Interesting Times

BY ALAN S. BLINDER AND MARK ZANDI, Moody's Analytics, 6-30-10

The U.S. economy has made enormous progress since the dark days of early 2009. Eighteen months ago, the global financial system was on the brink of collapse and the U.S. was suffering its worst economic downturn since the 1930s. Real GDP was falling at about a 6% annual rate, and monthly job losses averaged close to 750,000. Today, the financial system is operating much more normally, real GDP is advancing at a nearly 3% pace, and job growth has resumed, albeit at an insufficient pace.

From the perspective of early 2009, this rapid snap back was a surprise. Maybe the country and the world were just lucky. But we take another view: The Great Recession gave way to recovery as quickly as it did largely because of the unprecedented responses by monetary and fiscal policymakers.

A stunning range of initiatives was undertaken by the Federal Reserve, the Bush and Obama administrations, and Congress. While the effectiveness of any individual element certainly can be debated, there is little doubt that in total, the policy response was highly effective. If policymakers had not reacted as aggressively or as quickly as they did, the financial system might still be unsettled, the economy might still be shrinking, and the costs to U.S. taxpayers would have been vastly greater.

Broadly speaking, the government set out to accomplish two goals: to stabilize the sickly financial system and to mitigate the burgeoning recession, ultimately restarting economic growth. The first task was made necessary by the financial crisis, which struck in the summer of 2007 and spiraled into a financial panic in the fall of 2008. After the Lehman Brothers bankruptcy, liquidity evaporated, credit spreads ballooned, stock prices fell sharply, and a string of major financial institutions failed. The second task was made necessary by the devastating effects of the financial crisis on the real economy, which began to contract at an alarming rate after Lehman.

The Federal Reserve took a number of extraordinary steps to quell the financial panic. In late 2007, it established the first of what would eventually become an alphabet soup of new credit facilities designed to provide liquidity to financial institutions and markets.  The Fed aggressively lowered interest rates during 2008, adopting a zero-interest-rate policy by year’s end. It engaged in massive quantitative easing in 2009 and early 2010, purchasing Treasury bonds and Fannie Mae and Freddie Mac mortgage-backed securities (MBS) to bring down long-term interest rates.

The FDIC also worked to stem the financial turmoil by increasing deposit insurance limits and guaranteeing bank debt. Congress established the Troubled Asset Relief Program (TARP) in October 2008, part of which was used by the Treasury to inject much-needed capital into the nation’s banks. The Treasury and Federal Reserve ordered the 19 largest bank holding companies to conduct comprehensive stress tests in the spring of 2009, to determine if they had sufficient capital to withstand further adverse circumstances—and to raise more capital if necessary. Once the results were made public, the stress tests and subsequent capital raising restored confidence in the banking system.

The effort to end the recession and jump-start the recovery was built around a series of fiscal stimulus measures. Tax rebate checks were mailed to lower- and middle-income households in the spring of 2008; the American Restoration and Recovery Act (ARRA) was passed in early 2009; and several smaller stimulus measures became law in late 2009 and early 2010.  In all, close to $1 trillion, roughly 7 percent of GDP, will be spent on fiscal stimulus. The stimulus has done what it was supposed to do: end the Great Recession and spur recovery. We do not believe it a coincidence that the turnaround from recession to recovery occurred last summer, just as the ARRA was providing its maximum economic benefit.

Stemming the slide also involved rescuing the nation’s housing and auto industries. The housing bubble and bust were the proximate causes of the financial crisis, setting off a vicious cycle of falling house prices and surging foreclosures. Policymakers appear to have broken this cycle with an array of efforts, including the Fed’s actions to bring down mortgage rates, an increase in conforming loan limits, a dramatic expansion of FHA lending, a series of tax credits for homebuyers, and the use of TARP funds to mitigate foreclosures. While the housing market remains troubled, its steepest declines are in the past.

The near collapse of the domestic auto industry in late 2008 also threatened to exacerbate the recession. GM and Chrysler eventually went through bankruptcies, but TARP funds were used to make the process relatively orderly. GM is already on its way to being a publicly traded company again. Without financial help from the federal government, all three domestic vehicle producers and many of their suppliers might have had to liquidate many operations, with devastating effects on the broader economy, and especially on the Midwest.

