Federal Reserve documents 36 page

recession’s official end two years earlier. Moreover, extensive revisions of previous years’ data would show that the recession had been deeper and the recovery slower than we had thought. As of mid-2011, the country’s output of goods and services had only just reached its pre-recession peak, and employment was more than six and a half million jobs below its peak. Economists are criticized for not being able to predict the future, but, because the data are incomplete and subject to revision, we cannot even be sure what happened in the recent past. Noisy data make effective policymaking all the more difficult.

We endlessly debated the economy’s apparent inability to reach escape velocity—to reach the point where growth was self-sustaining. Unforeseen shocks like the Japanese earthquake and tsunami were insufficient explanation. I came to think of the other, more significant, barriers to growth as headwinds— factors that we had expected to slow the recovery but which were proving more substantial and more persistent than we had thought.

One headwind was the lingering effects of the financial crisis. Although U.S. financial markets and institutions had largely stabilized, credit was still tight. Only applicants with the best credit scores were getting loans. Tight credit meant the creation of fewer new businesses and fewer expansions of existing businesses—and thus fewer new jobs. Even households and firms that could borrow were declining to do so. Instead, they spent cautiously and focused on paying down debt. The situation, unfortunately, was confirming the financial accelerator theory that Mark Gertler and I had developed during my academic days. Our research suggested that recessions worsen the financial conditions of both borrowers and lenders, which restricts the flow of credit, which makes the downturn deeper and more protracted. As I told Mark, I would have preferred to see our theory disproven.

Tight credit contributed to another persistent headwind: the slow housing recovery. Normally, a rapid rebound in home construction and related industries such as realty and home improvement helps fuel growth after a recession. Not this time. Builders would start construction on only about 600,000 private homes in 2011, compared with more than 2 million in 2005. To some extent, that drop represented the flip side of the pre-crisis boom. Too many houses had been built, and now the excess supply was being worked off. Additionally, mortgage lending terms, too easy before the crisis, had swung to the opposite extreme. Potential borrowers, including many would-be first-time buyers, were being turned away. Other drags on home lending and construction included high numbers of foreclosures and distress sales, which held down home prices, and regulatory uncertainty—about the future of Fannie and Freddie, for instance.

Fiscal policy—at state, local, and federal levels—was also blowing the wrong way. After enacting President Obama’s stimulus package in February 2009, Congress had shifted into austerity mode, echoing the trend in Europe. Meanwhile, balanced-budget requirements had forced state and local governments to cut jobs and construction as their tax revenues fell. This headwind was no soft breeze. Government employment usually rises during economic recovery, but this time public-sector jobs (excluding census workers) would fall by more than 750,000 from their peak before turning up. (More than 300,000 of those who lost jobs were teachers.) Fed staff had estimated that QE2 might create an additional 700,000 jobs.

Tight fiscal policies were arguably offsetting much of the effect of our monetary efforts.

Speaking publicly about the fiscal headwind was a particular challenge. Government spending and taxation are outside the Fed’s jurisdiction. On the other hand, fiscal policies were holding back the recovery and job creation and thus challenging our ability to meet our employment mandate. After long discussions with the Board staff, I decided on a two-pronged public approach. First, I would emphasize that the Fed, especially with short-term interest rates close to zero, couldn’t do it alone. The economy needed help from Congress—if not from additional spending (on roads and bridges, for example), then at least in areas such as retraining unemployed workers. Second, I would point out that the federal deficit, while a serious matter, was primarily a longer-run concern, reflecting in large part the challenges of dealing with an aging population and rising health-care costs. Congress needed to focus its deficit fighting on these longer-term issues. Raising current taxes or reducing current spending would only slow the recovery without solving the longer-run problem.

IF THE CREDIT, housing, and fiscal headwinds were not a sufficient challenge for the economy, financial conditions deteriorated again during the summer of 2011, in part because of a resurgence of the European crisis. The bailouts of Greece in May 2010 and Ireland in November 2010 were followed by a package for Portugal (of 78 billion euros) in May 2011. Each country receiving aid was required to aggressively reduce its budget deficit and implement reforms to improve its economic competitiveness and efficiency. Ideally, imposing tough conditions on bailout recipients reduces moral hazard and leads them to correct the poor policies that got them into trouble in the first place. If the terms were not tough, other countries in similar straits wouldn’t make the hard choices required to avoid having to ask for a bailout.

On the other hand, tough bailout conditions only work if the requirements make sense and if they can be implemented without causing the political collapse of the recipient government. Was Europe getting it right? The question was important for Europe, of course, but also for the rest of the world, which was linked to Europe financially and through trade. With Tim Geithner (at meetings and conference calls of international groups like the G-7 and the G-20) and on my own (at central bank meetings in Basel and elsewhere), I listened to hours of debate.

Tim and I largely agreed that Europe was getting it wrong. We did not hesitate to say so. Doubtless some countries needed to tighten their fiscal belts; and many countries in Europe, not only those receiving bailouts, could benefit from eliminating heavy-handed regulations that made their economies inefficient. For example, some countries make firing workers very difficult, which makes employers reluctant to hire in the first place. But Europe was on the wrong track, we thought, in several crucial respects.

