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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 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 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 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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