In this blog, I discuss how the US’s response to the GFC compares to its response to the Great Depression. It is by no means comprehensive (this is a blog, not a thesis). But it will hopefully paint a good picture of the general situation.
The Great Depression
For much of history up to World War II, much of the world was attached to the Gold Standard of fixed exchange rates. Every currency was set at its own fixed value relative to gold.
If your economy grows strongly, money will flow into your country (more people will buy your currency) to take advantage of the investment opportunities. This causes a flexible exchange rate to appreciate. So the exchange rate is the thing that absorbs this international ‘shock’ instead of the internal economy.
Under the Gold Standard however, a high-growth economy attracts more gold. And because the exchange rate is not allowed to appreciate, the central bank must ‘sterilise’ this gold inflow by printing more money. This creates more inflation, making local investments less profitable, thereby slowing down/ stopping/ reversing the gold inflows.
The opposite is true for a weak-growth economy. If investment/ gold is flowing out of the economy and the exchange rate is unable to depreciate in response, the Central Bank must pull money out of the system and/ or increase interest rates. This causes price deflation and attracts gold/ investment back to their economy.
So under a Gold Standard, the internal economy has to absorb this ‘shock’ via the inflation rate.
Unfortunately, unions tend to be hesitant to allow their workers to accept a pay cut (I’m not blaming them, this is just their job). So wages, which are a significant part of overall prices, are downwardly ‘sticky’. So the inflation rate may not fall enough to offset these gold outflows. And this is what causes the unemployment rate to rise.
So, if you don’t allow an external measure (the exchange rate) to correct the external shock, the internal economy has to absorb it. And this happens either through the inflation rate, or through employment, or both.
Leading up to the Great Depression, the US economy was booming (aptly named “The Roaring Twenties”). Gold flowed in. But instead of sterilising these inflows by printing more money, the US wanted to hoard more gold (presumably as a buffer against future crises – oh, the irony). But by not printing money, the US inflation rate remained too low. And the exchange rate, being fixed, didn’t appreciate like a floating exchange rate would. So gold continued to leave the rest of the world and flow into the US.
The rest of the world (starting with France, I think), upon seeing this happen, attempted to protect their gold reserves and preserve their pegging to the Gold Standard. They did this by cutting back on their own money printing and increasing their domestic interest rates to make their economies more profitable for investment.
And naturally, with this increased global demand for gold, and much of the world forcing their inflation rates down by not printing money, and crippling their internal economies with high interest rates, the world was plunged into a downward deflationary spiral which would eventually become known as the Great Depression.
This, in my opinion (and many others), was the cause of the economic downturn. The 1929 Wall Street Crash was just the trigger. The usual ‘irrational exuberance’ and ‘animal spirits’ of markets and individuals, too much debt and risky investments no doubt contributed. But the system of the Gold Standard – and its improper enforcement – laid the groundwork.
But many modern academics and economists, including former head of the Federal Reserve, Ben Bernanke, acknowledge that the US Federal Reserve (other central banks in other countries too) was actually the one responsible for turning this initial downturn into what would become known as the Great Depression. The Federal Reserve could have contained the fall out with the right policies (see my previous blog). But they didn’t.
Instead of flooding the financial sector with liquidity, bailing out systemically important institutions where necessary, and dropping interest rates (you know, what a central bank is created to do during a crisis), the Federal Reserve decided to continue maintaining their pegging to the Gold Standard. To this end, they even prematurely increased interest rates on one occasion. To provide the required extra liquidity would have caused the US dollar to depreciate, breaking their pegging.
There are also those that say the Federal Reserve wanted to allow the US economy to crash to weed out the bad debt, and allow the economy to come back stronger (the very Darwinian ‘liquidationist’ view). Or maybe they were just incompetent.
Unfortunately, without this central bank support, the financial system ran out of money. Institutions collapsed, and the resultant crash took the rest of the good economy with it (contagion) – not just the parts that needed correcting. Fiscal policy was also insufficient to support a recovery until the late 1930s (a little spending spree known as World War II).
