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Big Freeze part 4: A US recovery

Published: August 6 2008 20:17 | Last updated: August 6 2008 20:17

Macroeconomists, like medical scientists, use case studies to teach their students about the maladies to
which the system is susceptible. For supply shocks and stagflation, the example is the 1970s. The
financial dislocations that occur when bubbles burst are illustrated by the Great Depression and Japan’s
problems in the 1990s. The importance of central bank credibility in resisting inflation emerges from
discussion of the experience of the late 1960s and the 1970s.

What is most remarkable and troubling about our current difficulties is that all these elements – supply
shocks, financial dislocations and concern about rising underlying inflation – are present at once.
Moreover, the crisis is global in scope. Concerns about recession are spreading from the US to much of
the industrialised world. Significant slowdowns appear more likely in a number of emerging markets, with
inflation concerns worldwide at their highest level in more than a decade. There is a growing consensus
that the west is facing the most serious financial crisis since the second world war.

Perhaps unsurprisingly in the face of so many adverse surprises, the policy debate has become
cacophonous. Some emphasise the necessity of the painful adjustments under way, while others urge
their mitigation. Some focus on product price inflation, others on asset price deflation as the principal
problem. Some focus on assuring that imprudent lending by financial institutions is discouraged, others
on assuring that financing for investment by households and businesses remains available. Some focus
on slowing market adjustments to prevent panic, others on the need for rapid adjustment of prices to
true fundamental levels, even if this is painful in the short run.

Equally unsurprisingly given the chaotic debate, policymaking has become increasingly reactive and
erratic, with a growing tendency to repeat traditional errors. While US policymakers have long cited
Japan’s indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market
manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a
negative example, they are increasingly repeating Japan’s errors.

Within the past month, the Treasury has made explicit the implicit guarantee on the $5,000bn
(£2,500bn, €3,250bn) balance sheet of Fannie Mae and Freddie Mac in order to prevent a run on the
government-sponsored enterprises while imposing no penalties on shareholders or forcing any changes
on management – not even the cessation of dividends.

The Securities and Exchange Commission has sought to make

short-selling harder, with the stated objective of raising (many

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would say manipulating) the stock prices of financial institutions,

while some in Congress have proposed to prevent certain
investors from going long on commodity futures. Without much
sign of official resistance, the global banking industry is pushing
for less reliance on market prices and more on managerial
judgment in valuing the assets where bad credit and investment
decisions have led to hundreds of billions of dollars of losses over
the past year.

Setting policy in a more proactive and principled way requires

reaching a number of judgments regarding where things currently
stand and the likely effects of potential actions or failures to act. In
an effort to advance the debate, the remainder of this article
poses and provides my answer to what seem to me to be the
crucial questions for American economic policy.

How long will the economy stay weak on the current policy
path?

The best available estimates suggest that the American economy is operating between 2 and 2.5 per
cent below its sustainable potential level. This translates into more than $300bn, or $4,000 for the
average family of four, in lost output. Even if, as I think unlikely, recession is avoided, growth is almost
certain to be so slow that the gap between actual and potential output comes close to doubling over the
next year or so. Given that unemployment peaked nearly two years after the end of the last recession,
output and employment are likely to remain below their potential levels for several years in the best of
circumstances.

Given the combined impact of rising commodity prices, falling house prices, reduced availability of credit
and rising uncertainty, it is surprising that the economy has shown as much strength as it has in recent
months. While it is possible that this speaks in some way to its enormous resilience, the preponderant
probability is that, as the effects of tax rebates wear off and those of tighter credit conditions feed
through, the economy will take another downwards turn.

Just as the bottom was called early a number of times in Japan in the early 1990s and in the US in the
early 1930s, we have seen and no doubt will see moments of sunlight that create hope that the worst is
past. Yet it bears emphasis that in the current context there can be no confident reliance on the
equilibrating powers of the market.

Alan Greenspan has been fond of explaining that the resilience of the US financial system and economy
results from reliance on two pillars: banks and capital markets. When the banks were in trouble, as in
1991, capital markets took up the slack; when the capital markets were in trouble, as in 1998, the banks
took up the slack. Unfortunately, today both the banks and the capital markets show signs of crisis.

