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How They Killed the Economy

Barack Obama; drawing by John Springs

The United States economy is slowly reviving: it grew by 2.2 percent in the third quarter of 2009 and by 5.7 percent in the fourth quarter, a trend that may signal an end to the worst recession we have had since the Great Depression. The country avoided a much more severe economic collapse only because government responses to this breakdown, both in the US and abroad, have been more effective than those of the 1930s were.

Nonetheless, housing is still depressed and nearly 10 percent of the labor force was unemployed in January. We have lost more than eight million jobs, over half of them permanently, since the recession began in December 2007; and long-term unemployment is at record highs. Even if the economy grows 5 percent a year over the next three years, which seems unlikely, the US will probably not return to full employment before 2013.1

That an even worse disaster has been averted, in part by people who studied the lessons of what happened in the past, underscores our need to understand what went wrong this time and what must still be done to restore the economy and avert another collapse. Almost everyone agrees that the crisis developed in part because of failures of regulation—principally of banks, mortgage brokers, and derivatives markets—and much effort is currently being devoted to revamping and shoring up the regulatory system.

Alan Greenspan’s Federal Reserve bears responsibility for some of these supervisory failures; it also kept interest rates “too low too long,” thereby exacerbating the dangers to the economy. The failures of the Fed’s monetary policy are particularly significant—without them the need for effective regulation would have been much less urgent. This may help explain why the embattled Fed Chairman Ben Bernanke, who was confirmed on January 28 for a second four-year term in the most contested vote ever for a Fed chairman, tried to counter those who blame the Fed in a speech before the American Economic Association a few weeks before the vote. But like many of the Fed’s critics, Bernanke focused only on whether the Fed should have started raising interest rates before it actually did in June 2004. He did not address a more critical issue: Did the slow and predictable pace at which it raised rates encourage the excessive risk-taking that brought down the financial system and the world economy?2

By any measure, the crisis was a consequence of extraordinarily reckless behavior—by banks and other financial institutions, by governments and their financial regulators, and by consumers—behavior that continued even in the face of a widely shared sense that serious trouble was brewing. Charles Bean, deputy governor for monetary policy of the Bank of England, was not the only central banker to admit, in November 2008, that major trends of the world economy had “vexed policymakers for some time. We knew they were unsustainable and worried that the unwinding might be disorderly…. However, nothing very much was done… ” (emphasis added).

Even Chuck Prince, the former CEO of Citigroup, was aware of the risks when in July 2007 he boasted that the bank was not pulling back from its aggressive lending: “When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing…(emphasis added) —a prime example of the kind of illusions that led to disaster. Consumers, too, were carried along on the wave of easy credit and by rising home prices; they borrowed to the hilt, often by refinancing their appreciating homes, and saved almost nothing.3

The failure of central bankers and regulators to rein in leverage—the practice of borrowing as much as thirty or more times one’s equity capital to increase investment potential4 —and excessive risk-taking owes much to complacency that had developed over the preceding twenty to twenty-five years. This was a period that many economists call the “great moderation,” when economic growth was relatively steady, inflation was low, recessions were short and mild, and serious crises were weathered without severe downturns. Partly this was because the most serious economic crises are centered in the banking and financial system, the basic source of credit, and none of those that occurred during this period involved the banking system in a major way.

The list of crises that were contained is long and impressive, including the stock market crash of 1987, the junk bond collapse of 1989–1990, the Asian crisis of 1997, the Russian default in 1998, the failure of Long Term Capital Management—a large and hugely leveraged hedge fund—later that year, and the collapse of technology stocks in 2000–2001. Quick and effective responses to these and other dangers by Greenspan’s Fed appear to have induced banks and investors to rely unduly on its ability to stave off collapses that threaten the system, and to ignore the serious malfunctioning of the financial markets. These same successes may have led Greenspan himself to believe that he actually was, in the words of the Financial Times, the “guardian angel of the financial markets.”

