What follows are partial notes for a talk to the Dallas Rotary Club today,
March 2, 2011.
I guess the subprime origins of the financial crisis don’t need retelling at this point. The ensuing recession began in December 2007 and officially ended (semi-officially anyway) in mid-2009, when GDP started growing again. So, that’s about 18 months of deep recession, and now about 20 months of weak recovery.
Employment declined for two years during 2008 and 2009 and started growing again in early 2010. Then it turned down again for a few months and lately has been growing very slowly.
The unemployment rate peaked at 10.1 % in October 2009 and now stands at 9%–with 0.8% coming off in the past 2 months.
Last summer’s talk of a possible double dip has faded away.
I happen to think that extraordinary measures to prevent the financial crisis from creating a 2nd Great Depression were justified. A relative benign outcome was not preordained.
It could easily have gone the other way, but, now that it didn’t, critics are quick to second guess what was done and point only to adverse consequences.
Not all measures worked the same, however.
Let me first praise the Federal Reserve’s heroic measures–since no one else seems willing to do so. First, came its rapid easing of conventional monetary policy. Then, devising innovative ways to lend to teetering banks. Finally, its support of the financial system with massive asset purchases in frozen markets, including commercial paper, mortgage backed securities, and currently Treasury notes.
The resulting expansion of the Fed’s balance sheet increased the Fed’s earnings, which, as usual, were turned back over to the Treasury’s general fund, effectively, supplementing taxpayer funds and reducing the fiscal burden.
In other words, the Fed’s policies not only did not use taxpayer funds, they supplement taxpayer funds. But nobody seems to know that.
(More on the Fed in a moment)
The Treasury’s Tarp Program (Troubled Asset Relief Program) was also successful in saving the banking system, and TARP will also prove to be profitable for the taxpayers. You heard right: not a cost to the taxpayers, but a profit.
The Treasury bought preferred stock in over 700 banks to give them an additional capital cushion, while mortgage backed securities and mark to market accounting were wiping bank capital out. But the Treasury got a 5% dividend from the banks in return, plus warrants on their common stock that could be sold later at a profit.
Most banks, including all the major banks, have already repaid the Treasury, as I said, at a profit. Only a few small ones have not yet.
The public thinks of these Fed and Treasury programs as government spending, but they really were loans and investments—ultimately profitable loans and investments.
That’s not true, however, of the huge stimulus package. That was old-fashioned spending: money spent, money gone.
While the stimulus package no doubt provided some support for jobs, is was not well designed, not focused, and not targeted well to create jobs. While it had to have helped some, most agree that it was not worth its huge cost in adding to budget deficits and the debt.
We are on our 3rd year of about a $1½ trillion budget deficit, about 10 percent of GDP, and our national debt held by the public has risen from under 40% of GDP to over 60% of GDP, and rising. You usually see extrapolations of these trends in the press which give you much worse numbers. But they can’t be extrapolated too far because they are unsustainable. Something has to give.
Now that falling off the cliff is no longer a likely outcome, attention has shifted to how inflationary all these measures will be, and how much will they trash the dollar.
My own view is that, based on what has been done already, we won’t necessarily get much higher inflation or a much weaker dollar. That is yet to be determined.
Normally, massive Fed lending and asset purchases—along with large budget deficits—would be highly inflationary, but, so far, these actions have not led to excessive money creation, which is what causes inflation.
Bank reserves have expanded greatly, but banks have been so traumatized that they are holding onto more of those new reserves than required by regulation. In other words, banks have been holding most of their new reserves as “excess” reserves, so they haven’t been turned into deposit money. Until they are, we won’t have a major inflation risk. When they are, eventually, the Fed will have the delicate task of offsetting their inflationary impact.
Here is my little catechism:
–Money has to be created to be spent.
–Money has to be spent to stimulate the economy and/or cause significant inflation.
–Money has to be spent in the foreign exchange market to weaken the dollar.
What about too easy fiscal policy?
Government spending financed without new money creation doesn’t tend to be inflationary. The danger, in my opinion, comes not from what has already happened, but from what might happen next–in other words, the Fed’s “exit strategy.”
When banks finally start using their excess reserves aggressively, it may over-stimulate the economy and cause a significant inflation problem.
The delicate task for monetary policy at that point will be for Mr. Bernanke to offset a rapid rise in the shrunken reserves to money multiplier with an offsetting reduction in bank reserves—a delicate task, but not impossible.
Mr. Bernanke is a life-long student of the Great Depression.
He believes that the Government and the Fed made the mistake of tightening prematurely in the 1930’s, turning what might have been a garden variety recession into a great depression. He believes that while waiting too long to tighten may cause inflation to rise; that is a lesser danger than tightening prematurely and chocking off the fragile expansion.
We have had some encouraging signs lately that you probably didn’t read about in the newspapers or hear about on TV.
They say that Wagner’s music was better than it sounds. Similarly, the latest headlines on GDP and employment growth sounded much worse than they were when you look under the hood. Fourth quarter real GDP rose only 2.8%, up from only 2.6% growth in the 3rd quarter. However, most of that weakness came from inventory depletion, which, under today’s circumstances, is a positive sign. Corrected for inventory declines, real GDP growth would have been a very strong 6.7%.
But practically nobody noticed.
We’ll get a new employment report Friday, but the last one, for January, was also much stronger than the headline number: By one measure, the one that got the attention, total employment grew a paltry 32K jobs, even though the unemployment rate fell a huge 4/10 of 1 percent.
People, most journalists included, just assumed that the large decline in the unemployment rate on weak employment growth was caused by discouraged workers dropping out of the labor force. That often happens, but not this time.
Employment in the other survey—the one that generates the unemployment estimate—grew approximately 600,000 jobs, way above the 32,000 that got the headlines.
These stronger GDP and Employment numbers may be anomalies, or they may be the beginning, finally, of a significant pick-up in growth. And more rapid growth is necessary to get our fiscal house in order.
We need to cut government spending, and we need more tax revenue, whether from higher or lower tax rates, but that won’t be sufficient.
The only way to get out of our fiscal hole is to stop digging and grow our way out of it—while holding down spending for multiple years and reforming our tax code in a more pro-growth direction.
If you have any suggestions, send them to Washington.