Consequently, due to a Gold Standard that set the scene, a Wall Street crash, improper Federal Reserve policy, and insufficient fiscal support, the US underwent massive economic contraction. Deflation was widespread and unemployment rose to 25%.
So it was completely unsurprising and predictable that the countries that abandoned the Gold Standard earliest – freeing up their exchange rate to depreciate and their monetary policy to support employment and economic growth – recovered the fastest.
The Global Financial Crisis
Now the GFC…
The US’s monetary response was swift and strong – emergency liquidity to keep the system operating, targeted bailouts of systemically important financial institutions, and rock bottom interest rates. There was also an initially strong fiscal response – about $1 trillion enacted by the Obama Administration. So the actual recession and price deflation was relatively short-lived. The unemployment rate peaked at 10% instead of 25%.
However, further fiscal stimulus was hindered by deficit- and debt-obsessed politicians. This was the basis of the US government shut down and debt ceiling debate in 2012. So the resultant recovery was less complete and more prolonged than it could have been. But while this lack of stimulus was a continued drag on the US economy, this political stalemate also helped avoid a Europe-scale crisis, where governments were actually cutting spending, driving their economies into another actual Depression.
But even with the less disastrous fiscal policy in the US, its insufficiency still forced further measures by the Federal Reserve to compensate for the government’s fiscal impotency. And these measures could create further problems down the line.
These extraordinary measures by the Federal Reserve included their now-(in)famous ‘quantitative easing’ – injections of monumental amounts of liquidity into the system ($85 billion per month!), beyond the emergency liquidity and bailouts of the initial panic.
As mentioned in my previous blog, this kind of liquidity doesn’t create wealth and employment, per se. It is merely designed to create confidence that the financial sector won’t run out of money in the short term, thereby avoiding a bank run that can spread to the whole economy. And by lowering interest rates, it can also encourage greater investment by households, industry and government to kick-start the real economic recovery.
The Federal Reserve also went beyond their usual purchasing of short term financial market assets (to drop short term interest rates) to purchasing longer term assets (causing long term interest rates to drop). This was intended to show potential borrowers (households, industry and government) that anything they borrowed at the time would not be subject to higher interest rates in a few years. All the more incentive to borrow money and kick-start the economy, right?
Specifically, by December 2012, because of these actions by the Federal Reserve, the US government was able to issue 10-year inflation-protected bonds at the historically low level of -0.87% (yes, negative!) interest, and 30-year bonds (only available since February 22 2010) at 0.24% interest.
After the Federal Reserve announced its plans to slow down its $85 billion-per-month bond-buying program (its quantitative easing program) in 2013, rates jumped noticeably. This was just in response to the announcement – quantitative easing hadn’t actually ended, or even slowed down yet. So quantitative easing definitely had a big impact on government borrowing costs. But even since this jump in 2013, the 10- and 30-year securities have still hovered around just 0.4% and 1.0% respectively.
Even with around $19 trillion worth of debt late last year, US federal interest payments were just 1.3% of GDP (low by international standards). With the infrastructure in which the US could have invested (or just repaired), it seems insane that they wouldn’t take this once-in-three-generation opportunity to do so. But they stubbornly refused.
This is why the Federal Reserve had to do the heavy lifting for the government, and for so much longer than ideal. So, if there is a risk from the Federal Reserve’s actions on, for example, financial stability, at least some of the blame needs to be levelled at the government. But, as mentioned in a previous blog, increasing interest rates prematurely, because of fears of financial instability, is not advisable. There is a weak link between interest rates and financial instability. Macroprudential tools should be used.
“Raising interest rates is a poor strategy for managing asset bubbles. Low interest rates did not cause the housing bubble of the early 2000s and higher interest rates would have been ineffective at preventing it. To deflate an asset bubble, interest rates would have to be raised to levels that would cause enormous damage to the labour market. Fortunately, the Federal Reserve has numerous tools besides rate increase that would be more effective and inflict less collateral damage on the nonfinancial side of the economy”. Josh Bivens and Dean Baker, The Wrong Tool for the Right Job, May 2016.
