there are other ideas.
There is much to be said about unemployment insurance’s ability to alleviate suffering in a recessionary environment, and its relative ease of further implementation. The payments to those who are receiving no income are certainly spent, helping to keep spending levels closer to the expected levels before layoffs. Recently Harvard professor and popular textbook author, Greg Mankiw wrote on his blog about the pros and cons of unemployment benefits:
The pros are that it reduces households' income uncertainty and that it props up aggregate demand when the economy goes into a downturn. The cons are that it has a budgetary cost (and thus, other things equal, means higher tax rates now or later) and that it reduces the job search efforts of the unemployed. (My Agnosticism)
While it may seem ridiculous to accuse the unemployed of not doing their diligence when looking for a job with high unemployment, this is not the only problem with unemployment insurance. In his famous paper, “Equilibrium Unemployment as a Worker Discipline Device,” Joseph Stiglitz notes that unemployment benefits “also reduce labor demand as workers become more expensive, so they cause unemployment to rise for two reasons” (439) Since firms are responsible for at least part of the cost of unemployment benefits, firms will be less willing to hire workers that they will have to pay even after the workers are gone; the price increase in worker benefits causes labor demand to fall. This is clearly not a pro-growth policy; however, if other policies bring down the cost of labor in other areas, this could be tolerated by firms and provide for further recovery.
Another proposal could be a complete, pro-growth overhaul of fiscal policy. Gary Becker advocates a plan of lowering taxes, in particular taxes on capital, as well as lowering spending on entitlements, such as Social Security and Medicare (“An Economic Growth Agenda”). Tasked with finding a plan to promote growth and tame the deficit, Erskine Bowles and Alan Simpson have produced a plan designed to do just that. According to their slide deck, the plan, “achieves nearly $4 trillion in deficit reduction through 2020: 50+ specific ways to cut outdated programs and strengthen competitiveness by making Washington cut and invest, not borrow and spend,” and, “reduces tax rates, abolishes the AMT, and cuts backdoor spending in the tax code” (Bowles and Simpson). Much of the “backdoor spending in the tax code” is buried in tax exemptions and rebates. As Greg Mankiw illustrates, “If we eliminate tax expenditures and reduce marginal tax rates, as Mr. Bowles and Mr. Simpson propose, we are essentially doing what economic conservatives have long advocated: cutting spending and taxes” (Deficit Reduction Plan). These ideas, which form the crux of their proposal, seem quite similar to what Dr. Becker was proposing just a few days earlier; these ideas are not particularly unorthodox. However, not everyone received the proposal with enthusiasm.
The deficit commission seems to have managed to split the political divide and looks like it is being flanked by both sides before being swallowed up entirely. Paul Krugman is especially vicious:
It produced a package that may have had some good things in it, but also, remarkably, introduced a whole slew of new bad ideas that weren’t even in the debate before. A 21 percent of GDP limit on revenues? Cutting the top marginal rate to 23 percent? Sharp reductions in the government work force without, as far as anyone can tell, a commensurate reduction in the work to be done? Instead of cutting through the fog, the commission brought out an extra smoke machine. (“The Soft Bigotry”)
He finishes his critique by saying, “The kindest thing we can do now is pretend the whole thing never happened” (“The Soft bigotry”). Republicans, on the other hand, see cause for concern with the treatment of the recent healthcare overhaul:
This is the huge carrot that Bowles-Simpson offers to Democrats. More than just leaving Obamacare in place, the co-chairmen of the deficit commission rely on Obamacare as the framework for cutting the growth of government spending on health care. (Random Thoughts)
According to the Christian Science Monitor, Republican Representative Paul Ryan’s “problem with the debt commission report, he said, was that ‘it not only didn’t address the elephant in the room, health care, it made it fatter’” (Feldmann). The plan of broadening the tax base, lowering marginal rates and eliminating deductions seems to have allowed those on the left to claim that this is a right wing fantasy of tax cuts for the rich, while those on the right can call it a net tax increase that does not deal with the largest spending item on the bill. Despite the pessimism, it has eked out bipartisan support.