The general pattern of those years was similar to earlier extended periods of growth and great optimism. The standards for issuing credit and for supervising those who do so tend to deteriorate markedly during such prolonged periods of prosperity (as the junk bond collapse also showed on a much smaller scale). This is one reason why financial crises typically follow booms. It also is why, as an economic expansion lengthens, regulators of financial institutions should be—but seldom are—especially vigilant; and regulations should be—but were not—adapted to automatically constrain risks as the expansion progresses. (Regulations should also function “countercyclically” in downturns, by encouraging lending and investment as conditions worsen.) Because the US regulatory system was deeply flawed, reflecting pressures from powerful commercial banks, investment banks, and insurance companies, and negligently implemented, it failed to counteract the prevailing optimism and cool the housing and credit markets. Instead it fostered the inflating bubbles.5

Along with hubris and complacency, ideology also explains some of the supervisory negligence. In October 2008, appearing before the Government Oversight Committee of the House of Representatives, Greenspan famously confessed to being in a “state of shocked disbelief” that the “self-interest” of banks and other market participants had not prevented the “once-in-a-century credit tsunami” that was devastating the world economy. Under questioning the former Fed chairman went further, admitting that the events of 2007–2008 had revealed a “flaw” in his own laissez-faire worldview. He reminded the committee that he had been concerned as early as 2005 that “the protracted period of underpricing of risk…would have dire consequences.” Yet he had done little to contain that threat, and the consequences, he said, turned out to be “much broader than anything I could have imagined.”6

Although he has confessed to some regulatory failure, Greenspan has fiercely resisted criticisms of his monetary policy itself—especially suggestions that his policy of keeping interest rates low for so long encouraged the housing bubble and the explosion of borrowing throughout the economy. It must sting more deeply that the most forceful attacks on his monetary policy have been leveled by Stanford Professor John Taylor, an esteemed monetary economist and Greenspan’s “good friend and former colleague.” Taylor served in the Ford, Bush I, and Bush II administrations, including as undersecretary of the Treasury for international affairs between 2001 and 2005. His first public criticism was made two years after leaving that position in a paper presented to the annual August gathering of central bankers and monetary economists in Jackson Hole, Wyoming, that is sponsored by the Federal Reserve Bank of Kansas City. The paper is the heart of Taylor’s new book, Getting Off Track.

Taylor argues that if the Fed had started raising interest rates in 2002, shortly after the end of the recession that followed the bursting of the technology stock bubble, the housing market would not have grown as wildly as it did. He bases his argument on his own “Taylor rule,” a guide to monetary policy he developed in the early 1990s, that quantifies how forcefully the Fed should adjust interest rates in response to changes in inflation and GDP. Taylor rules are widely used by economists and policymakers and there are many different versions reflecting variations in the way they are applied, particularly in how inflation is measured. Taylor measures inflation by the average change in the Consumer Price Index (CPI) over the preceding four quarters, a choice that has a big impact on his conclusions.7

By contrast, the Fed and many economists prefer using “core” inflation measures because they exclude the effects of food and energy prices, which can be very volatile. During the late 1980s and most of the 1990s the CPI and core measures of inflation largely moved in tandem and Fed policy was very close to that prescribed by the Taylor rule. In 2002 and 2003, however, the CPI and core inflation diverged sharply, the former rising rapidly and the latter falling, leading to conflicting implications for appropriate monetary policy. Both Federal Reserve Vice Chairman Donald Kohn in 2007 and Chairman Bernanke this January pointed to the importance of Taylor’s choice of an inflation measure in convincingly criticizing his suggestion that the Fed should have begun raising interest rates in early 2002—when the recovery from the 2001 recession was still anemic and the risks of deflation were clear.8

But Taylor’s general contention that low rates after 2003 encouraged the housing bubble is largely persuasive, although mostly for different reasons than he provides. In June 2004 the Fed finally began raising the federal funds rate—the rate banks charge one another for overnight loans9 —as the recovery stabilized and employment and inflation began rising more rapidly. It probably should have started raising rates slightly earlier. Most important, the Fed raised rates only in increments of a quarter of a percentage point (twenty-five basis points); after seventeen such increases the federal funds rate peaked again in June 2006. Fourteen of these “measured” rate rises were attributable to Greenspan and three to Bernanke, who replaced him in February 2006.

