The Federal Reserve and the Financial Crisis
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Finally, the Fed has also begun to provide guidance to investors and the public about what we expect to do with the federal funds rate in the future, given how we currently see the economy. So, given how we currently see the economy, we tell the market something about where we think the rates are going to go. To the extent that the market better understands our plans, that is going to help reduce uncertainty in financial markets. And to the extent that our plans are, in some sense, more aggressive than the market anticipated, we will also tend to ease policy conditions.
The recession—the period of contraction, which was very severe—officially came to an end. There is a committee called the National Bureau of Economic Research, which officially designates the beginning and end dates of recessions. I was a member of that committee before I became a policymaker. And they determined that this recession began in December 2007 and ended in June 2009, so it was a long recession. When they say the recession ended, what that means basically is not that things are back to normal; it just means that the contraction has stopped and the economy is now growing again. So we have been growing now for almost three years, averaging about 2.5 percent a year. But as I described, we are still some distance from being back to normal. So when we say the economy is no longer in recession, we do not mean that things are great. We just mean that we are no longer actually contracting; we are now growing.
Figure 33 gives a picture of the sluggish economic recovery. The darker line in the graph shows the path of real GDP since 2007. The shaded area shows the period of the recession according to the National Bureau of Economic Research. You can see that it begins in December 2007, and real GDP begins to decline during that period. In mid-2009, the recession is officially over. And you can see that,
since then, the darker line has been moving up as the real economy has been expanding.
Figure 33. Real GDP, 2007–2012
Note: Vertical shading represents NBER recession dates. The average recovery is calculated using the average growth rate in quarters following NBER troughs since 1949.
Source: Bureau of Economic Analysis
But you can also see a comparison. Suppose that the economy had been recovering since mid-2009 at the average pace of previous recoveries in the postwar period. That average recovery is shown by the lighter line. You can see that this recovery has been slower than the average recovery in the post–World War II period. It is actually even worse than that, in a way, because this was the most severe recession in the post–World War II period. And so you would expect that recovery might be a little quicker as the economy comes back to its normal level, but in fact it has been actually slower in terms of growth than previous postwar recoveries.
An implication of the sluggish recovery is only very slow improvement in the unemployment rate. In Figure 34, you can see the unemployment rate rising sharply during the recession period, peaking at around 10 percent, and then slowly coming down to its current value of about 8.3 percent. That is still quite high. Figure 35 shows single-family housing starts. As I discussed, housing starts collapsed even before the recession began. Of course, that was a trigger of the recession. And you see how very sharply construction declined. If you look at the most recent year or two, you see that there have been a few little wiggles, but the housing market has not come back.
Figure 34. Unemployment Rate, 2007-2012
Note: Vertical shading represents NBER recession dates.Value of the first quarter of 2012 is the February reading.
Source: Bureau of Labor Statistics
Figure 35. Single-Family Housing Starts, 1979–2011
Note: Vertical shading represents NBER recession dates.
Source: Census Bureau
So this is one answer to the question, why has this recovery been more sluggish than normal? One reason certainly is the housing market. In a usual recovery, housing comes back. It is an important part of the recovery process. Construction workers get put back to work, related industries such as furniture and appliances begin to expand, and that is part of the recovery process. But in this case, we have not seen that. Why not?
Figure 36. Homeowner Vacancy Rate for Single-Family Homes, 1980-2010
Note: Vertical shading represents NBER recession dates.
Source: Census Bureau
There are still a lot of structural factors in the housing market that are preventing a more robust recovery. On the supply side, we still have a very high excess supply of housing, a high vacancy rate. Figure 36 shows the percentage of housing units in the United States that are vacant, such as foreclosed homes or homes where the seller is unable to find a buyer. You can see that the vacancy rate peaked at more than 2.5 percent during the recession. It has come down some but is still well above normal levels. There are a lot of homes on the market, and that produces excess supply and falling house prices.
On the demand side, you might think that a lot of people would be buying houses these days because houses are really affordable. Prices are down a lot; mortgage rates are low. And so if you are able to buy a house, you can get an awful lot of house for your monthly payment now, compared to a few years ago. But being able to take advantage of that affordability requires, among other things, that you get a mortgage. Figure 37 shows what is happening in the mortgage market. The bottom line shows the tenth percentile and the top line the ninetieth percentile of credit scores of people receiving mortgages. And you can see that before the crisis, people with relatively low credit scores were able to get mortgages. But since the crisis, you can see the whole bottom part of the shaded area has been cut away, implying that people with lower credit scores—and 700 is not a terrible credit score—are unable to get mortgages. In general, conditions have been much tighter for obtaining mortgages. So even though housing is very affordable and monthly payments are affordable, a lot of people are unable to get mortgages.
Figure 37. Credit Scores on Newly Originated Mortgages, 1995-2011
Note: Shaded region shows tenth to ninetieth percentile; line shows the median.