With the exception of the aforementioned Paul Krugman, many economists seem to see the benefits of the deficit commission. Glen Hubbard, dean of Columbia Business School, praises the reduction in marginal tax rates with offsetting eliminations of tax deductions, which often benefit the affluent more than those who are not, as a way of making the tax code fairer:
This is why the two chairmen suggested that the government reduce marginal tax rates for households to a range from 8 percent to 23 percent, based on income (as opposed to 10 percent to 35 percent now). This cut in rates — which should promote job creation, entrepreneurship, saving and investment — would be made possible by limiting many of the deductions that make the tax code so complicated and often inequitable. (Left, Right and Wrong)
He finishes by giving “two cheers for this first draft of our economic future” (Left, Right and Wrong). Most are not this favorable; the consensus seems to be that “while Bowles-Simpson is quite far from my ideal budget plan, it represents an improvement over what we have now” (Random Thoughts). Greg Mankiw states that it “is not perfect, but it is far better than the status quo” (Deficit Reduction Plan). Tyler Cowen echoes these sentiments, writing that, “As a movie preview I judge this as "good enough." It basically declares that some major deductions have to be on the table and it gets us to the next step” (The Deficit Commission Report). Either way, these responses seemed to be good enough. According to the Wall Street Journal, “A majority of the White House debt-reduction panel, representing a cross-section of the political spectrum, backed a sweeping yet controversial overhaul of U.S. tax and spending policies Friday, a sign that both parties are ready to put sacrosanct programs on the table to address the budget deficit” (Majority of Panel). Thus far, the most far ranging proposal seems to also be the easiest to pass.
Make no mistake; this major overhaul is intended to tackle the budget deficit, not necessarily the recession. However, any pro-growth policy can have a positive impact. To this end, the Journal reports, “A resolution of the tax issue and the surge in support for drastic steps to reduce the deficit could bring economic benefits, Mr. Holtz-Eakin said. ‘We've got a business sector staring at Washington, totally paralyzed by what they see coming out,’ he said” (Majority of Panel). This proposal could add a degree of certainty to the business sector, since it aims to simplify the tax code, while reducing marginal rates. In this way, perhaps the overhaul of the tax code and balancing of the budget could bring about an end to recession.
Obviously, it is not always feasible, or desirable to demolish the way governments earn and spend money just to get out of a recession. Suicide prevention professionals would refer to that as a permanent solution to a temporary problem. Having seemingly exhausted the limits of what can be accomplished by legislation, it is time to turn to the Federal Reserve Bank. The central bank has been quite busy throughout the crisis, with two separate quantitative easing sessions, and numerous lending and liquidity programs. Certainly it holds the key to solving the economic riddle.
In December of 2008, the Federal Reserve cut the federal funds rate to a range of 0 to 25 basis points (Ensuring Sound Monetary Policy). At that point, the only thing for the Federal Open Market Committee to do further was to engage in more creative monetary policy. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, details the actions taken:
As the turmoil in credit markets continued, we expanded the types of institutions that could access Fed lending and the types of assets we took onto our balance sheet. But the size of that lending soon made sterilization no longer feasible. Since September 2008, the Fed has increased total market liquidity while altering the allocation of credit to particular markets. As a result, the Fed's balance sheet has more than doubled from just over $900 billion last September to almost $2 trillion in January 2009. (Ensuring Sound Monetary Policy)
He goes on to explain that, “This policy of quantitative easing has come into play because the nominal policy rate has effectively reached zero and further accommodation seems desirable. By expanding the quantity of bank reserves beyond that needed to keep the funds rate at zero, this policy is meant to support the economy” (Ensuring Sound Monetary Policy). While this program seemed effective for awhile, it would become clear that not only did this not fully bring the economy out of recession; it did not even fully prevent the specter of deflation from rearing its head. A new quantitative easing program would be necessary to continue the boost to the economy.
In November, The Federal Reserve announced a second round of quantitative easing; according to The Economic Times, a branch of the Financial Times, this round is worth $75 billion per month in treasury bonds for eight months, resulting in $600 billion in fresh liquidity (QE2). Vikas Agarwal reports on the expected function of the new program:
The main objective of the FED behind QE2 is to stimulate economic activity by cutting down interest yields on bonds, and thereby forcing investors to invest in more risky assets such as equity. The idea is this will in turn create a wealth effect and result in more spending, which will in turn inflate the economy. Also, the continued low interest rate helps in servicing interest payments of the federal deficit. (Impact and Expectations)
This seems to be similar to the explanation given for why the Philips curve, the relationship between inflation and unemployment, seems to work. Inflation is effectively a negative interest rate; therefore, investors must put money in higher performing assets to keep pace. The desired effect being that for businesses, this higher performing asset is capital and labor. However, it is entirely possible that this rule may not apply in this case.