It was not ideal. Ideal would have been more fiscal support instead of more monetary support. But it was what the Federal Reserve had to do in the face of an uncooperative government. And as this extra liquidity starts being absorbed over time by the system (being lent out by the financial sector), the Federal Reserve will be able to start withdrawing it from the system to prevent inflation from rising to far. This may just require allowing all the assets they bought in exchange for this liquidity to mature/ not be rolled over.
As for the structural response required of governments and central banks after a financial crisis, a little bit of history. After the Great Depression, the Glass-Steagall Act was created to prevent a similar event in the future. Among other things, it stated that commercial banks and investment banks were not allowed to merge into a single super-entity. The logic was that, by keeping these activities separate, risky speculative investment activity (if/ when it inevitably went pear-shaped) wouldn’t risk taking down the more responsible commercial lending component of the financial sector. Contagion would be less widespread because the institutions would be more separate and less affected by each other’s idiosyncratic fortunes.
The Clinton Administration repealed Glass-Steagall in the 1990s. So there are many that suggest that by allowing investment banking and commercial lending activities to become intertwined, these new super-entities were able to get around certain financial regulations, and lend money to much more risky areas (i.e. the sub-prime mortgage market) without being subject to the same regulations as traditional banks. Furthermore, they could do it at a magnitude that wouldn’t have been possible without the resources of the combined entity. Consequently, this caused (or at least contributed to) the GFC.
But I have to disagree with this logic. If this were true, we would have expected to see commercial banks collapsing because of their investment banking activities, or investment banks collapsing because of their commercial banking activities, or both. But it didn’t really happen this way. Banks like Wachovia and Washington Mutual ran into trouble because of their lending activities; investment banks like Bear Stearns and Lehman Brothers because of their investment banking activities; AIG, the world’s largest insurer, too. There was very little overlap between commercial lending and investment banking in these institutions where Glass-Steagall would have made a significant difference. In fact, Citi was probably the only exception.
But whether it was the lack of Glass-Steagall or not, a lack of regulation and oversight was unambiguously a major cause of the GFC. So the US enacted the Dodd-Frank Act as an attempt to correct the issues that caused the crisis. Among other things, the new Act:
· Increases capital reserve requirements for financial institutions.
· Prevents banks from making risky bets with their own money (the ‘Volker rule’).
· Limits fees that retailers are charged for debit card transactions (the ‘Durbin amendment’).
· Requires brokers to act in their clients’ best interests when providing retirement advice (the ‘fiduciary rule’ – though not explicitly part of Dodd-Frank). This may alleviate some of my own concerns about the retirement village sector becoming the next financial crisis (unless it is threatened by Donald Trump).
· Gives regulators greater ability to seize control of institutions on the brink of collapse. This will help keep systemically important institutions running and/ or cleanly unwind them, without rewarding their stockholders and bondholders (i.e. without promoting moral hazard).
· Created the Consumer Financial Protection Bureau which prohibits financial advisers giving misleading or fraudulent sales pitches to consumers. By many accounts, it has been very effective at detecting and deterring such fraud, thereby reducing bad loans and the risks of financial crisis.
· Established the Financial Stability Oversight Council, a collective of regulators who monitor risks and threats to the financial system. This includes ‘too big to fail’ institutions.
The Dodd-Frank Act is an important step in the right direction. It has shown good signs of success, and hasn’t prevented individuals or businesses from borrowing, despite claims by Donald Trump (banks have actually increased their consumer lending of credit cards and auto loans, and business lending).
Ben Bernanke has recently stated that the US’s financial system is now stronger, more robust, and more resilient to future crises than it was before the GFC. But by many accounts, the Act did not go far enough. Which makes it particularly concerning when the likes of Donald Trump want to get rid of the Act, because they say it hinders the economy. If there is another crisis soon, it won’t be because the Act went too far – it’ll be because it didn’t go far enough.