Although the economic pain was severe and the budgetary costs were great, this sounds like a success story.  Yet nearly all aspects of the government’s response have been subjected to intense criticism. The Federal Reserve has been accused of overstepping its mandate by conducting fiscal as well as monetary policy. Critics have attacked efforts to stem the decline in house prices as inappropriate; claimed that foreclosure mitigation efforts were ineffective; and argued that the auto bailout was both unnecessary and unfair. Particularly heavy criticism has been aimed at the TARP and the Recovery Act, both of which have become deeply unpopular.

The Troubled Asset Relief Program was controversial from its inception. Both the program’s $700 billion headline price tag and its goal of "bailing out" financial institutions—including some of the same institutions that triggered the panic in the first place—were hard for citizens and legislators to swallow. To this day, many believe the TARP was a costly failure. In fact, TARP has been a substantial success, helping to restore stability to the financial system and to end the freefall in housing and auto markets. Its ultimate cost to taxpayers will be a small fraction of the headline $700 billion figure: A number below $100 billion seems more likely to us, with the bank bailout component probably turning a profit.

Criticism of the ARRA has also been strident, focusing on the high price tag, the slow speed of delivery, and the fact that the unemployment rate rose much higher than the Administration predicted in January 2009.

While we would not defend every aspect of the stimulus, we believe this criticism is largely misplaced, for these reasons:

The unusually large size of the fiscal stimulus (equal to about 7% of GDP) is consistent with the extraordinarily severe downturn and the limited ability to use monetary policy once interest rates neared zero.

Regarding speed, almost $500 billion has been spent to date. What matters for economic growth is the pace of stimulus spending, which surged from nothing at the start of 2009 to over $100 billion (over $400 billion at an annual rate) in the second quarter. That is a big change in a short period, and it is one major reason why the Great Recession ended and recovery began last summer.

Critics who argue that the ARRA failed because it did not keep unemployment below 8% ignore the facts that (a) unemployment was already above 8% when the ARRA was passed and (b) most private forecasters (including Moody’s Analytics) misjudged how serious the downturn would be. If anything, this forecasting error suggests the stimulus package should have been even larger than it was.

This study attempts to quantify the contributions of the TARP, the stimulus, and other government initiatives to ending the financial panic and the Great Recession. In sum, we find they were highly effective. Without such a determined and aggressive response by policymakers, the economy would likely have fallen into a much deeper slump.

Quantifying the economic impact

To quantify the economic impacts of the fiscal stimulus and the financial-market policies such as the TARP and the Fed’s quantitative easing, we simulated the Moody’s Analytics’ model of the U.S. economy under four scenarios:

1. a baseline that includes all the policies actually pursued

2. a counterfactual scenario with the fiscal stimulus but without the financial policies

3. a counterfactual with the financial policies but without fiscal stimulus

4. a scenario that excludes all the policy responses.8

The differences between Scenario 1 and Scenario 4 provide the answers we seek about the impacts of the panoply of anti-recession policies. Scenarios 2 and 3 enable us to decompose the overall impact into the components stemming from the fiscal stimulus and financial initiatives. All simulations begin in the first quarter of 2008 with the start of the Great Recession, and end in the fourth quarter of 2012.

Estimating the economic impact of the policies is not an accounting exercise, but an econometric one. It is not feasible to identify and count each job created or saved by these policies. Rather, outcomes for employment and other activity must be estimated using a statistical representation of the economy based on historical relationships, such as the Moody’s Analytics model. This model is regularly used for forecasting, scenario analysis, and quantifying the impacts of a wide range of policies on the economy. The Congressional Budget Office and the Obama Administration have derived their impact estimates for policies such as the fiscal stimulus using a similar approach.

The modeling techniques for simulating the fiscal policies were straightforward, and have been used by countless modelers over the years. While the scale of the fiscal stimulus was massive, most of the instruments themselves (tax cuts, spending) were conventional, so not much innovation was required on our part.

But modeling the vast array of financial policies, most of which were unprecedented and unconventional, required some creativity, and forced us to make some major simplifying assumptions. Our basic approach was to treat the financial policies as ways to reduce credit spreads, particularly the three credit spreads that play key roles in the Moody’s Analytics model: The so-called TED spread between three-month Libor and three-month Treasury bills; the spread between fixed mortgage rates and 10-year Treasury bonds; and the "junk bond" (below investment grade) spread over Treasury bonds. All three of these spreads rose alarmingly during the crisis, but came tumbling down once the financial medicine was applied. The key question for us was how much of the decline in credit spreads to attribute to the policies, and here we tried several different assumptions.9 All of this is discussed in Appendix B.

