Federal Reserve documents 34 page

might soon spur a palpable improvement on Main Street. Unfortunately, it was not to be. Financial turmoil erupted again, this time in Europe, and with a virulence that threatened the U.S. economy and other economies around the globe.

The panic of 2007–2009 had hit Western Europe hard. Following the Lehman shock, many European countries experienced output declines and job losses similar to those in the United States. Many Europeans, especially politicians, had blamed Anglo-American “cowboy capitalism” for their predicament. (At international meetings, Tim and I never denied the United States’ responsibility for the original crisis, although the European banks that eagerly bought securitized subprime loans were hardly blameless.) This new European crisis, however, was almost entirely homegrown. Fundamentally, it arose because of a mismatch in European monetary and fiscal arrangements. Sixteen countries, in 2010, shared a common currency, the euro, but each—within ill-enforced limits—pursued separate tax and spending policies.

The adoption of the euro was a grand experiment, part of a broader move, started in the 1950s, toward greater economic integration. By drawing member states closer economically, Europe’s leaders hoped not only to promote growth but also to increase political unity, which they saw as a necessary antidote to a long history of intra-European warfare, including two catastrophic world wars. Perhaps, they hoped, Germans, Italians, and Portuguese would someday think of themselves as citizens of Europe first and citizens of their home country second.

Starting in 1999, eleven of the twenty-eight European Union countries, including Germany, France, Spain, and Italy, agreed to replace their marks, francs, pesetas, and lire with the euro, which would be managed by a single central bank, the European Central Bank. Existing national central banks would become part of a eurozone system, assuming roles roughly analogous to those played by Reserve Banks within the Federal Reserve System. With a single currency, doing business across national borders would become easier. For countries like Italy or Greece, with histories of inflation and currency devaluation, the new common currency had the additional benefit of conferring instant anti-inflation credibility—so long as the ECB was perceived by market participants to be sufficiently tough on inflation.

Every effort was made to ensure that it would be. Europe’s newly created central bank was given a single mandate, to maintain price stability—in contrast to the Fed’s dual mandate to foster job creation as well as low inflation. The ECB’s headquarters were located in Frankfurt, the financial capital of Germany and the home of its national central bank, the Bundesbank. The symbolism was not subtle. The ECB was expected to adopt the “hard money” anti-inflation stance of the Bundesbank, not the more dovish approach that had characterized central banks in southern Europe. Before they could join the common currency, countries were required to achieve sufficiently low levels of government deficits and debt (as specified in an agreement known as the Stability and Growth Pact) as well as achieve modest inflation.

On the whole, the introduction of the euro was remarkably smooth. It quickly gained global acceptance second only to the dollar. More countries joined the original eleven. Europeans hoped that

their new currency—in combination with the harmonization of regulations and the removal of restrictions on the movement of people, goods, and financial capital across European borders—would convey some of the same economic advantages enjoyed by the United States, with its single currency and open borders between states.

The eurozone, however, differs from the United States in one crucial respect. In the United States, the federal government tries to manage fiscal policy in the interests of the country as a whole, and the U.S. national debt is guaranteed by the country as a whole. In the eurozone, fiscal policy is set by the parliaments of each country. There is no supranational authority, analogous to the ECB, for tax and spending policies. This lack of fiscal integration and coordination, together with marked differences across Europe in labor market and other economic policies, ultimately spawned enormous problems.

The trigger of the European crisis had occurred in October 2009 but at the time drew little notice in the United States. Shortly after taking office, the new prime minister of Greece, George Papandreou, the son of a former prime minister and economics professor at Harvard and other universities, announced that the Greek budget deficit was far higher than the government had previously reported. The corrected figure showed the deficit to be close to 13 percent of a year’s output, compared with the ceiling of 3 percent specified by the Stability and Growth Pact. Papandreou’s shocking announcement struck at a core assumption of the pact—that member countries were able to monitor each other’s budgets effectively. It also raised the question of why investors were willing to lend so much to the Greek government, at very low interest rates, in the first place.

Greece’s easy access to international capital markets reflected the euro’s success. By adopting the common currency in 2001, Greece had effectively turned its monetary policy over to the ECB. It borrowed in euros rather than in drachmas. No longer could it reduce the value of its debt through inflation or currency devaluation. Investors presumed Greece would abide by, or at least hew close to, the limits on government deficits and debt specified in the Stability and Growth Pact. Finally, even though the treaty that led to the creation of the euro forbade bailouts of governments, lenders came to believe that the eurozone countries would collectively aid a member rather than permit a default that could disrupt financial markets and jeopardize investor confidence in other borrowing countries. That was moral hazard at the country level, reminiscent of the implicit guarantee of Fannie Mae and Freddie Mac by the U.S. government. For these reasons, Greece had been able to borrow at interest rates very close to what Germany, the most creditworthy country, had to pay. But, as the world learned in October 2009, Greece had borrowed far beyond its means, all the while doctoring the statistics to obscure that fact. It soon became clear that, without outside help, Greece would default.

