Consensus Stabilization Policy Is Wrong, Part II

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This is the second in  my three-part series on the wrong-headed policy consensus on how to prevent future Great Recessions. The installment will summarize relevant macro analysis, drawing from the GEM Project’s modeling of extreme instability. Unlike much macroeconomics today, the argument is intuitive and easily grasped. It also includes some relevant evidence and outlines an alternative approach that would be much more effective in preventing future Great Recessions.

Understanding extreme instability. In order to get a handle on the costly 2008-09 extreme instability, three facts of must be kept in mind. First, in modern, specialized economies, many wages and prices adjust slowly to market disruptions. As a result, contractions in total spending generate involuntary job loss and underutilized capital. Adverse nominal demand movements are always at the heart of recessions and depressions.

Second, in the wake of the 2008 bankruptcy of Lehman Brothers, many investors/lenders became uncertain about the nation’s ability to avoid near-term depression. They rationally became more inactive, delaying acquisition of financial assets. Financial markets quickly reacted to the absence of buyers, and asset prices began a frightening collapse. Recall that the S&P 500 equity index lost nearly a third of its value in the month following the Lehman failure. Sidelined buyers were reasonably waiting for a halt to the contraction of total spending and the emergence of credible asset-market bottoms.

Third is the destabilizing feedback that inherently exists between cumulating damage to the financial system’s capacity to recycle saving into investment/consumption and collapsing aggregate demand. A lesson of both history and logic is that unchecked contractions in nominal spending in highly specialized economies result in depression. The destruction in living standards, massive permanent job loss, idle capital stock, huge private/public debt default, and other predictable costs of a 21st century depression would make its 1930s predecessor look like a walk in the park. In one of its relatively minor outcomes, government debt would quickly swell by many, many trillions of dollars, saddling taxpayers with an unmanageable increase in liabilities.

The 2008-09 collapse in asset prices and the damage to business and household creditworthiness quickly ate up (mark-to-market) bank capital. Facing industry-wide capital inadequacy, bank managements rationally sought to reduce assets, cutting back sharply on lending and substantially aggravating the on-going contraction in total spending. Moreover, as increasingly inactive lenders cut back on short-term funding to banks (and nonbanks), even more financial-institution asset fire sales were needed to balance their books. In acute-instability crises, the effective policy response to adverse feedback dynamics has long been including temporary injections of public funds to help mitigate the effects of rapidly deteriorating bank capital on total spending. But wait. Sheila Bair, as outlined in last week’s post, has a different idea. No bailouts, put the banking system into bankruptcy, liquidate assets, and frighten even more investors/lenders into inaction. Such actions supercharge any brewing collapse in in aggregate demand. Bair is focused on the short-term political benefits available from exploiting the broadly held myth of taxpayer losses from big-bank “bailouts”. (See below.) She either does not understand or does not care that such political expediency will make future crises much more difficult to manage.

Superior policy. A better-designed policy consensus on preventing future Great Recessions is needed. It should be mindful of the two fundamental characteristics of highly specialized economies that have already been emphasized:

  • Given the rational inability of many wages and product prices to contract (absent very long lags) in response to rising unemployment and excess capacity, effective stabilization policy focuses on total nominal spending. In the perilous circumstances of an unchecked demand collapse (e.g., what was spontaneously brewing in the second half of 2008 and early 2009), authorities cannot dawdle. Their response must be on-target, big and quick. There are no policymaker do-overs when confronting gathering depressions.
  • Financial institutions exist to channel saving into spending on investment and, to a lesser extent, consumption. A substantial persisting breakdown in financial markets assures an unchecked collapse in total nominal demand. In particular, investor/lender uncertainty with respect to the credibility of stabilization authorities’ trend full-employment objective motivates rational asset-acquisition inaction and consequent debilitating feedback between financial-sector disruption and collapsing total spending.

Building on those facts, proper analysis provides a compelling alternative to the current consensus sink-all-boats approach to managing instability crises. The focus shifts to concerted government action – on all fronts, in size and with speed – to halt and reverse collapsing nominal demand. An explicit objective must be to restore, especially to investors and lenders, the credibility of the trend real-side (full-employment) objective of stabilization authorities. Such credibility is the antidote to damaging macro uncertainty. Effective strategy crucially features rapid, large-scale actions to unfreeze financial markets. The alternative approach describes, in a nutshell, Ben Bernanke’s successful policymaking in 2008-09.

With the reversal in total spending in middle-2009, real activity began to improve and asset markets quickly bounced back to near pre-recession levels. Banks’ mark-to-market insolvency melted away. Effective all-in demand-management policies bailed the entire country out of a bleak future that included saddling taxpayers with multiple trillions of dollars in liabilities. By contrast, potential TARP losses in 2008-09, which are the moral focus of today’s public-policy consensus, were the smallest of small potatoes. Throwing away part of the effective stabilization toolbox (capital injections as well as other classes of intervention that support total spending), either out of ignorance or for temporary political gain, is unconscionable. Instead, policies to prevent future Great Recessions should focus both on constructing the most credible, powerful tools for intervening in aggregate demand and on convincing investors/lenders globally of the power of that toolkit and authorities’ determination to use it in future instability crises.

Some evidence. A couple of additional facts are instructive. First, taxpayer losses from large-bank “bailouts” during the Great Recession are a myth. Instead of losses, the Treasury made a handsome profit on TARP capital injections to the biggest banks. Indeed, large-bank (above-market) interest payments and warrants largely paid for the below-the-radar multi-billion-dollar TARP losses on defaulted loans to the auto and insurance industries. The first policy-consensus pillar is no more than a politically convenient fabrication, rejected by the facts. This essay, however, makes a more important point. The big-bank capital injections helped prevent multi-trillion-dollar taxpayer losses that would have occurred if the 2008 demand contraction had had been allowed to morph into a 1930s-class depression.

A second class of evidence should help seal the deal. If the public-policy problem is the prevention of future episodes of extreme instability, consensus thinking ought to be informed by what worked to stabilize the economy in 2009. Recall that Fed policy had a single objective: To halt and reverse the collapse in total spending. In designing how to accomplish that, Bernanke understood that financial markets, suffering from sidelined buyers who had become uncertain about trend macro prospects, had to be unfrozen. Accomplished that was critical to the reversal of total demand reversed; and production, employment, and income began to slowly recover. By contrast, and this is important, asset prices rebounded rapidly. The pattern of the post-crisis recovery is uniquely consistent with the confidence-centric extreme-instability dynamics presented above.

The most important evidence has been conveniently ignored in the construction of the current policy consensus on how to prevent future Great Recessions. Next week looks at examples of the most egregious mistakes that resulted.

Blog Type: Policy/Topical San Miguel de Allende, Mexico


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