Source: LPS Applied Analytics
So, with a lot of excess supply in the housing market and with a lot of people unable to get mortgage credit or afraid to get back into the housing market, house prices have been declining, as shown in Figure 38. Recently we have seen some leveling off, but so far not much evidence of an upturn. Declining house prices mean it is not profitable to build new houses, and so construction has been quite weak. And more broadly, when existing homeowners see their house prices decline, it may mean they cannot get home equity lines of credit or they just feel poorer. And so that affects not just their housing behavior, but also their willingness and ability to buy other business services. So the declines in housing prices and, to some extent, also stock prices are part of the reason consumers have been cautious and less willing to spend.
Figure 38. Prices of Existing Single-Family Houses, 1980–2012
Note: Includes purchase transactions only.
Source: CoreLogic
Housing was a major cause of this crisis and recession. The other major factor was the financial crisis and its impact on credit markets. And that is another reason the recovery has been somewhat slower than we would have hoped. As I have discussed, the U.S. banking system is stronger than it was three years ago. The amount of capital in the banking system over the past three years has increased by something like three hundred billion dollars, a very significant increase. And generally speaking, we are seeing credit terms getting a bit easier. We are seeing expansions in bank lending in a lot of categories. So there is certainly some improvement in banking and credit.
Nevertheless, there are still scenarios where credit remains tight. I have already talked about mortgages: if you have anything less than a perfect credit score, it is very difficult to get a mortgage these days. And other categories such as small businesses have also found it difficult to get credit. It is well known that small business is an important creator of jobs, so the inability to start a small business or t
o get credit to expand a small business is one of the reasons job creation has been relatively slow.
Another aspect of financial and credit markets has to do with the European situation. Following the financial crisis in Europe, which was very severe alongside of ours, there is now a second stage in which the solvency issues of a number of countries, the concerns about whether countries such as Greece and Portugal and Ireland can pay their creditors, have led to stressed financial conditions in Europe. And those have negatively affected the United States by creating risk aversion and volatility in the financial markets.
A lesson worth drawing from this is that monetary policy is a powerful tool but it cannot solve all the problems that there are. And in particular, what we are seeing in this recovery is a number of structural issues relating, for example, to the housing market, to the mortgage market, to banks, to credit extension, and of course to the European situation, where other kinds of policies—whether fiscal policies or housing policies or whatever they may be—are needed to get the economy going again. So the Fed can provide stimulus. It can provide low interest rates. But monetary policy by itself cannot solve important structural, fiscal, and other problems that affect the economy.
This is all rather discouraging. Again, it has taken a while to get back to where we are, and we are still a long way from where we would like to be. So let me say a few words about the long run. We did have, of course, a major trauma. The crisis was very deep. We have a lot of people who have been unemployed for a long time. About 40 percent or more of all the unemployed had been unemployed for six months or more. And if you are unemployed for six months or a year or two years, your skills will start to atrophy and your ability to get reemployed will decline. So that clearly is a problem. And then there are many other issues that the United States was facing even before the crisis, such as federal budget deficits, and those have not gone away. In fact, they have gotten somewhat worse through the recession. So clearly, there have been some real headwinds for our economy.
That said, I think it is important to understand that our economy has faced many short-term shocks in the past, and some not so short-term, but it has always been able to recover. We have a lot of strengths in this economy. It is, of course, the largest economy in the world; between 20 and 25 percent of all output in the world is produced in the United States, even though we have something like 6 percent or less of the world’s population. And the reason that we are so productive has to do with the diverse set of industries we have; our entrepreneurial culture, which still is clearly the best in the world; the flexibility of our labor markets and our capital markets; and our technology, which remains one of our very strongest points. Increasingly, technology has been driving economic growth. And with some of the finest universities and research centers in the world as magnets for talented people from around the world, the United States has been very successful in the research and development area. So, that has also been a source of ongoing growth and innovation in our economy. Again, we have weaknesses and the financial crisis highlighted a few, but we have also tried to address them by strengthening our financial regulatory system.
I find Figure 39 interesting, to put in perspective what I have been discussing during these lectures. The dashed line shows a constant growth rate of a little over 3 percent in real terms. This is a log scale, so the straight line means a constant growth rate. And you can see that, going back to 1900, the United States economy has grown reasonably consistently at around 3 percent annually for more than a century. In the 1930s, you can see the big swing as the Great Depression pulled actual output below the trend line. And then you can see the movement above the trend line during World War II. But look what happened after World War II: we went right back to the trend line. There were recessions and booms and busts in the postwar period, but growth remained fairly close to the trend line. Now, if you look to the very far right, you see where we are today: we are below the trend line. There are debates about whether that decline is permanent. But looking at history, I think there is a reasonable chance that the U.S. economy will return to a healthy annual growth rate somewhere in the 3 percent range. There are factors to take into account, such as changes in our population growth rate, the aging of our population, and so on. But broadly speaking, what this graph shows is that, over long periods, our economy has been successful in maintaining long-term economic growth.
