Fault Lines: How Hidden Fractures Still Threaten the World Economy
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Because he is a careful economist, in addition to being a very good one, Bernanke suggested that there was merit in all three explanations. However, he stressed the view that monetary policy had become much better. Unlike the policy makers in the 1960s and 1970s, who operated with rudimentary and often incorrect beliefs about economic relationships, today’s central bankers, he felt, understood far better how the economy works. Bernanke is, if anything, more cautious and nuanced than the typical policy maker, but the overall tone of his speech was triumphant: the policy levers for managing a modern economy were well understood, which was why we already had milder recessions. The implication, perhaps unintended, was that with steady progress, we could do away with recessions altogether.
By September 2008, however, Bernanke, now chairman of the Federal Reserve Board, having realized the limits of monetary policy, was pleading for help from Congress, arguing that “despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial markets remain under extraordinary stress. Action by Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy.”1 In short, monetary policy was not working, and only a bailout of the financial system by Congress could stabilize the economy and avert a depression. Where had the Fed gone wrong?
With the benefit of hindsight, it appears that the Federal Reserve made two mistakes. First, the jobless recovery from the recession of 2001 induced the Fed to keep interest rates extremely low for a sustained period. A lot of excesses were building up, in the rest of the world as well as in the United States, but theory and politics conveniently came together to keep the Fed on hold. Second, the Fed actively encouraged the financial markets to believe it would follow an asymmetric policy: it would not lean against a potential unsustainable rise in asset prices, but it would remain ready to pick up the pieces if a bubble burst. Both these implied promises did considerable damage, because in attempting to stimulate sluggish job creation, they set off an orgy of financial risk taking.
Unfortunately, because the Fed’s actions were consistent both with its mandate and with the prevailing academic orthodoxy, it has not been forced to rethink its policies. Moreover, in an environment of high and persistent unemployment, the political pressure on it to persist with such policies will make change very difficult.
The Federal Reserve’s Objectives
The Federal Reserve has a mandate from Congress to promote a healthy economy. This means maintaining maximum sustainable employment and stable prices. Also, it has been entrusted since its founding in 1913 (in the wake of the Banker’s Panic of 1907) with helping to ensure the stability of the financial system.2
In the past, economists believed that the components of the healthy-economy mandate—the goals of maximum sustainable employment (high growth) and stable prices (low inflation)—were incompatible over the long run, because high growth might require high inflation. Implicit in this trade-off (known as the Phillips curve after William Phillips, who found such a relationship in the U.K. economy between 1861 and 1957) was the belief that you could fool all of the people all of the time. Injecting more inflation would lead people to believe they were getting paid more for the goods they produced and to work harder—thus expanding output—not realizing that everything else was becoming costlier at the same time.
In the late 1960s and early 1970s, even as data suggested the Phillips-curve relationship between inflation and unemployment was breaking down, the “rational expectations” revolution started taking hold of monetary economics. It explained why the Phillips-curve relationship was theoretically untenable. The essential idea was that the public understood the objectives of policy makers and the frameworks they operated with, so they would not cooperate by being fooled. If the central bank had a policy of inducing high inflation, producers would rationally expect that all prices would go up and would not exert more effort when they saw the prices of their own products go up. Rather, they would understand that the additional dollar they earned was actually worth less in terms of its ability to purchase goods and services. The long-run level of employment of the economy would be determined by factors like the business climate, incentives to innovate, and the ability of firms to hire or lay off workers easily, not by inflation.
This view eliminated the incompatibility in the long run between the economic goals of low inflation and maximum sustainable employment. According to the new orthodoxy, by keeping inflation low and thus eliminating all the uncertainty and distortions associated with high and variable inflation, central bankers would give the economy its best chance of achieving its potential growth rate and thus maximum sustainable employment. However, there is still a short-run trade-off between growth and inflation, stemming from the notion that every economy has a potential growth rate—an inbuilt maximum safe speed. Make the economy go any faster, and wages and inflation start accelerating because demand exceeds productive capacity; slow it down, and wages and inflation start falling. When the potential growth rate is reached, the economy is effectively at maximum sustainable employment—all the unemployed are either fully occupied in searching for appropriate jobs or are unemployable—and any effort to further accelerate growth will only increase competition and wages for employed workers, and thus inflation. So the ideal central-bank policy is to keep the economy perpetually at its potential growth rate.
Unfortunately, no one really knows what the potential growth rate is, though they have reasonable guesses. And this rate can change if the structure of the economy changes—for example, if the industries that are dominant in the economy change. The best indicator for a central banker is inflation. A rise in the inflation rate indicates that the economy is exceeding the speed limit; if the inflation rate is falling, the economy can benefit from more stimulus. Of course, because monetary policy operates with lags—raise interest rates now, and the effects are felt in the economy only many months later—a central bank that waits until it stares inflation in the eye before withdrawing stimulus has waited too long. Therefore, central banks attempt to project what their policies will do (typically over a two- to three-year horizon) and adopt policies that will keep future inflation close to a target and thus maintain growth close to potential.