There seems to be a risk that structural issues with the economy may be in large part to blame for the current crisis; perhaps the tax system has too many problems with it to make being competitive difficult, or maybe the economy is moving away from the education level and content of many of its workers. In any case, structural unemployment would be difficult for higher levels of liquidity to help, resulting in both high unemployment, and possibly high inflation. Richard Fisher, President and CEO of the Federal Reserve Bank of Dallas, has his doubts about the potential efficacy of more open market activity on the part of the Fed:
One of my most intellectually credentialed and also pragmatic colleagues, your very own president of the Minneapolis Fed, Narayana Kocherlakota, has noted that one of our deep-seated problems is structural unemployment. He believes that we do not have a workforce adequate to the needs of the high-value-added businesses that define the U.S. “Firms have jobs but can’t find appropriate workers,” he says. And he concludes, “It is hard to see how the Fed can do much to cure this problem.”[7] I would add that if this is true, then the matching of job skills to needs is doubly complicated if businesses feel handicapped by the current tax and regulatory regime or find other countries better placed to expand in a globalized, cyber-ized economy that encourages investment to gravitate to optimal locations for enhancing return on investment. (To Ease) Clearly there is some trepidation on the part of a few of the Federal Reserve’s own presidents. Another loud voice in the policy debate is Larry Kudlow; he hosts popular television and radio shows, with economic credentials. He also seems to be stealing his script from the Minneapolis and Dallas Fed presidents:
Now, after the severe financial panic of two years ago, it seems clear that too many tax and regulatory obstacles are blocking satisfactory job creation. And it also seems clear that a number of fresh new incentives will be necessary to spur the kind of prosperity that Americans desire. Following the deep recession, we need shock-therapy, pro-growth, tax-cut and deregulatory incentives. (Shock Therapy)
Furthermore, this idea of changing to a more pro-growth tax structure seems to be the key to both Gary Becker’s ideas and the deficit commission. Perhaps the idea is for the Federal Reserve to move ahead with further quantitative easing, knowing that it will not help as much in an adverse environment, but assuming that a deal will be done on the deficit commission’s recommendations.
Despite many of these scathing critiques, there are a number who are at least cautiously optimistic about the efforts the Fed is making. Before the announcement of the latest round of quantitative easing, Tyler Cowen expressed his desire for more Federal Reserve action in the New York Times, writing, “As high unemployment continues, more and more people, including top economists, are asking the Fed to promise a credible commitment to a more expansionary monetary policy. This approach will work only if the Fed finds a way to be bold — and if we find a way to believe in it” (Brave and Smiley Face). This appears to be more or less what the Fed is currently doing. Writing in defense of the new easing scheme on his blog, Marginal Revolution, Cowen posits that, “Still, QEII may do some good. Money matters, even if we don't always understand how or why, and excessively tight money has never done market-oriented economics any favors” (Don’t flip out). Others are equally cautious, with Greg Mankiw writing that, “I say it is a "good idea" because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation” (QE2). Others believe that the Federal Reserve is not doing enough; Paul Krugman, just as he lead the criticism that the fiscal stimulus was too small, again he leads the charge that QE2 will not be enough to make a difference:
For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little. Reasonable estimates suggest that the Fed’s new policy is unlikely to reduce interest rates enough to make more than a modest dent in unemployment. The only way the Fed might accomplish more is by changing expectations — specifically, by leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash. (Doing It Again)
Krugman also seems to have at least one unlikely ally; Scott Sumner, a self defined conservative, found himself “hoping for something much more shocking, so that we could really sink our teeth into the market responses” (Will it work?). The package that has been enacted seems to make a pretty clean cut between those who want nothing done and those who want everything done.
The actual response from the Fed seems to indicate that it acknowledged the structural issues in the economy, and did not want to deliver a plan bold enough to wreck the economy in the event that the structural issues go unfixed. However, it did deliver something, accounting for the potential for those problems to be repaired, assuming those problems exist altogether. QE2 should be big enough to cause at least modest gains assuming the structure is not so bad that the extra liquidity is not invested overseas or held in banks. If there is the inflation and growth the Bank is looking for, more can be enacted. Or as Scott Sumner believes, “QE has a modest positive impact, contrary to Keynesian models. But it won’t produce high inflation, contrary to monetarist models. Targeting the forecast—call it the Goldilocks model”
This sort of inflation driven recovery has recent precedent in Japan. Throughout the 1980s Japanese banks were making bad loans to under qualified borrowers; when the bubble burst, Japan lost a decade to stagnation. Stimulus that did not stimulate, followed by tax increases to pay the difference did not help overcome the recession. Japan was caught in what Paul Krugman termed a “liquidity trap;” since interest rates were near zero, there was not much for orthodox monetary policy to do. There was also a major bank bailout, in an attempt to restore functionality to credit markets, before finally there was an attempt to generate some inflation. Krugman writes that, “Once you take the possibility of a liquidity trap seriously – and the case of Japan makes it clear that we should – it’s impossible to escape the conclusion that expected inflation can be a good thing, because it helps you get out of the trap” (Depression Economics 75). Japan ultimately did not use inflation as a way out of recession, and while exports seem to be helping, it still is not quite back to its height before the bubble burst.