Although austerity in the more troubled countries was probably unavoidable, given how indebted they were, it predictably pushed them deeper into recession. Unfortunately, the Europeans showed no inclination to offset necessary austerity in weaker countries by spending more and taxing less in countries, like Germany, that could afford to do so. Instead, Germany and other better-off countries also cut their

budgets, purportedly to serve as examples to more benighted nations. As a result, fiscal policy for the eurozone as a whole was highly contractionary. The eurozone’s macroeconomic approach seemed to boil down to “no pain, no gain,” irrespective of whether the pain was actually achieving anything. At the same time, the ECB exacerbated the effect of this fiscal austerity by tightening monetary policy. When inflation rose above the ECB’s target of “below but close to 2 percent,” it twice raised interest rates, in April and July of 2011, despite high unemployment and continued financial stress. Unlike the Fed, it decided against looking through temporary increases in oil and crop prices. I found the decision hard to understand, although it was consistent with the ECB’s response to higher oil prices in the summer of 2008, when it had also raised rates. Fiscal austerity throughout the eurozone, along with higher interest rates from the ECB, virtually guaranteed very slow growth in Europe as a whole and outright economic contraction and soaring joblessness in countries like Greece, Ireland, and Portugal.

Beyond concerns about near-term growth in Europe, Tim and I also believed too little was being done to address the basic structural problem of the eurozone: the mismatch of a single monetary policy and central bank with the uncoordinated fiscal policies of seventeen independent countries. (The membership had reached seventeen when Estonia joined the ECB at the start of 2011.) Some steps had been taken, including tougher enforcement of the rules limiting deficits. And no one expected European countries in the foreseeable future to become fiscally integrated like the states of the United States. Still, Europe’s leaders would reject or put off plausible and constructive acts of fiscal cooperation—like undertaking joint infrastructure projects, creating a common fund to safely shut down failing banks, and sharing the risk of bank failures by establishing a eurozone-wide system of deposit insurance.

Another contentious issue concerned how to treat countries that, even after rigorous austerity, were unable to pay their debts. Should they be bailed out by other eurozone members and the International Monetary Fund? Or should private lenders, many of them European banks, bear some of the losses as well? The situation was analogous to the question of whether to impose losses on the senior creditors of Washington Mutual during the crisis. We (Tim, especially) had opposed that, because we feared that it would fan the panic and increase contagion. For similar reasons, we opposed forcing private creditors to bear losses if a eurozone country defaulted. Jean-Claude Trichet strongly agreed with us, though he opposed other U.S. positions. (In particular, he did not see much scope for monetary or fiscal policy to help the eurozone economy, preferring to focus on budget balancing and structural reforms.) On the issue of country default, though, Jean-Claude’s worry, like ours, was that, once the genie was out of the bottle, lenders’ confidence in other vulnerable European borrowers would evaporate.

The issue gained relevance over the summer as it became clear that Greece’s imploding economy would prevent it from servicing its debts, despite its bailout. European politicians began to discuss forcing private lenders to take losses, along with official lenders (European governments and the IMF). They saw loss sharing as an antidote to moral hazard as well as a way to protect their taxpayers. In contrast, Trichet and the ECB argued strenuously against any default or restructuring of Greek debt that

might prompt contagion. (Economics aside, Trichet also seemed to view default as inherently dishonorable.) Ireland and Portugal were safe from contagion for the moment, since, as recipients of official loans, they did not have to borrow on private markets. However, two much larger countries, Spain and Italy, could be at risk.

On July 21, European leaders assembled a new package for Greece, roughly doubling the 110 billion euros in loans approved in May 2010. But, for the first time, private holders of Greek debt were also forced to make concessions, in the form of lower rates and a longer repayment period. It was, in effect, a partial default. Predictably, private lenders soon began to pull back from the bonds of Italy and Spain. At the beginning of 2011, ten-year Italian bonds yielded 4.7 percent, and ten-year Spanish bonds 5.4 percent (both up from about 4 percent a year earlier). As discussions of Greek restructuring proceeded, those yields began to rise; by August 1, Italian bonds paid 6 percent and Spanish bonds 6.2 percent. Spanish yields then stabilized and declined, but by the end of the year the yield on Italian bonds was 7.1 percent, even though the ECB restarted its program of bond purchases in August.

A rise of a few percentage points in interest rates might not seem important. But higher interest costs directly increase government deficits. A vicious circle can set in: Lenders, fearful of default, demand higher interest rates, but the higher interest rates themselves make ultimate default more likely. Over the summer of 2011, more and more people were thinking the unthinkable—that the euro would collapse as countries defaulted and either withdrew or were expelled from the common currency. With already weakened European banks holding large quantities of government debt, country defaults could bring down the European banking system as well. It looked like a financial disaster in the making—one potentially worse than the crisis of 2007–2009.

