Earlier today, I had a brief e-mail exchange in which I said that I had basically thrown in the towel on US (and global) policy makers. Early on in this crisis, I had advocated a number of policy paths which I think would have been infinitely superior to the ones actually chosen by the Bush and Obama Administrations, especially in regards to limiting the socialization of losses. I am talking about massive fiscal stimulus, big bank pre-privatization, a move away from the asset-based economy and the accumulation of debt, and a reallocation of resources.
Quite frankly, none of these suggestions have been taken on. As I discussed in March when making a few comments on this blogger's harsher tone about the credit crisis, the prevailing view in policy circles seems to be that we are in full recovery mode now, the remedies we put in place having been highly effective. Therefore, we can put in a few minor tweaks to the financial system, use our propaganda machine to tout them as the largest regulatory changes since the Great Depression, and then return to business as usual.
I find this narrative very unsettling and the complacent view it represents as likely to lead to another systemic crisis in short order. But the mindset is fixed. This is the reality of our policy making elite.
And it seems that I am not the only one who has come to this conclusion. Mark Thoma voiced similar views in a post earlier today. In a post entitled "Giving Up on Policymakers," Professor Thoma said:
I've been pushing hard for more help for labor markets for quite awhile... but it's probably time for me to give up and accept that we are going to have a slower recovery than we could have had with more aggressive fiscal policy...
The fiscal policy response to the crisis has been disappointing. Monetary policy loses its effectiveness in a recession. There are some things monetary policy can do...But when it comes to providing a big shock to aggregate demand sufficient to turn the economy around and propel it back toward full employment, monetary policy alone isn't enough. It's true that monetary policy can lower real interest rates -- even at the zero bound for the federal funds rate, it's still possible to use quantitative easing to nudge long-term interest rates downward -- the problem is that all this does is create an incentive for more investment and consumption (mainly of durables), there is nothing to guarantee that people will actually respond...
Because monetary policy loses effectiveness in a deep recession -- something I've been teaching for decades -- I was among the first to call for aggressive fiscal policy. Fiscal policy creates demand directly, it does not rely upon incentives and the hope that people will respond to them. When the crisis hit, we needed fiscal policy right away. Given the lags between changes in policy and actual effects on the economy, which were known to be lengthy, and given that monetary policy was not going to be enough, there was no time to "wait and see" (as many people I respect were calling for). But the reality is that fiscal policy didn't get put into place until much, much later, far too late to stop the worst of the downturn (and it wasn't big enough anyway). The way too slow policy process, and the way too small policy that came out of it, was frustrating to watch.
I think we'd be much better off today if we'd done what is necessary right away instead of hoping and hoping that things weren't going to be so bad, and that we could escape the need for an aggressive policy intervention. This crisis has taught me that policy of that magnitude is nearly impossible to put in place based upon what looks to be happening, i.e. before the recession actually occurs. There must be clear evidence that a severe recession is actually underway before policy will be considered. Unfortunately, by that time it's too late to prevent the worst part of the downturn.
Now that we are hitting the other side, I'm feeling frustrated again with the lack of action from policymakers. I expect the recovery to proceed at a snail's pace, labor markets in particular. If employment rebounds quickly, great, but that's not what I think is going to happen, and that's not what the evidence suggests. If the recovery is going to be slow, then it's not too late to provide more help. Instead of getting back to full employment by, say, 2013, we could get there sooner if we act now.
I agree with Professor Thoma. His comment near the end of his post was the one of greatest importance:
But, as I said at the beginning, even though it's not too late for more help to make a difference, it's not going to happen.
The question, then, is what is going to happen. I have made my arguments on this in the past. For example.
I expect the following to occur:
- Public pressure to withdraw monetary and fiscal stimulus will work and stimulus will be reduced quicker than many anticipate - beginning sometime in early 2010. The Fed has already said it will stop buying mortgages in March and the Obama Administration is now focused on deficit reduction as evidenced by the paltry jobs bill just passed.
- The fiscally weak state and local governments will therefore receive little aid from the federal government. This will result in budget cuts, tax increases, and layoffs by the end of Q2 2010.
- At the same time, the inventory cycle's impact on GDP growth will attenuate. By the second half of 2010, inventories will not add considerably to GDP.
- Meanwhile, the reduction of Fed support for the mortgage market will reveal weaknesses there. Mortgage rates may increase, decreasing housing demand.
- Employment will be weak in this environment, leading to another spate of defaults and foreclosures.
- The foreclosures and weak housing demand will pressure house prices and weaken lender balance sheets, especially because of second-lien exposure. This will in turn reduce credit growth.
I expect the weakness in GDP from this scenario to be evident sometime in the second half of 2010.
But what about other more bullish views out there? Why can't the economy be robust enough to withstand these problems? Aren't banks earning enough to reduce capital constraints to lending? Isn't consumption growth resuming? Why are munis the next shoe to drop? Couldn't it be that the rise in asset prices will buoy their revenue streams? These are all questions I ask myself (probably not publicly since "Is economic boom around the corner?" in Sep 2009). But I fail to see how in a world of the Greek sovereign debt crisis, the disputed Chinese asset bubble and a potential Sino-American trade war that these preconditions do not necessarily lead to economic weakness for the foreseeable future.
So rather than repeat these points ad nauseam, I am asking you the readers to debate this for me. What am I missing?