In the years before the crisis, central bankers and academia thus converged on variants of targeting inflation as their primary objective. Of course, they also had to consider the objective of financial stability. According to conventional wisdom, central bankers had only one instrument with which to carry out monetary policy—the short-term interest rate—and they could not target more than one objective with it. Concerns about financial stability would complicate and make less intellectually rigorous the process of setting monetary policy. Financial stability was left to be tackled through “prudential” measures like capital requirements and relegated to the less glamorous supervisory and regulatory arms of central banks.
The Interest Rate and Its Effects
The Fed conducts monetary policy largely through the short-term interest rate (the overnight federal funds rate). It sets this rate by intervening in the interbank market for reserve money. Through this rate, the Fed hopes to influence the long-term interest rate. According to the most commonly held economic view, investors in the market see the long-term interest rate (say the ten-year Treasury bond rate) as being a function of the sequence of the short-term interest rates that are expected to prevail over time. So if the short-term interest rate is expected to remain low over the next ten years, the long-term interest rate will be low, whereas if the rate is expected to be low only for the next two months and then climb to a higher plateau, the long-term interest rate will be high. This reasoning is known as the expectations hypothesis. By holding down the short-term rate, especially if the market believes it will be held low for a sustained period, the Fed can influence expectations of the future short-term rate and hence the long-term interest rate.
Long-term
interest rates are extremely important in the economy. A lower long-term interest rate increases the value of long-term assets such as equity, bonds, and houses because dividends, interest payments, and the services provided by the house are discounted at a lower rate. It thus increases household wealth and, consequently, spending. A low long-term interest rate also makes it less attractive for households to save and more attractive to consume, thus again contributing to demand. Finally, long-term interest rates determine the profitability of real investment: lower long-term interest rates make today’s value of future profits higher, giving corporations more incentive to invest as well as greater ability to borrow.
The short-term interest rate may also have direct effects on economic activity. Many borrowing rates are tied to short-term interest rates: for example, the interest payment on an adjustable-rate mortgage falls if the Fed cuts interest rates, leaving more money for households to spend. Through a low policy rate, the Fed may also signal to the market that it intends to keep liquidity conditions—that is, the ability to borrow—easy over the foreseeable future. Banks and finance companies then have the incentive to make illiquid term loans, confident that they can refinance from the market.
What I have outlined is the conventional view of how monetary policy works. Let us now see how the Fed responded to the dot-com bust and the recession in 2001, and what the conventional view may have missed out.
The Response to the Dot-Com Bust
After the crash in the NASDAQ index in 2000–2001 and the recession that followed, the Federal Reserve tried to offset the collapse in investment by cutting short-term interest rates steadily. From a level of 6½ percent in January 2001, interest rates were brought down to 1 percent by June 2003. Such a low level, unprecedented in the post-1971 era of floating exchange rates, sent a strong signal to the economy. House purchases picked up as more people found they could afford the lower mortgage payments. Increased housing demand encouraged more home construction, which was already being given a boost by the low interest rates at which developers could borrow.
Output growth, riding on productivity growth, was strong, but jobs were really what the public and politicians wanted. Growth by itself did not put food on the table, pay bills, or reduce anxiety for those who were unemployed and seeing their benefits running out, or for those who feared for their jobs. Unfortunately, as we have seen, job growth simply did not pick up. Industrial and service companies continued pruning workers, and the new jobs in construction did not offset job losses elsewhere. Unemployment peaked only in June 2003, long after output growth had resumed and the recession was officially over.
With inflation low and unemployment high, the Fed’s healthy-economy mandate suggested it should keep interest rates low. Indeed, given the level of unemployment and the consequent slack in the economy, Fed officials, including Ben Bernanke, openly worried about the possibility of deflation, even in mid-2003, when quarterly GDP growth was around 3 percent.3 The Federal Reserve seemed to be influenced by the recent experience of Japan, which had faced prolonged price deflation and slow growth in the 1990s as a result of the collapse of its real estate bubble. But this concern was misplaced: unlike Japan, the United States in 2001 had not experienced a debt crisis, only a meltdown of the overvalued tech stocks. A debt crisis could have caused a downward spiral of bankruptcies, job losses, and fire sales that might have triggered a deflation. But the effects of a stock meltdown were, and historically have been, much milder.4 Consumer price inflation in the United States never fell below 1 percent over this period, despite downward pressure from low-cost imports (we do not, of course, know what it would have been without the easy Fed policy); and more important, future expectations of inflation were firmly above 1 percent and nearer 2 percent, the Fed’s unofficial target. Indeed, the disinflationary pressures at that time may well have arisen because foreign competition was forcing U.S. producers to become more productive as well as to keep wage increases limited, rather than because demand was excessively low.