The eurozone grappled with how to respond, if at all. Superficially, allowing Greece to default made some sense. A small country on the periphery of Europe, it accounted for only a tiny share of eurozone trade and investment. Default would encourage investors to be more careful in the future, reducing moral hazard. And declining to intervene would avoid a voter backlash in countries that would be expected to

finance any rescue, like Germany.

On the other hand, much as Lehman’s failure had shaken the entire financial system, a Greek default could have far-reaching implications for Europe and the world. Although Greece was Europe’s most profligate borrower, it was not the only country that had amassed substantial public and private debts. Private capital had poured into Spain before the crisis, financing a construction boom that had since busted. Ireland’s promise in 2008 to protect its banks’ creditors had resulted in massive government deficits when it had to bail out its large banks. Portugal’s relatively weak economy had in turn weakened its fiscal position. And Italy’s government debts were the highest in Europe. If Greece defaulted, investors might conclude that other overindebted eurozone countries were next. The interest rates those countries would have to pay might jump, triggering a cascade of debt crises.

The potential effects of a Greek default on the European banking system were also a concern. Many European banks had been severely weakened by the earlier crisis and remained short of capital. That posed a particularly serious threat to the eurozone economy because bank lending makes up a much larger share of overall credit in Europe than in the United States. Most European banks outside of Greece did not hold large quantities of Greek government debt (French banks were probably the most exposed), but they held substantial amounts of the debt, both public and private, of other vulnerable eurozone countries. If defaults spread beyond Greece, the stability of Europe’s entire banking system could be at risk.

Finally, policymakers had to weigh what might happen if Greece, after a default, also abandoned the euro and returned to its own currency. One reason to do so would be to regain monetary policy independence, which might help the Greek government respond to the economic crash that was likely to follow a default. But if Greece left the euro, fears that other countries might follow would no doubt increase. Even the possibility that the eurozone might break apart would inflict damage. For example, bank depositors in a country thought to be at risk of leaving the euro would worry that their euro-denominated deposits might be forcibly converted to the new, and presumably less valuable, national currency. To avoid that risk, depositors might withdraw their euros from their own country’s banks in favor of, say, German banks (which, in an era of cross-border branching, might simply mean walking a block down the street or clicking on a bank’s website). These withdrawals could quickly degenerate into a full-fledged run on the suspect country’s banks.

For these reasons, finance ministers and especially central bank governors in Europe generally, if grudgingly, concluded that they would have to assist Greece. ECB president Jean-Claude Trichet, who had decried the Lehman failure, was particularly adamant on this point and sought to persuade other European policymakers. Recognizing that financial instability would not be confined to Europe, Tim and I —in meetings, conference calls, and one-to-one conversations—pushed our European counterparts to address their problems as fast and as definitively as possible. The International Monetary Fund and countries outside Europe, also worried about possible spillover effects, likewise pushed for rapid resolution of the crisis.

As European leaders debated what to do, the consequences of not having a single fiscal authority for the eurozone became apparent. Discussions about sharing the burden of providing aid moved ponderously and revealed substantial disagreements. It took almost four months from Papandreou’s disclosure of Greece’s debts for the eurozone governments to promise help for Greece, and even then with few details. After more back-and-forth, Prime Minister Papandreou asked the eurozone countries for a bailout on April 23, 2010. By this time, reflecting rising default fears, yields on Greek ten-year bonds were about 6 percentage points higher than yields on comparable German bonds, up from 1 percentage point the previous October. On Sunday, May 2, European leaders announced a rescue package of 110 billion euros, about $145 billion. Two-thirds of the package would come from loans from individual European countries and one-third from the International Monetary Fund, fulfilling its role as lender to countries in danger of default.

However, markets saw the European effort as vague and insufficiently ambitious. The May 2 announcement did little to improve borrowing terms for Portugal and Ireland, whose bond yields were also rising, although not so far as Greek yields. In the United States, the Dow Jones industrial average rose on Monday, the day after the announcement, but then fell 7 percent over the rest of the week. And the people of Greece—the supposed beneficiaries of the agreement—saw the proposed rescue terms, including steep cuts in public spending, as unfair. Rioters spilled into Athens’ streets, and, on May 5, three people died when a Greek bank was firebombed.