Figure 39. Real GDP, 1900-2010
Note: Vertical shading represents NBER recession dates; dashed line denotes trend.
Sources: For 1900–1928, Historical Statistics of the United States, Millennial Edition, table Ca9; for 1929–present, Bureau of Economic Analysis
I will say a few words about regulatory changes. In the last couple of lectures I discussed the vulnerabilities in both the private and public sectors in the financial system. On the public side, the crisis revealed many weaknesses in our regulatory system. We saw what happened with Lehman Brothers and AIG, the effects of the “too big to fail” problem on our system, and more generally, the problem of the lack of attention to the broad stability of the system as opposed to individual parts of the system.
There has been a very substantial amount of financial regulatory reform in the United States since 2008, and the biggest piece of legislation is the so-called Dodd-Frank Act.5 This legislation, officially named the Wall Street Reform and Consumer Protection Act, which was passed in the summer of 2010, was a comprehensive set of financial reforms addressing many of the vulnerabilities that I discussed earlier.
Now, what were these vulnerabilities? One was the fact that there was nobody watching over the whole system, nobody looking at the entire financial system to spot risks and threats to overall financial stability. So, one of the main themes of the Dodd-Frank Act is to try to create a systemic approach, where regulators look at the whole system and not just individual components of it. Among the tools to do that is a newly created council called the Financial Stability Oversight Council (FSOC), of which the Fed is a member, which helps regulators coordinate. We meet regularly in this council and discuss economic and financial developments and talk about ways that we can look at the whole system and try to avoid various kinds of problems.
Moreover, the Dodd-Frank Act gave all regulators responsibility to take into account broad systemic implications of their own individual regulatory and supervisory actions. And in particular, the Federal Reserve has greatly restructured our supervisory divisions so that we are looking now very comprehensively at a whole range of financial markets and financial institutions. As a result, now we have a big picture that we did not have before the crisis.
I mentioned in my discussion of vulnerabilities the many gaps in the financial system. There were important firms, such as AIG, for example, but others as well, that had no significant comprehensive oversight by any regulatory agency. The Dodd-Frank Act provides a fail-safe in that the FSOC can designate, by vote, any institution it views as not being adequately regulated to come under the supervision of the Federal Reserve. That process is going on now. So there will not be any more large, complex, systemically critical firms that have no oversight. Likewise, the FSOC can also designate the so-called financial market utilities like a stock exchange or some other major exchange to be supervised by the Fed and other agencies. So those gaps are being closed. We will not have the situation that we had before the crisis.
Another set of problems had to do with “too big to fail” and dealing with firms that are systemically critical. The approach to dealing with too big to fail or systemically critical institutions is two-pronged. On the one hand, under Dodd-Frank, large, complex, systemically important financial institutions are going to face tougher supervision regulation than other firms. The Federal Reserve, working with international regulators, has established higher capital requirements that these firms will be subject to, including surcharges for the very largest and most systemic firms. Rules like the Volcker Rule, which prohibits bank affiliates from taking risky bets
on their own accounts, will try to reduce the riskiness of large firms. Stress tests will be conducted. Dodd-Frank requires that large firms be stress tested by the Fed once a year and conduct their own stress tests once a year. So we will be comfortable, or at least more comfortable, that these firms can withstand a major shock to the financial system.
Now, one part of tackling “too big to fail” is to bring these large, complex firms under more stringent scrutiny: more supervision, more capital reserves, more stress tests, more restrictions on their activities. But the other side of tackling “too big to fail” is, well, failing. In the crisis, the Fed and the other financial agencies faced a terrible choice of either trying to prevent some large firms such as AIG from failing, which was a bad choice because it ratified “too big to fail” and meant that the firms were not adequately punished for the risks they took, or letting them fail and potentially destabilize the whole financial system and the economy. So that is the “too big to fail” problem. The only way to solve that problem, in the end, is to make it safe for a big firm to fail. One of the main elements of the Dodd-Frank Act is what is called the “orderly liquidation authority,” which has been given to the FDIC. The FDIC already has the authority to shut down a failing bank, and it can do that quickly and efficiently, typically over the weekend. And depositors are made whole. The FDIC’s ability to do that has prevented panics and bank runs since the 1930s. The idea here is that the FDIC will do something similar, but for large, complex firms, which obviously is much more difficult. But in cooperation with the Fed, and with regulators from other countries in the case of multinational firms, work is under way to prepare. So should it happen that a large firm comes to the brink of insolvency and cannot find a solution—cannot find new capital, for example—the Fed’s ability to intervene the way we did in 2008 has been taken away. Legally, we cannot do that anymore. The only option we will have is to work with the FDIC to safely wind down the firm, and that will ultimately reduce or, we hope, eliminate the “too big to fail” problem.