This is a guest post by a colleague and TWN regular Richard Vague
Handling the Economic Crisis – A Report Card
If we really want to have enduring, muscular economic growth, then where’s the enhanced support for the truly cutting edge things that will make that happen?
Repatriating telemarketing jobs from the Philippines and textile jobs from China isn’t going to do it. And it won’t just be “green” investment, a non-trivial part of which is misguided. It will instead be nanotechnology, stem-cell research, genetic engineering and the many other nascent industries that require highest order intellectual capital and can be the giant industries of tomorrow.
In the meantime, there’s an ugly, deep recession to fix.
The cause of the recession was straightforward, and the same as the cause of most other such booms and busts dating back to the start of the Industrial Age. Far too much leverage. In this case, it was too much leverage in the mortgage business, resulting in a stunningly rapid and massive $3+ trillion (or 80+%) build-up in mortgage loans in roughly four years, much of which went to unqualified buyers. And almost nobody noticed.
This overleveraging was brought by gross mismanagement of the government’s Fannie Mae and Freddie Mac programs, by underregulated lending entities including hedge funds and insurance companies, by conflicted rating agencies, and by too-low interest rates courtesy of the Fed. And whatever emergency “dry-powder” we had as a nation to deal with this kind of situation had already been spent on the multi-trillion dollar Iraqi War and other niceties, as evidenced by an increase in Federal debt under President Bush from $5 trillion to almost $11 trillion.
And then In the midst of this increasingly fragile mortgage crisis, somebody inexplicably let Lehman Brothers fail, and everybody went running for cover.
On the surface, navigating towards a solution to this crisis seems confusing, because so many people have used it as an excuse to drag out their pre-existing agendas. Pro-labor?
Well then voila! – the cause is the decline in manufacturing jobs – even though that has little to do with it.
But the path to recovery is fairly straightforward, and involves four items which I have previously outlined in TWN. The immediate-term steps to a solution I proposed – in order of importance – were accommodative money policy, lender recapitalization, stimulus by way of accelerated spending on necessary projects, the coordination of these actions internationally.
Here’s the interim report card on the actions of our government on each:
Federal Reserve Bank accommodation – the grade is A. For all the Fed’s bungling and mismanagement before and since, it stepped in quickly and assertively and did the two most critical things needed in any crash, 1) it increased the money supply and, 2) except for Lehman, it stepped in as lender of last resort to the financial institution industry. This is the biggest single difference between the current crisis and the Depression.
There, Fed restrictions and inactions caused the money to fall by a draconian 30% -drying up money across the nation – and no institution served as the lender of last resort to the financial services industry. (Add to that Smoot-Hawley and an increase in taxes, and you’ve got the ingredients that turned the Crash of 1929 into the Great Depression.) By way of contrast, in the Depression, GDP declined over 40%, as compared to today’s single digit decline, and unemployment reached a third of the workforce, as compared to today’s reported 10%.
With this monetary expansion, concerns of future inflation are justified, but that will need to be addressed after a recovery is underway.
Lender recapitalization. Grade is D. On the good side, no other institutional collapses have occurred since Lehman, but it is as if Rube Goldberg himself designed the many facets of the bank recovery plan, and the government felt that no straightforward solution should be used if a convoluted alternative were available.
Regardless of the government’s approach, a healthy banking system can preserve and create more jobs than any government stimulus program. So the needed end goal is banks that have appropriately recognized losses, and have then raised a full, new measure of capital so that they can provide unfettered support for deserving customers. But this has not happened, and bank loans across the country continue to decline steeply.
Contrary to the statements of some commentators, there are legions of borrowers – whether small, medium or large – that are deserving but are having their loans curtailed or withdrawn, causing them to shrink their businesses or shelve expansion plans. Anecdotally, we hear that while regulators are being accommodating to banks on existing problems credits, they are being very restrictive on the extension of new credit, resulting in enough “zombie”-ness to prevent them thus far from playing the robust role needed in the recovery.
I deem the failure to get to the lending system at all levels fully recapitalized and ready to lend to be the biggest shortcoming of government’s efforts to date, and far more important than the stimulus package. I also find this to be the area where I am most pessimistic about the government’s ability to right its course.
Stimulus. The Grade is F. How can we give the stimulus any other grade when it is already July, and only the tiniest sliver of stimulus money has reached its intended destinations? And how can Paul Krugman continue to call for another stimulus bill when the current one is still largely undeployed? (His repeated invocation of 1937 ignores that the retrenchment of that year was just as likely the result of monetary and tax policy as reduced stimulus.)
Even if the stimulus package were comprised only of the most worthy projects, the fact that it has moved so slowly would warrant the F. However, the stimulus package was a slapdash bill filled with initiatives that won’t help. I continue to recommend a position somewhere between doing nothing and doing all that Krugman advocates – a stimulus effort that consist of as many truly necessary projects as can be found accelerated into the present, but no pork.
The truth is, the level of our nation’s debt to GDP is rising to perilous heights unseen since World War II – 70%? 80%? 100%? – and there will be hell to pay for this when the recovery begins. Stagflation anyone?
International coordination – the grade is B. We have avoided a repeat of Smoot-Hawley, even though the impulse to re-smoot is always present, and present in trace amount in places like the Waxman bill. Further, we have stepped up support to the World Bank and IMF. And we have maintained an active dialogue with other countries, though the actions of other countries in dealing with the recession have often seemed more appropriate than our own.
Overall – the grade is C. The economy is fragile, unemployment continues to rise, and the economy could just as easily retrench as go forward.
The longer-term structural changes needed are as follows. First and foremost, we need a regulatory structure that is broad enough to encompass all lenders, and powerful enough to impose appropriately high capital requirements, which is the essence of containing leverage. Further, we need some mechanism to prevent the Fed from adopting unnecessarily low rates – and thus inappropriate stimulus – in periods when the economy is growing; something along the lines of a Taylor Rule approach. And ultimately, after the recovery is underway, we will need to get federal debt to GDP levels out of the stratosphere.
A final structural issue that has been discussed frequently in this crisis is the disequilibrium between the countries with export economies that build up excess cash such as China, and the large trade-deficit countries such as the United States. In the view of some, the mortgage boom was unavoidable because the large surpluses of other countries were being reinvested in the U.S.
While I don’t disagree with some aspects of this view, I believe that higher short term rates and higher capital requirements applied appropriately to all lenders would have prevented most of the overbuilding and associated excess lending. Couple those changes with Soros’s plan to have a larger short-term loan facility available to other countries to obviate their need to build up cash reserves, and we will have addressed much of this problem. (Further, Soros’s fundamental concern about the structural post World War II increase in system-wide leverage could be addressed, at least in part, by capital requirements.
So let’s get the banks back lending again, let’s keep the stimulus focused on necessary projects, let’s support international liquidity efforts, and let’s hope the Fed continues to be accommodating.
I find the “too-big-to-fail” debate at least somewhat mystifying, because a bank failure can
be structured so that the bank continues to operate without missing a step. The bank closes one evening, and reopens under FDIC ownership the very next day. Most of the bank’s customer’s are unaffected; and most employees other than top management keep their jobs.
The stockholders and bondholders are wiped out, but they were investors who knew their capital was at risk. The board of directors and top managers are out, but they were the ones responsible. The government owns the bank, but it can readily sell the bank or make a public offering of new stock in the bank in due course as the internal problems are sifted through and bad assets are partitioned off to a separate entity.
— Richard Vague