One of the main problems faced by Japan was inadequate policy early enough to save their economy. Charles Collyns writes that, “A more recent cautionary tale is provided by Japan in the 1990s, where the impact on bank and corporate balance sheets of the collapse of the house and equity price bubbles was allowed to go unaddressed for many years, contributing to a decade of weak growth.” While a sluggish response was a huge issue, they also had little room for monetary policy answers without getting creative as Krugman notes, “Japan was slow to cut interest rates after the bubble burst, but it eventually cut them all the way to zero and it still wasn’t enough. Now what?” (Depression Economics 71) This was what led to Keynesian attempts to fix the economy, which seemed to be poorly constructed. By the end, inflation was being considered as a cure, before exports took over the recovery.
Krugman does point out that stimulus could work better in the United States than it did in Japan; despite seemingly similar crises and responses, the American response has been swift, coming to similar conclusions as to what must be done much faster than their Japanese counterpart, with the benefit of knowing what happens to policymakers who delay, “For one thing, we aren’t yet stuck in the trap of deflationary expectations that Japan fell into after years of insufficiently forceful policies. And Japan waited far too long to recapitalize its banking system, a mistake we hopefully won’t repeat” (Depression Economics 188). This book was written before much of the cleanup of the financial crisis was accomplished. Clearly there is little deflationary expectation among investors; the Federal Reserve Bank of Cleveland’s Expected Inflation Yield Curve predicts inflation above one percent for its entire time horizon (Inflation Expectations). And bank recapitalization began almost immediately after the big banks started falling apart. Michael D Bordo praised central bank speed in his remarks to a conference in Chile saying that the haste of policy makers is a lesson well learned by current officials from past problems:
Fourth and finally is the speed of response by the monetary authorities in the US and Europe in resolving both the liquidity and solvency aspects of the crisis. This is in contrast to the Great Depression when the Fed did virtually nothing and it was up to FDR by devaluing the dollar in 1933 and the Treasury through its gold purchases thereafter, to jump start the economy. It is also in contrast to the slow response by the Japanese authorities in the aftermath of the collapse of Japan’s stock market and real estate bubbles.
However, even following these suggestions, the Federal Reserve is still forced to get creative with their monetary policy, to create expectations of inflation without riling up inflation hawks.
On the other hand, perhaps riling up inflation hawks is not such a bad idea. Michael Woodford, professor at Columbia University, writes in the Financial Times of a plan he would enact to allow an announced, planned one time increase in inflation to prop up expected rates of inflation, and drive down expected short term interest rates:
Changes in these expectations would stimulate current spending: an expectation that low short-term rates will last for longer will lower long-term interest rates and an expectation of higher inflation should also reduce the perceived real rate of interest. Both of these steps would increase current expenditure by households and firms, giving the US economy a much-needed boost. (Bernanke needs inflation)
Obviously, these are the goals of the new quantitative easing; it should stimulate spending in households and firms, helping the recovery. Bernanke, however, has been hesitant to promise anything concrete; much of what the Fed does relies on being able to control expectations. With unorthodox policy tools in hand, he does not want to lose the trust of the people. He does not need to deliver inflation or expectations, since there are plenty of willing political actors who will cry from the mountaintops about the coming inflation if given the proper nudge.