Raising interest rates so slowly and steadily promoted excessive risk-taking, and should have concerned Greenspan, according to his stated views. The Fed’s policies thus seem especially peculiar. They helped to create a false sense of security and stability that enticed financial institutions and investors to leverage their investments enormously, borrowing sums that dwarfed the capital they committed.

Such blindly optimistic short-term profit-seeking dominated the investment world for at least two reasons. First, all crises over the preceding quarter-century had apparently been contained by effective Fed actions, suggesting that any new problems would be dealt with as well. Second, by telegraphing its intentions to raise rates only at a “measured” pace, the Fed eliminated concerns about a sharp rise in interest rates, a principal worry for highly leveraged investors. And because these deliberate rate increases began when the federal funds rate was only one percent, attractive rates were guaranteed to persist for some time.[]

  1. 1

    Two pairs of economists have compared the current crisis to the Great Depression and to eighteen postwar banking crises, including five in developed economies. Although the world economy began recovering much sooner than in the Great Depression, compared to postwar financial crises the current US version is considered “severe by any metric.” See Barry Eichengreen and Kevin H. O’Rourke, “A Tale of Two Depressions,” September 1, 2009, available at voxeu.org/index.php?q=node/3421 ; see also Carmen M. Reinhart and Kenneth S. Rogoff, “Is the 2007 US Sub-prime Financial Crisis So Different? An International Historical Comparison,” American Economic Review, Vol. 98, No. 2 (May 2008), and “The Aftermath of Financial Crises,” American Economic Review, Vol. 99, No. 2 (May 2009).

  2. 2

    Ben S. Bernanke, “Monetary Policy and the Housing Bubble,” speech at the Annual Meeting of the American Economic Association, January 3, 2010, www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm.

  3. 3

    Charles Bean, “Some Lessons for Monetary Policy from the Recent Financial Turmoil,” remarks at the Conference on Globalization, Inflation and Monetary Policy, Istanbul, November 22, 2008, www.bankofengland.co.uk/publications/speeches/2008/speech368.pdf . Prince is quoted in Michiyo Nakamoto and David Wighton, “Citigroup Chief Stays Bullish on Buy-outs,” Financial Times, July 9, 2007, www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html .

  4. 4

    Leverage is borrowing used to finance an investment and is measured as the total value of the investment relative to the equity (nonborrowed) portion. Leverage amplifies both gains and losses and, as Robert Solow explained in these pages, played a “central role” in creating the crisis. See “How to Understand the Disaster,” The New York Review, May 14, 2009.

  5. 5

    The economist Hyman Minsky has long emphasized the importance of the relationship between credit standards and the business cycle, and it is not surprising that his work has gained much attention in the last few years. See, for example, his John Maynard Keynes ( Columbia University Press, 1975) and “The Financial Instability Hypothesis,” May 1992, levy.org/pubs/wp74.pdf; and Janet Yellen, “A Minsky Meltdown: Lessons for Central Bankers,” FRBSF Economic Letter, May 1, 2009, frbsf.org/publications/economics/letter/2009/el2009-15.html.

  6. 6

    Testimony of Alan Greenspan, House Committee of Government Oversight and Reform, October 23, 2008, clipsandcomment.com/wp-content/uploads/2008/10/greenspan-testimony-20081023.pdf.

  7. 7

    Taylor writes that the federal funds rate, which the Fed controls, should be 1.5 times the inflation rate, plus 0.5 times the “output gap” (the difference between actual GDP and potential GDP) plus one. The output gap can also be measured as the difference between the current unemployment rate and the “full employment” rate, generally thought to be between 4 and 5 percent, making the current gap 5–6 percent.

  8. 8

    Donald L. Kohn, “John Taylor Rules,” paper presented to the Conference on John Taylor’s Contributions to Monetary Theory and Policy, Federal Reserve Bank of Dallas, October 12, 2007, federalreserve.gov/newsevents/speech/kohn20071012a.htm.

  9. 9

    Monetary policy typically operates through the federal funds rate. By providing money to the banking system, or by withdrawing it, the Fed can control this oversight rate and generally influence longer-term rates as well. During the crisis, however, the federal funds rate has been lowered to near zero, forcing the Fed to use more unconventional measures such as buying longer-term Treasury securities and mortgages to push the rates down.

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