Thursday, October 13, 2011

The desirability of an expansionary credit-driven recovery?

Even as the debate rages about how best to achieve recovery, there is the issue of what should constitute recovery. Though there cannot be much argument about the need to bring down unemployment rates to the pre-recession lows, the need to restore the other macroeconomic parameters (notably those related to financial sector and household consumption) to its pre-recession peak is questionable.

Roger Farmer, an ardent advocate of the superiority of quantitative easing over fiscal expansion and a strong believer of the self-fulfilling effect of market confidence, writes,

"Housing wealth in the US has fallen by 34% since its peak in 2006, and is still declining. The stock market fell by almost 50% from its 2007 peak and remains down by nearly a third. This enormous loss of wealth caused a large and persistent drop in consumption demand, which has led to an increase in unemployment... A quantitative-easing policy in which a central bank buys risky assets can prevent price fluctuations and restore the value of financial wealth...

My work provides a new and coherent approach to macroeconomics that explains how a lack of confidence can lead to persistent unemployment. It supports the purchase of equities by central banks to reduce asset-price volatility, restore the value of wealth, and prevent a future market crash...

The Great Recession did not turn into Great Depression II because of coordinated action by governments around the world. Although fiscal expansion may have played a role in this success, central bank intervention was the most important component by far. Quantitative easing works by increasing the value of wealth."


The underlying assumption behind Prof Farmer's hypothesis is that normalcy can be achieved only with a restoration of the pre-crisis financial asset values. The same assumption drives the logic of those advocating expansionary policies - somehow consumers will start to buy, businesses will invest, and banks will lend, thereby restoring normalcy in economic growth, and this in turn requires adequate time so that market confidence will revive and asset values will regain their old highs.

The logic behind monetary accommodation is to buy some time so that the forces of economic growth can be catalyzed into action. It is hoped that if market expectations can be shaped, it could pave the way for growth - investments, jobs, and consumption - which in turn would restore asset values to the pre-recession era standard.

Expansionary policies, especially on the monetary side - like maintaining ultra-low interest rates for an extended period of time - have the potential to generate and amplify existing distortions. One manifestation of this is the deepening divide between the bigger firms and the small and medium businesses in the US. While the former have continued to access credit at ultra-low interest rates and pile on record profits, the later have been badly squeezed in the credit markets. Risk averse banks have been wary of lending to these companies, who are the predominaty actors in creating jobs in the US economy. The result

Another example is the phenomenon of the existing TBTF institutions getting even bigger and more riskier riding on the back of the favorable policy regime. In fact, as Nassim Nicholas Taleb and Mark Spitznagel have argued persuasively in a recent article, the US Treasury and the Fed, as part of TARP and the numerous other unconventional monetary policies, have transferred an astonishing $2.2 trillion to the major American banks and this figure is estimated to reach $5 trillion by end of the decade. They write about how banks, despite their recklessness, were bailed out by the US government.

"Banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.

Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers – and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankers’ compensation last year was back at its pre-crisis level."


Banks benefitted immensely from the prolonged period of access to ultra-low interest rates, blanket credit guarantees, collateral standards dilution, and massive capital injections. At the height of the crisis, the Fed backstopped bank losses by becoming the lender, insurer and even purchaser (buying up illiquid and risk-filled mortgage backed securities to prevent values plummeting) for the entire financial system.

As the crisis expanded and the strains started showing on some of the largest financial institutions, it became increasingly evident that their failure would have catastrophic consequences on the economy. So the momentum gathered to provide all possible liquidity support and even direct bailouts, if need be, so as to contain the spread of systemic risks. The underlying premise was that it was mainly a liquidity crisis (and not a solvency one), and if the banks were given enough time, market confidence would be restored, asset values would recover, and balance sheets will be repaired.

It can be safely argued that this strategy worked, and the balance sheets of the biggest banks have recovered considerably from the depths of 2008-09. However, unfortunately, this relatively quick recovery has blanked out all institutional memory of the lessons from the sub-prime crisis. Apart from some cosmetic changes, financial markets continue merrily with limited regulation.

The same old unhealthy practices, ones that led to the build-up of systemic risks in the first place, are back along with the driving force behind these trends - distorted incentives of traders, executives and managers. Executive compensation is back to the halcyon days of the pre-crisis era. The big financial institutions have gotten bigger and enjoy the benefits of a market place where even as their smaller competitors are credit constrained, they themselves have access to capital at utlra-low rates for an extended period of time. It clearly appears as though nothing has changed, and the cycle looks set to repeat, with the markets in wait for the next bubble to inflate.

In a recent post about the Eurozone crisis, Tyler Cowen had written that though the Eurozone governments had on paper a balanced budget, their commitment to a single currency was a massive naked put, relative to their GDP, which was not internalized into the national budgets. Similarly, the growing sizes of the TBTF institutions and the resultant concentration of risks, is a very large naked put by the US government in favor of its TBTF institutions, one which is unfortunately not reflected in the US government's fiscal balance. Only when disaster strikes and the bailout checks have to be signed, the true magnitude of the fiscal commitment becomes obvious.

Finally, there is the impact of the extraordinary monetary accommodation in the US on the world economy, especially the emerging economies. The massive stocks of easy money sloshing around poses great threats to financial market stability. For a start, it can trigger off destabilising capital inflows into emerging economies and undesirable sharp currency appreciation. However, these flows can quickly reverse, leaving currencies and equity markets battered.

The aftermath of the sub-prime mortgage crisis presented a great opportunity for regulators to clamp down on the several unhealthy business practices in financial markets that were primarily responsible for the mess. However, that window of opportunity is almost gone. And more worryingly, the market conditions that has emerged in the aftermath of the crisis may be perpetuating or even amplifying many of the worst offending excesses.

We appear to have been left with the worst of all worlds. The regulators have failed to seize the opportunity. The market conditions in the aftermath of the crisis works towards making the big institutions even bigger. And amidst all this, the credit markets remain seized up and the economy continues to show no signs of any recovery.

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