As the Dow’s response to the announcement of the Greek package suggested, the United States was hardly isolated from Europe’s financial woes. Volatility in U.S. stock markets in May 2010 was the highest since the period after Lehman, reflecting a global surge in fear and risk aversion. To assess the risk of financial contagion reaching the United States, Nellie Liang’s group, together with the Fed’s bank supervisors, worked long hours trying to assess U.S. exposures. The good news was that U.S. banks held relatively little European government debt, including Greek debt. On the other hand, many of them had extensive exposure to the major European banks and to the European economy more broadly—through loans to European businesses, for example. And U.S. money market funds had provided considerable funding to European banks, mainly for the banks’ lending in the United States.

After the negative response to the May 2 announcement, European policymakers tried again. On May 7, they announced tougher enforcement of the curbs on government deficits and debt for all eurozone countries, together with a commitment to tighten their fiscal belts. On Sunday, May 9, they announced the creation of the European Financial Stability Facility and a related agency, with authority to borrow up to 500 billion euros on international capital markets. The funds, which were in addition to the 110 billion euros committed to Greece, could be used to help any eurozone country. In addition, the ECB made clear its readiness to buy government bonds of troubled countries, through its newly created Securities Market Program. The objective was to reduce interest rates on the bonds. The ECB would make modest purchases of bonds over the next several months before putting the program on hold. The program was not

a form of quantitative easing, however, as the ECB would match its purchases of sovereign bonds with sales of other assets, leaving the overall size of its balance sheet unchanged.

On May 9, at the request of Jean-Claude Trichet, I called a videoconference of the FOMC to discuss renewing some of the currency swap lines we had closed three months earlier. I had also received concerned calls from Mervyn King and Masaaki Shirakawa. It was a delicate moment for the Fed. The Senate was preparing to vote on the Dodd-Frank Act. I worried that senators would see the renewal of the swaps as a bailout of foreign banks, despite the fact that the swaps involved no credit risk and would help prevent European financial turmoil from crossing the Atlantic. The potential legislative consequences aside, it seemed to me that the health of the U.S. economy was linked to what happened in Europe. Moreover, with its Securities Market Program, the ECB was taking some politically daring steps of its own. I also continued to believe that central bank cooperation could have benefits for confidence over and above the direct effects of our collective actions. Consequently, I pushed for, and the FOMC approved, the resumption of the swaps with the ECB, the Bank of England, the Swiss National Bank, and the Bank of Canada. To avert possible political fallout as best I could, I met with legislators, including at a private briefing of the Senate Banking Committee on May 11. To my relief, most of the attending senators seemed to appreciate that promoting global financial stability was in the interest of the United States.

Markets responded more positively than they had the previous week to the latest European actions, as well as to the news of the swap lines. Yields on Greek, Portuguese, and Irish government debt dropped sharply on Monday, and the Dow jumped nearly 400 points, about 4 percent, a sign that investors saw the threat to the U.S. economy as diminished. Still, over time, optimism about resolving Europe’s problems faded. Investors worried that Greece would not be able to service its debt even with the aid package. Portugal’s and Ireland’s fiscal positions looked less and less healthy. Eventually, concerns about Italy and Spain, both much larger economies, arose as well. No one was sure whether Europe’s resources and political will were sufficient to solve all these problems, or whether banks and other lenders would be forced to share in losses. Thus, after a brief respite, yields on the bonds of countries seen as at risk resumed their upward trek. The Dow again declined; U.S. stocks would fall 13 percent from the day that the Greek prime minister asked for aid in April until early July. European bank regulators conducted a stress test of the continent’s banks in July. But, unlike the U.S. stress tests of the previous year, investors did not see the results as credible, and Europe’s banks remained wary of lending, including to each other.

The crisis would still be rolling when, at an ECB conference in Frankfurt on November 19, I met with Jean-Claude Trichet. The center of financial turmoil had shifted from the United States to Europe. “Now, Jean-Claude, it is your turn,” I told him. He laughed wryly. Nine days later, the IMF and the European Union, drawing on the facility it had established, agreed to an 85-billion-euro rescue of Ireland.

WHEN THE FEDERAL Open Market Committee had gathered for its April 27–28, 2010, meeting, just four

days after Prime Minister Papandreou asked the rest of Europe for aid, I and most of my colleagues expressed guarded optimism about prospects for the U.S. economy. We discussed risks that European developments might pose to the United States, but to date those risks had not materialized. Unemployment remained very high—at 9.7 percent from January through March. But we hoped and expected that economic growth would continue to strengthen. We thought that nascent improvements in household spending and business capital investment should offset the ebbing effects of the Obama administration’s 2009 fiscal stimulus—enough to bring unemployment down modestly by the end of the year. Inflation remained low—perhaps a bit too low—but we expected it to rise gradually.