The results

Under the baseline scenario, which includes all the financial and fiscal policies, and is the most likely outlook for the economy, the recovery that began a year ago is expected to remain intact. The economy struggles during the second half of this year, as the sources of growth that powered the first year of recovery—including the stimulus and a powerful inventory swing—begin to fade. Fallout from the European debt crisis also weighs on the U.S. economy. But by this time next year, the economy gains traction as businesses respond to better profitability and stronger balance sheets by investing and hiring more. In the baseline scenario, real GDP, which declined 2.4% in 2009, expands 2.9% in 2010 and 3.6% in 2011, with monthly job growth averaging near 100,000 in 2010 and above 200,000 in 2011. Unemployment is still close to 10% at the end of 2010, but closer to 9% by the end of 2011. The federal budget deficit is $1.4 trillion in the current 2010 fiscal year, equal to approximately 10% of GDP. It falls only slowly, to $1.15 trillion in FY 2011 and to $900 billion in FY 2012.

In the scenario that excludes all the extraordinary policies, the downturn continues into 2011. Real GDP falls a stunning 7.4% in 2009 and another 3.7% in 2010. The peak-to-trough decline in GDP is therefore close to 12%, compared to an actual decline of about 4%. By the time employment hits bottom, some 16.6 million jobs are lost in this scenario—about twice as many as actually were lost. The unemployment rate peaks at 16.5%, and although not determined in this analysis, it would not be surprising if the underemployment rate approached one-fourth of the labor force. The federal budget deficit surges to over $2 trillion in fiscal year 2010, $2.6 trillion in fiscal year 2011, and $2.25 trillion in FY 2012. Remember, this is with no policy response. With outright deflation in prices and wages in 2009-2011, this dark scenario constitutes a 1930s-like depression.

The differences between the baseline scenario and the scenario with no policy responses are summarized in Table 4. These differences represent our estimates of the combined effects of the full range of policies—and they are huge. By 2011, real GDP is $1.8 trillion (15%) higher because of the policies; there are almost 10 million more jobs, and the unemployment rate is about 6½ percentage points lower. The inflation rate is about 3 percentage points higher (roughly 2% instead of -1%). That’s what averting a depression means.

But how much of this gigantic effect was due to the government’s efforts to stabilize the financial system and how much was due to the fiscal stimulus? The other two scenarios are designed to answer those questions.

The financial policy responses were especially important. In the scenario without them, but including the fiscal stimulus, the recession would only now be winding down, a full year after the downturn’s actual end. Real GDP declines by 5% in 2009, and it grows only a bit in 2010, with a peak-to-trough decline of about 6% (see Table 5). Some 12 million payroll jobs are lost peak-to-trough in this scenario, and the unemployment rate peaks at 13%. There is also a lengthy period of modest deflation in this scenario. The federal deficit is $1.75 trillion in fiscal year 2010, and remains a disconcertingly high $1.5 trillion in fiscal year 2011 and $1.1 trillion in FY 2012.

The differences between the baseline and the scenario based on no financial policy responses are summarized in Table 6. They represent our estimates of the combined effects of the various policy efforts to stabilize the financial system—and they are very large. By 2011, real GDP is almost $800 billion (6%) higher because of the policies, and the unemployment rate is almost 3 percentage points lower. By the second quarter of 2011—when the difference between the baseline and this scenario is at its largest—the financial-rescue policies are credited with saving almost 5 million jobs.

In the scenario that includes all the financial policies but none of the fiscal stimulus, the recession ends in the fourth quarter of 2009 and expands very slowly through summer 2010. Real GDP declines almost 4% in 2009 and increases only 1% in 2010 (see Table 7). The peak-to-trough decline in employment is more than 10 million. The economy finally gains some traction by early 2011, but by then unemployment is peaking at nearly 12%. The federal budget deficit reaches $1.6 trillion in fiscal year 2010, $1.3 trillion in FY 2011, and $1 trillion in FY 2012. These results are broadly consistent with those of the Congressional Budget Office in its analysis of the economic impact of the ARRA.10

The differences between the baseline and the scenario based on no fiscal stimulus are summarized in Table 8. These differences represent our estimates of the sizable effects of all the fiscal stimulus efforts. Because of the fiscal stimulus, real GDP is about $460 billion (more than 6%) higher by 2010, when the impacts are at their maximum; there are 2.7 million more jobs; and the unemployment rate is almost 1.5 percentage points lower.