By mid-2003, almost every measure of economic activity other than inflation and unemployment was picking up strongly. Demand in the United States was strong: the United States’ trade deficit, a measure of the demand in the United States that was being satisfied from abroad, was widening rapidly. Indeed, one reason that the pace of U.S. job growth was especially slow in manufacturing may have been that countries outside the United States, like China and Japan, were resisting the appreciation of their currencies against the weakening dollar, thus ensuring that their exports continued to be competitive in the U.S. marketplace. The Fed was now effectively adding stimulus to a world economy that was growing strongly, with jobs being created elsewhere but not in the United States. Commodity prices around the world started a steady rise, suggesting that worldwide economic slack was decreasing. If the Federal Reserve, the world’s central banker in all but name, had been focused on sustainable world growth, it should have been tightening monetary policy by raising interest rates. But its mandate covered only the United States.
John Taylor of Stanford University has pointed out that even measured against what is known as the Taylor rule (an empirical characterization of past Federal Reserve interest-rate policy, which sees the short-term policy rate as a function of the inflation rate and the gap between the output the economy is capable of and what it actually produces), the Fed should have started raising interest rates by early 2002.5 But it continued to reduce rates until as late as June 2003. In a speech in 2010 at the American Economic Association’s annual meetings, Ben Bernanke defended Fed policy, saying that if inflation was properly measured, the Fed had not departed from the Taylor rule during this period. In truth, the problem was that output growth had not resulted in job growth. And the Fed was focused not on output, as the Taylor rule would suggest, but on jobs.6
When the Fed finally started to raise rates in June 2004, it was extremely fearful of killing off a nascent jobs recovery. So it took pains to accompany its rate hikes with announcements that interest rates would be low for “a considerable period” and would rise slowly at a “measured pace”—namely, 25 basis points at every scheduled meeting of the board. This strategy clearly helped keep long-term interest rates low, but not because expectations of future short-term rates came down, as the expectations hypothesis would suggest. Instead, the risk premium on long-term government bonds—the additional spread that the market demands to take the risk of bond prices fluctuating—fell even as the Fed raised short-term interest rates, with the result that long-term interest rates fell and bond prices rose.7 Indeed, a generally low premium for risk ensured that the prices of all risky or long-term assets, including housing, rose, even as the Fed raised rates slowly. The Fed’s policy seemed to be working because it made risk more tolerable!
The Fed did worry about the deteriorating quality of lending and made some supervisory noises over time. But with its foot pressed firmly on the interest-rate accelerator, the supervisory measures were ineffective. Ultimately, it was probably also Fed actions that brought the party to an end. Higher short-term interest rates raised the payments on adjustable-rate mortgages as well as prospective payments on mortgages with rate resets. With demand for housing falling off (and Fannie and Freddie eventually tempering their purchases of mortgage-backed securities), house prices stopped rising. As a result, overextended borrowers found it hard to refinance before the initially low “teaser” rates on their mortgages expired, and households began to default on payments. Foreclosures caused house-price declines, and the whole momentum of the boom was reversed. The Fed, as we now know, intervened too late. The bubble had inflated enormously, and the ensuing bust has been extremely painful.
Did the Fed Make Mistakes?
With the benefit of hindsight, it easy to suggest that the Fed made mistakes even in the traditional conduct of monetary policy: for instance, it may well have overestimated the risk of deflation. In some ways, though, the threat of deflation seemed to be a low-probability red herring
, put forth to explain why the Fed kept rates on hold. The true problem was unemployment, which made raising rates politically impossible. In the past, when economic growth and job recovery coincided, this was not an issue. With jobless recoveries though, growth and jobs became somewhat divorced. The Fed would have to be on hold for a long time if it wanted to see jobs reappear.
For those who believe the Federal Reserve is too independent, the notion that it is subject to political pressure may seem unthinkable. Yet, as Fed governors admit in private, pressure is applied all the time by Congress. Powerful politicians, in off-the-record conversations with Fed governors, frequently make veiled and not-so-veiled threats to scrutinize Federal Reserve activities and reduce its independence unless the Fed complies with their wishes. Although typically they stay off monetary policy, their desires are not hard to read when unemployment is high. Ironically, the Federal Reserve’s desire to remain independent is the lever with which Congress makes it compliant.
At this time, however, the Fed needed little convincing to keep interest rates low. The prevailing orthodoxy suggested that Fed policy makers should worry only if inflation was getting out of hand. And it was not: inflation in the prices of goods (like cars and milk) and services (like haircuts and laundry) was quiescent, and indeed, if anything, the Fed feared deflation. So the Fed was free to focus on the second part of its mandate, full employment. Yet even while the Fed attempted to convince unwilling corporations to invest through ultralow interest rates, the prices of financial assets and housing were skyrocketing. But the orthodoxy suggested asset prices could be ignored.