The point can be put in another way. Four vicious cycles are simultaneously under way: falling asset
prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are
reducing their ability to finance investment, which in turn reduces asset values, causing further losses;
the weakness of the financial system is reducing growth, which in turn weakens the financial system;
and falling output is hitting employment, which in turn leads to reduced demand for output.

Without active efforts to interfere with these mechanisms, there can be no basis for confidence that the
American economy will recover even in the medium term.

Are substantial output losses necessary or desirable?

It is often argued that the current economic downturn is an inevitability that cannot be prevented, or that
is necessary and desirable. Some observers almost seem to suggest that a recession is a kind of just
desert for a country that has lived beyond its means. The more serious concerns are that an economic
downturn is a necessary concomitant of increasing US national saving and reducing current account
deficits, or of preserving the credibility of the Federal Reserve’s commitment to price stability.

Granting that US consumer spending grew more rapidly than gross domestic product over most of the
past decade and that ultimately the consumption share of GDP will have to fall back to more normal
levels, it is hard to see why necessary increases in saving require a protracted recession. Instead,
declines in consumer spending and improvements in the government’s fiscal position should be
sequenced to coincide with improvements in net exports and investment. Allowing consumer spending to
spiral downwards without offsetting policy actions risks reducing investment and incomes in the US and
transmitting the US slowdown to the rest of the world. Moreover, even if the argument for supporting
consumption at present were rejected, there would still be a strong argument for supporting investment
in areas such as infrastructure, where there is no evidence of a glut and considerable evidence of

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shortfalls.

As for the inflation question, constant vigilance is necessary. It is certainly true that product price
inflation has ticked upwards, though this seems to be heavily commodity-related. Even if commodity
prices do not fall but only stop rising, the result will be an improvement in standard inflation measures.
Moreover, if the principal problem is commodity price inflation, there are surely better ways to address it
than increasing unemployment and reducing capital utilisation.

Crucially for the inflation process, there is not yet evidence of rising wage pressures or increases in the
growth rate of unit labour costs. Nor do indexed bond markets reveal a significant change in longer-term
inflationary expectations. In an environment of rising unemployment, greater worker insecurity and
increasing global competition, there are likely to be substantial pressures militating against any rapid
increase in wages in the big industrial economies. Without rapid increases in labour costs, which are by
far the largest component of production costs, it is hard to see how higher rates of inflation can be
entrenched.

On balance, in the US at least, the risk that output will be too low over the next several years seems
considerably greater than the risk that it will be too great and cause the economy to overheat or
overborrow.

Can policy stimulate demand without adverse side-effects?

With the Federal funds rate at 2 per cent, the remaining scope for monetary policy to stimulate the US
economy is surely very limited. Even here, those who see a case for raising rates should remember that
in the current environment the Fed funds rate is a very misleading indicator, as widening credit spreads
and increased term premiums have caused borrowing costs to fall much less than the policy interest
rate.

There remains considerable scope, however, for fiscal policy to stimulate demand on both the tax and
spending sides over the next several years. The limited available evidence suggests that the propensity
to consume out of the recent round of rebates was larger than many thought. More important, given the
pressures on state and local budgets and the dramatic increase in some inputs (the cost of building
highways has risen 70 per cent since 2004), there is now a substantial backlog of infrastructure projects
that have been interrupted or put on hold. Allowing these projects to go forward on a significant scale
would stimulate the economy and would channel demand towards the construction workers – mostly
men with relatively little education – who have borne the brunt of the economic downturn and whose
medium-term prospects are bleakest.

In thinking about fiscal policy, it is essential to consider both near and long term. For the near term,
larger deficits are likely to be potent in stimulating demand, especially in the context of an economy
where there are constraints on the ability to lend and borrow. This is especially the case when new
spending is directed at addressing the “repressed deficit” associated with the failure to maintain an
adequate infrastructure.

Success in using fiscal policy will depend on also taking concrete steps that reduce projected deficits in
the medium to long term. The enactment of new permanent measures, such as the extension of the
2001 tax cuts, without means to pay for them would be counterproductive. Conversely, measures that
pointed to long-term fiscal savings would reinforce fiscal stimulus.