Unfortunately, our projections increasingly looked too rosy as spring turned to summer. By the time of the next FOMC meeting, on June 22–23, the outlook was somewhat weaker than in April. Nevertheless, as planned, we continued to discuss ways to gradually shrink our swollen balance sheet at the appropriate time. A few of the inflation hawks argued for beginning to sell securities fairly soon, but most Committee members wanted to wait until the economic recovery was well and obviously under way. That was my position, too. Given the deterioration in the outlook, however, I thought we might be thinking too narrowly. It was fine to talk about our eventual exit from easy money, but we needed also to consider what we would do if the economy required more support.

A week after the meeting, Bill Dudley warned about an issue that, until then, had not given us much pause. When we ended QE1 at the end of March, we decided we would not replace our Fannie- and Freddie-guaranteed mortgage-backed securities as they matured. Our MBS holdings shrank when the mortgages underlying the securities were paid off—because of home sales or refinancings. Over time, the slow runoff would result in passive monetary tightening as our balance sheet declined. It seemed a minor concern. But Bill warned that a recent drop in mortgage rates, which had fallen from about 5 percent to 4.5 percent over the past two months, might well spark a mortgage refinancing wave that could lead to a more rapid runoff in our MBS and a significant, if unintended, tightening of monetary policy.

By the time of our August 10 meeting, the economy was clearly losing momentum. Unemployment had remained flat at 9.5 percent into the summer, and inflation was running around 1 percent, not in immediate danger of lapsing into deflation, but too low for comfort. As I had early in 2008, I warned that the economy likely could not sustain very low growth for long. If growth did not pick up enough to boost consumer and business confidence, the economy might tumble into a new recession. To me, with more fiscal help unlikely, it seemed clear that the economy needed more support from monetary policy.

Bill English, the new director of the Monetary Affairs Division, outlined the policy options for the Committee. Bill, like me, was a graduate of MIT and a student of Stan Fischer. A month earlier he had succeeded Brian Madigan, who retired after a thirty-year career at the Fed. I recommended, and the Committee accepted, the relatively modest step of halting the passive tightening that resulted from not replacing maturing MBS in our portfolio. To keep the size of the balance sheet constant, we agreed to begin purchasing additional longer-term Treasury securities as the MBS ran off. We were already

replacing our Treasury securities when they matured. We decided to replace the MBS with Treasuries as well to accommodate Jeff Lacker and several other Committee members who advocated moving toward a portfolio consisting only of Treasuries, as had been the norm before the crisis. Though it would not generate many headlines, our decision to replace maturing MBS let markets know we were concerned about the economic outlook and hinted at our willingness to do more if it continued to slide. Tom Hoenig, who had been dissenting throughout the year, dissented again. He didn’t think the economy needed more help from monetary policy, and he continued to worry that easy policy would increase risks to financial stability.

Our August 10 move was only a holding action. I knew that we needed to be ready to ease policy further and, importantly, that we needed to prepare the markets, the public, and the politicians for that possibility. I could do that on August 27 at the upcoming Jackson Hole conference. I decided to scrap my planned topic—the implementation of the Dodd-Frank Act—and instead talk about the economic outlook and our monetary policy options. I spent the weekend of August 14–15 working on the speech. In the absence of a decision by the FOMC, I could not make definitive promises. But just by discussing the possibilities at length I would send a signal that we were prepared to act.

Two weeks later, I stood at the podium in Jackson Lake Lodge. I made it clear that we still had tools available to support the economy. I said that we were determined to keep the recovery going and resist any descent toward deflation. I discussed further use of two policy options we had already employed— securities purchases and communication aimed at convincing markets that we would keep short-term interest rates low for a long time. Both options were meant to help spur economic growth and job creation by putting downward pressure on long-term interest rates. I added, though, that the benefits of further unorthodox policy steps should be weighed against their potential costs and risks.

We bided our time at the next meeting, on September 21, but with concerns about the sustainability of the recovery mounting, we made clear that action was close. We said that we were “prepared to provide additional accommodation if needed” to support the recovery and nudge inflation up to a more acceptable level.