Enter Sarah Palin. The Wall Street Journal reports that during a trade association conference in Phoenix, the potential presidential candidate remarked on the potential for inflation:
When Germany, a country that knows a thing or two about the dangers of inflation, warns us to think again, maybe it's time for Chairman Bernanke to cease and desist,’ according to Ms. Palin's remarks, obtained in advance by National Review magazine, before the Specialty Tools and Fasteners Distributors Association. ‘We don't want temporary, artificial economic growth bought at the expense of permanently higher inflation which will erode the value of our incomes and our savings
The economy needs some expected inflation, and the Republican Party delivers Sarah Palin. The opposition need not always come from a politician of dubious economic knowledge; professor Gavyn Davies opines on his blog at the Financial Times that, “However sympathetic you are to the need for further monetary easing (and actually I am towards the sympathetic end of the spectrum), it is not difficult to see why the dollar has been falling, and gold rising, in the markets today” (Fed breaks taboo). Larry Kudlow summarizes the conservative opposition to quantitative easing:
Republican economists, hedge fund managers, and even some presidential candidates are blasting the Fed for its $600 billion QE2 pump-priming operation. Quite sensibly, the group that signed an open letter to Ben Bernanke argues against dollar devaluation and inflation. At least a couple of the signees are Democrats. And following Sarah Palin’s Bernanke broadside, potential presidential candidate Mike Pence is on the hustings attacking the central bank. (Strong Retail Sales)
All of these voices are not stacked against easing per se; they are against the inflation they believe it will bring. If their complaints spread, they could prop up expected inflation, at least among those who do not get their information from the Fed. These could be a substantial number of households who, while not in tune with the current events in the macroeconomic policy circles, occasionally listen to a talk show and know what inflation does to prices. On the other hand, this could drive widespread panic, so maybe manipulating the hearts of the public is not the optimal policy action.
The closest crisis to the current one seems to be the dreadful cataclysm that swallowed a decade of economic growth in Japan; the lessons from that debacle are not particularly pretty. The biggest lesson seems to be the speed with which the crisis is handled, since Japan’s slow recovery mirrored its slow response. According to Reinhart and Rogoff, “Note that in severe Big Five cases, the growth rate has fallen by more than 5 percent from peak to trough and has remained low for roughly three years”(219). This seems to imply that this recession could end right on schedule. However, given the drastic measures under consideration and recently implemented, this seems rather optimistic. Paul Krugman gives another lesson from history; this time the teacher is America in 1937:
By then the U.S. economy had been growing rapidly for four years, although unemployment was still very high by normal standards. Nonetheless, American policymakers declared victory over the depression and tried to return to normal, orthodox economic policies. FDR tried to balance the budget; the Federal Reserve tried to “mop up” what it considered the excess reserves of banks. The result was disaster: the economy slumped again, unemployment soared, and people began talking about the ‘Roosevelt depression.’ Full recovery had to wait until World War II” (Depression Economics 196)
The key seems to be to act fast to prop the economy up, and be slow to remove the training wheels. A St. Louis Fed paper seems to support this theory, “Therefore, historical data tell us that if there is any positive association between money growth and GDP growth, the impact comes about 3 years after an initial acceleration of base growth” (GDP Growth). While it seemed like little was done on the economy after the stimulus, though the lens of history not only was the stimulus quite a lot, but subsequent treatment was rather extensive.
To tie this more firmly to the policymakers who paid the price in the recent election, Paul Krugman opines that, “When you say Obama should have focused more, what policies are you talking about? A bigger stimulus? As far as I can tell, almost no pundits are saying that. So what other concrete policies do they have in mind? I have never gotten an answer” (Focus Hocus Pocus). Unfortunately, history does not seem to indicate much that could have been done better; perhaps more expansionary monetary policy earlier, or an earlier recognition of the fundamental issues underlying the crash. One possibility seems to be that the problem is structural; if this is the case a long overdue overhaul could be in the works. Perhaps firms and consumers merely need a nudge to start spending again. QE2 could be this nudge. Both of these policies come too late for many who were ousted from congress in the recent election. If they work, history will remember an Obama administration too preoccupied with a health care overhaul of marginal short term value to save his party when ready solutions could have been available, if prompted in time to work before the midterm election.
Another possibility is that QE2 is not the spark, but does more good than ill. Given the relatively small size of the program, Chairman Bernanke may be using this as a pilot program; a much larger scheme may be on the way if this is of modest value. On the other hand a larger program could bring on the dreaded inflation that a smaller plan did not make evident. Or the easing may have a useful impact, but the result of the deficit commission plan may skew the results. The plan’s passage could boost investor confidence and the frontloaded benefits could be a boon to the economy; its failure could devastate confidence even further. To throw out another scenario, the plan could be seen as a contracting policy, since most budget balancing reduces spending, adding to further doubt in the event that it passes. Perhaps none of these policies are the answer, and those in charge are left casting about in the dark for a solution. This is the time when strong leaders emerge from unlikely places to fulfill their historic destiny. These may be uncharted, shark infested waters, but certainly all will be wiser by the end.
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