In the current global context, there is no reason why fiscal stimulus should be confined to the US.
Measures that increase spending in countries where high saving has led to large current account
surpluses are necessary if the global economy is to be rebalanced without a big downturn as US saving
eventually increases. China, where household consumption has fallen below 40 per cent of GDP – a
record peacetime low for any big economy – stands out in this regard.

How serious are the remaining financial problems?

This is unknowable given uncertainties about market fluctuations and the real economy. While there
surely will come a time when things hit bottom, it is not yet clear that it is at hand.

Several sources of evidence suggest that house prices will fall for some time to come, perhaps by 10 per
cent or more. Big further declines would be necessary to restore their traditional level relative to rents,
incomes or the price of other goods. There are growing signs that rates of default and foreclosure will
rise considerably even well outside the subprime sector.

Beyond housing, there are also grounds for considerable concern about consumer and automobile
credit, particularly if the economy turns down. Big and as yet not reported losses on commercial
construction lending lie ahead. While the rate of default on corporate debt has not yet reached high

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levels, this is likely to change in the near future. For example, the pricing of the debt of the big American
automobile companies now suggests a probability well over 90 per cent that one or more of them will go
into default in the next five years – and the probability would no doubt be greater if markets did not
recognise the possibility of extraordinary Federal support.

Then there is the problematic situation of the banking system. Where traditional non-mark to market
accounting is in use, banks have not yet revised estimates of their capital to reflect likely future losses.
In many cases, they have instead assumed that the market’s valuation of their assets reflects transient
liquidity factors rather than underlying problems, and so are planning with assumptions considerably
more optimistic than those embodied in market prices. Perhaps they will prove correct – but nothing in
the experience of the past year gives confidence in the judgment of those who believe that market prices
substantially undervalue their assets.

In all likelihood, the financial system will require very substantial capital infusions over the next year or
two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have
provided financial institutions with capital over the past year have been badly burned. As valuations fall,
it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain
market confidence, leading to further declines in valuation and yet another vicious cycle.

How can the authorities best support the financial system?

To date the focus of public policy has been on the extension of credit to banks and other financial
institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may
be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity,
lending can be highly efficacious. When the problems are of underlying solvency and the constraint on
lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency
basis, to plan policy responses to such problems.

First, as the ad hoc nature of the policy response to Bear Stearns and the GSEs illustrates, we do not
have a framework in place in which the authorities can do what is necessary to counter systemic risk
when a systemically important institution gets in trouble and at the same time protect the interests of
taxpayers and the broader financial system.

Second, there is as yet no framework in place for handling the large quantity of bad assets sitting on
financial institution balance sheets. During the last US banking crisis in the early 1990s, the Resolution
Trust Corporation was established to manage impaired assets of banks and savings and loan
institutions that the government had taken over. But it acquired assets only after the government took
over banks. Consideration should be given to whether the government should establish a mechanism for
purchasing assets from stressed banks in return for warrants or other consideration.

Third, there is the question of whether government will need to find a way to recapitalise institutions
through taking some kind of preferred interest, as ultimately proved necessary in the US in the 1930s
and Japan in the 1990s. This is obviously a big step that one wants to avoid if possible. But in the
absence of any framework for the government infusing capital, there is the danger that liabilities will
simply be guaranteed de facto or de jure with no other change made, creating problems down the road.
Government involvement in recapitalising financial institutions is like devaluation: a very unattractive last
resort. Delay is tempting, but it can be enormously costly.

...

Today, the end of the current financial crisis looks further away than it did in August 2007. Policy is not
yet ahead of the curve. I used to remark in the context of the emerging market crises of the 1990s that I
would date the moment of recovery from the first time an official pronouncement proved to be too
pessimistic. By this standard, recovery is not at hand.

The best prospects for managing a very difficult situation involve a comprehensive effort to support the
real economy through temporary fiscal stimulus and the financial system through a programme of
measures directed at capital rather than liquidity problems. These steps offer no assurance of success
but reactive drift raises the risks of costly failure.

The writer is Charles W. Eliot university professor at Harvard and a managing director of D.E. Shaw &
Co

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