THE SEPTEMBER MEETING was the first in many years without Don Kohn. Don, who was approaching his sixty-eighth birthday, had wanted to retire in the spring, at the end of his four-year term as vice chairman and after forty years in the Federal Reserve System. With at least two of the five Board seats vacant (except for one month) since Sue Bies’s departure in March 2007, I had persuaded Don to stay on for one meeting more and then another, until I could persuade him no longer. For me personally and for the entire Fed, Don’s retirement was a great loss. He is an outstanding economist and a wise policymaker, admired and trusted by colleagues throughout the Federal Reserve System and at central banks around the world. He knew the Fed and its history better than anyone. And throughout the crisis he provided steadfast moral support, leavened with dry, self-deprecating humor.

Without Don, the Board had only four governors. As had become routine, the Senate was again holding up nominees to fill the empty seats. President Obama had nominated Maryland’s chief financial regulator, Sarah Bloom Raskin; MIT professor Peter Diamond; and Janet Yellen to the Board on April 29, but the summer had passed without action.

I had known Peter and Janet for decades (Peter had been on the MIT faculty when I was a graduate student), and I strongly supported their nominations when Tim Geithner ran the names by me. I didn’t know Sarah, but she came well recommended. A lawyer, she had previously served as counsel to the Senate Banking Committee. We were always looking for people who could bring knowledge of community banking to the Board, and Sarah ably filled the bill.

Janet Yellen had been nominated to fill the vice chair position being vacated by Don. Like me, she was an academic economist. She received her doctorate from Yale, where her thesis supervisor had been James Tobin, a leading Keynesian and Nobel Prize winner. Janet’s Keynesian proclivities were clear in her research, which often focused on problems related to unemployment and wages. After graduate school and some time as an assistant professor at Harvard, she had taken a job at the Fed in Washington. There, in the cafeteria, she met George Akerlof, a shy and soft-spoken economist known for his creative research. Janet and George would become not only husband and wife but also coauthors and, for many years, colleagues on the faculty of the University of California at Berkeley. George would win the Nobel Prize for his work on how incomplete information on the part of buyers or sellers affects the functioning of markets.

Janet also had substantial policy experience. As I had, she served for two and a half years on the Fed’s Board of Governors under Chairman Greenspan and as chair of the Council of Economic Advisers, in her case for President Clinton. In addition, she had served as the president of the San Francisco Reserve Bank since 2004. At the time, she was a leader of the FOMC doves, a role that reflected her longstanding concerns about high unemployment and the hardships it imposed on individuals, families, and communities. More than many on the Committee, she had recognized that the recession touched off by the crisis had the potential to be very deep and required a strong response. That said, based on knowing her and on her record on the Board in the 1990s when inflation was a concern, I also had little doubt that she would tenaciously defend price stability when necessary. She prepared for meetings meticulously and backed her positions with careful analyses and with frequent references to the research literature or to work done by her staff under her direction. Her contributions were always among the most substantive at the meeting. The room hushed when she spoke.

The Senate ultimately confirmed Sarah and Janet, with little opposition. I swore them in on October 4. Peter Diamond’s nomination did not go well, despite his distinguished academic record. Peter had done important research in economic theory and in fiscal policy, Social Security, and labor markets. MIT had named him an Institute Professor—the highest rank on the faculty—and he was a past president of the American Economic Association. But Republicans on the Senate Banking Committee, led by Richard

Shelby, viewed him as too liberal. They blocked his nomination and the Senate returned it to the White House in August 2010.

At this point most people would have given up, but Peter asked the president to renominate him. Shortly thereafter, we learned that Peter would share in a Nobel Prize for his work on labor markets. Shelby, who based his opposition in part on Peter’s supposed lack of qualifications for the job, was implacable. “Unquestionably, the Nobel is a major honor. Yet being a Nobel recipient does not mean one is qualified for every conceivable position,” he said. Meanwhile, prominent anti-tax-increase activist Grover Norquist’s conservative Club for Growth announced that opposition to Diamond would be a key vote for their 2011 legislative scorecard, implying that yes voters risked being branded as insufficiently conservative. Peter would never be confirmed. In June 2011, he would withdraw his name, denouncing in a New York Times op-ed the “partisan polarization” in Washington. It was a real loss for the Fed and the country. The episode also showed that conservative animosity toward the Fed had not ended with the passage of the Dodd-Frank Act.

In March 2011, Janet would be succeeded as president in San Francisco by her research director, John Williams, a distinguished monetary economist whose research with Board economist David Reifschneider (one of the “nine schmucks”) and others had helped us think about the monetary policy implications of the zero lower bound on interest rates. John would prove to be a centrist on the FOMC, and I would often use him as a barometer of Committee sentiment.

Date: 2016-04-22; view: 637