Conclusion:
It’s impossible to prevent financial crises with 100% certainty. There will eventually be something that escapes our attention and slips through the cracks of the system’s regulation and oversight. It’s like trying to prevent your house from burning down – you can have smoke detectors, sprinkler systems, and live next door to a fire station, but if a bomb is dropped on your house, it’s going to burn down. You can minimise the chances of a crisis. But you can’t eradicate it without stifling the entire economy (and ironically, causing a crisis). But the central bank can respond properly during a crisis to minimise its impact.
Ben Bernanke and Co. did during the GFC what the Federal Reserve failed to do during the Great Depression. He studied the Great Depression extensively throughout his lifetime. He must have been wetting himself with fear and excitement when he realised it was happening again, not just in his lifetime, but during his tenure as the head of the Federal Reserve. And this made him extra resolved to not repeat the Federal Reserve’s Depression-era mistakes, where monetary policy was impotent to respond properly lest it destroy the US’s pegging to the Gold Standard. It’s unnerving to consider how easily the US could have slipped into Depression 2.0 if the Federal Reserve had allowed it. But there was no way Bernanke was going to be known as the Federal Reserve Chairman who once again, led the US into a depression.
This unprecedented liquidity response was needed to improve confidence that the financial system wouldn’t run out of money (thereby avoiding a bank run), and to lower long term interest rates to incentivise government, households and industry to borrow and invest. The failure was not in the Federal Reserve’s attempts to incentivise the government to invest. It was in the failure of the government’s fiscal response to capitalise on these incentives.
We may even learn more if Bernanke did go too strong for too long – it’ll show us the limits of central bank effectiveness. So I believe he did the right thing, either way. Now, the GFC and the Depression represent two valuable and opposing case studies of what happens when a central bank does two polar-opposite policy responses – particularly one as significant as the US Federal Reserve.
Ben Bernanke has recently stated that the US’s financial system is now stronger, more robust, and more resilient to future crises than it was before the GFC. But by many accounts, the Act did not go far enough. Which makes it particularly concerning when the likes of Donald Trump want to get rid of the Act, because they say it hinders the economy. If there is another crisis soon, it won’t be because the Act went too far – it’ll be because it didn’t go far enough.
Conclusion:
It’s impossible to prevent financial crises with 100% certainty. There will eventually be something that escapes our attention and slips through the cracks of the system’s regulation and oversight. It’s like trying to prevent your house from burning down – you can have smoke detectors, sprinkler systems, and live next door to a fire station, but if a bomb is dropped on your house, it’s going to burn down. You can minimise the chances of a crisis. But you can’t eradicate it without stifling the entire economy (and ironically, causing a crisis). But the central bank can respond properly during a crisis to minimise its impact.
Ben Bernanke and Co. did during the GFC what the Federal Reserve failed to do during the Great Depression. He studied the Great Depression extensively throughout his lifetime. He must have been wetting himself with fear and excitement when he realised it was happening again, not just in his lifetime, but during his tenure as the head of the Federal Reserve. And this made him extra resolved to not repeat the Federal Reserve’s Depression-era mistakes, where monetary policy was impotent to respond properly lest it destroy the US’s pegging to the Gold Standard. It’s unnerving to consider how easily the US could have slipped into Depression 2.0 if the Federal Reserve had allowed it. But there was no way Bernanke was going to be known as the Federal Reserve Chairman who once again, led the US into a depression.
This unprecedented liquidity response was needed to improve confidence that the financial system wouldn’t run out of money (thereby avoiding a bank run), and to lower long term interest rates to incentivise government, households and industry to borrow and invest. The failure was not in the Federal Reserve’s attempts to incentivise the government to invest. It was in the failure of the government’s fiscal response to capitalise on these incentives.
We may even learn more if Bernanke did go too strong for too long – it’ll show us the limits of central bank effectiveness. So I believe he did the right thing, either way. Now, the GFC and the Depression represent two valuable and opposing case studies of what happens when a central bank does two polar-opposite policy responses – particularly one as significant as the US Federal Reserve.
No comments:
Post a Comment