Notice that the combined effects of the financial and fiscal policies (Table 4) exceed the sum of the financial-policy effects (Table 6) and the fiscal-policy effects (Table 8) in isolation. This is because the policies tend to reinforce each other. To illustrate this dynamic, consider the impact of providing housing tax credits, which were part of the stimulus. The credits boost housing demand. House prices are thus higher, foreclosures decrease, and the financial system suffers smaller losses. These smaller losses, in turn, enhance the effectiveness of the financial-market policy efforts. Such positive interactions between financial and fiscal policies play out in numerous other ways as well.

Conclusions

The financial panic and Great Recession were massive blows to the U.S. economy. Employment is still some 8 million below where it was at its pre-recession peak, and the unemployment rate remains above 9%. The hit to the nation’s fiscal health has been equally disconcerting, with budget deficits in fiscal years 2009 and 2010 of close to $1.4 trillion.

These unprecedented deficits reflect both the recession itself and the costs of the government’s multi-faceted response to it. The total direct costs, including the TARP, the fiscal stimulus, and other efforts, such as addressing the mortgage-related losses at Fannie Mae and Freddie Mac, are expected to reach almost $1.6 trillion. Adding in nearly $750 billion in lost revenue from the weaker economy, the total budgetary cost of the crisis is projected to top $2.35 trillion, about 16% of GDP. For historical comparison, the savings-and-loan crisis of the early 1990s cost some $350 billion in today’s dollars: $275 billion in direct costs plus $75 billion due to the associated recession. This sum was equal to almost 6% of GDP at that time.

It is understandable that the still-fragile economy and the massive budget deficits have fueled criticism of the government’s response. No one can know for sure what the world would look like today if policymakers had not acted as they did—our estimates are just that, estimates. It is also not difficult to find fault with isolated aspects of the policy response. Were the bank and auto industry bailouts really necessary? Do extra UI benefits encourage the unemployed not to seek work? Should not bloated state and local governments be forced to cut wasteful budgets? Was the housing tax credit a giveaway to buyers who would have bought homes anyway? Are the foreclosure mitigation efforts the best that could have been done? The questions go on and on.

While all of these questions deserve careful consideration, it is clear that laissez faire was not an option; policymakers had to act. Not responding would have left both the economy and the government’s fiscal situation in far graver condition. We conclude that Ben Bernanke was probably right when he said that "We came very close in October [2008] to Depression 2.0."

While the TARP has not been a universal success, it has been instrumental in stabilizing the financial system and ending the recession. The Capital Purchase Program gave many financial institutions a lifeline when there was no other. Without the CPP’s equity infusions, the entire system might have come to a grinding halt. TARP also helped shore up asset prices, and protected the system by backstopping Fed and Treasury efforts to keep large financial institutions functioning. TARP money was also vital to ensuring an orderly restructuring of the auto industry at a time when its unraveling would have been a serious economic blow. TARP funds were not used as effectively in mitigating foreclosures, but policymakers should not stop trying.

The fiscal stimulus also fell short in some respects, but without it the economy might still be in recession. Increased unemployment insurance benefits and other transfer payments and tax cuts put cash into households’ pockets that they have largely spent, supporting output and employment. Without help from the federal government, state and local governments would have slashed payrolls and programs and raised taxes at just the wrong time. (Even with the stimulus, state and local governments have been cutting and will cut more.) Infrastructure spending is now kicking into high gear and will be a significant source of jobs through at least this time next year. And business tax cuts have contributed to increased investment and hiring.

When all is said and done, the financial and fiscal policies will have cost taxpayers a substantial sum, but not nearly as much as most had feared and not nearly as much as if policymakers had not acted at all. If the comprehensive policy responses saved the economy from another depression, as we estimate, they were well worth their cost.

 

Posted by John Bremner on August 1st, 2010 8:17 AMPost a Comment (0)

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