As this newest European crisis was building, on May 14, 2011, Dominique Strauss-Kahn, the managing director of the IMF, was arrested in New York City, accused of assaulting and attempting to rape a hotel maid. I was shocked. Many considered Strauss-Kahn the most likely successor to French president Nicolas Sarkozy. Brilliant and urbane, he had been a strong leader of the IMF. He was particularly clear-sighted about the need for the Europeans to act quickly and decisively to contain the crisis. No one could condone his alleged actions, but Strauss-Kahn’s expulsion from international policymaking left a major gap at a critical moment. John Lipsky, an American economist who had been serving as Strauss-Kahn’s deputy, filled in temporarily.

French finance minister Christine Lagarde, with the support of the U.S. government, succeeded Strauss-Kahn in July to become the first woman to head the IMF. The IMF’s chief economist, Olivier Blanchard, a good friend of mine who had spent many years on the faculty at MIT, stayed on. Despite having just served in the French government, Christine, like Strauss-Kahn before her, showed no favoritism to European borrowers. Indeed, she would often criticize European governments’ unwillingness to do more to foster economic growth. However, the Europeans, led by German finance minister Wolfgang Schдuble, showed little inclination to take advice, from the IMF, the Americans, or

anyone else. On this, at least, they agreed.

MEANWHILE, IN THE United States, Congress appeared to be doing its best to roil the financial markets further. It was in a standoff with the Obama administration over raising the federal government’s debt limit.

The debt ceiling law is a historical accident. Until World War I, when Congress approved spending, it routinely authorized any necessary issuance of government debt at the same time. In 1917, for administrative convenience, Congress passed a law that allowed the Treasury to issue debt as needed, so long as the total debt outstanding remained below a permitted amount. In effect, Congress separated its spending decisions from its borrowing decisions.

At some point, it dawned on legislators that approval of the debt ceiling could be used as a bargaining chip. Usually, these fights resembled Kabuki theater, with the party in power ensuring that the debt ceiling was raised (and taking the resulting political flak). Before 2011, the most serious battle had occurred in 1995, when a deadlock between President Clinton and the Republican Congress over the debt ceiling and spending bills led to two temporary shutdowns of the federal government. As political polarization in Washington increased, however, debt ceiling fights became less symbolic and, consequently, much more dangerous.

Many Americans believe that disputes about the debt ceiling concern how much the government should spend and tax. The debt limit is not about spending and taxing decisions themselves, however; rather, it is about whether the government will pay the bills for spending that has already occurred. Refusing to raise the debt limit is not analogous, as is sometimes claimed, to a family cutting up its credit cards. It is like a family running up large credit card bills and then refusing to pay.

One of the government’s key commitments is paying interest on the national debt. Failure to make those payments on time would constitute default on U.S. Treasury securities—the world’s most widely held and traded financial asset. At the time, about $10 trillion in U.S. government debt was held by individuals and institutions around the world. Even a short-lived default would likely have catastrophic financial consequences, while permanently damaging the credibility and creditworthiness of the U.S. government. A failure to make other government payments—to retirees, soldiers, hospitals, or contractors, for example—also would constitute an important breach of faith with serious financial and economic effects. Refusing to raise the debt limit takes the economic well-being of the country hostage. That ought to be unacceptable, no matter what the underlying issue being contested.

The fight over the debt limit in 2011 grew out of Republican efforts to cut government spending after the party’s gains in the 2010 midterm elections. Various efforts to find a compromise, including a bipartisan commission headed by Alan Simpson, a former Republican senator from Wyoming, and Erskine Bowles, a White House chief of staff in the Clinton administration, had failed to produce results. In April, Tim had warned Congress that, without an increase in the debt ceiling, the government would run

out of money around August 2. At the time of the warning, few thought that Congress would seriously consider default, and market reaction was muted.

The Federal Reserve serves as the fiscal agent for the Treasury, which means it processes most federal payments, including interest on Treasury securities. As the political debate went on, the Fed and Treasury discussed operational issues that could arise if Congress did not raise the debt ceiling on time. Fed supervisors and specialists in the plumbing of the financial system also talked to financial institutions about how they might deal with a delay in interest payments on Treasury securities. What we heard was disturbing: The computer systems used by banks and other financial institutions were almost completely unprepared to deal with even a short-lived default. The systems’ designers had not contemplated the possibility.

On July 31, after months of brinkmanship, Congress finally came to a budget agreement that allowed the debt ceiling to be raised. The agreement was complex. Besides specifying spending cuts over the next ten years, it established a joint congressional committee, nicknamed the “super committee,” to come up with additional reductions. If the committee failed to agree on sufficient cuts, it would trigger across-the-board cuts, known as “sequestration.” I was relieved to see a resolution of the crisis, but I worried about whether the fragile economic recovery could withstand the austerity measures that Congress seemed intent on imposing.

There was a postscript: On August 5, the Standard & Poor’s rating agency—citing, among other factors, the prospect of future budget brinkmanship—downgraded U.S. government debt to one notch below the top AAA rating. The rating agency had made an egregious error that caused it to overstate the estimated ten-year deficit by $2 trillion, which the Treasury quickly pointed out. S&P acknowledged the error but asserted that the mistake did not affect its judgment of the government’s creditworthiness. I had the feeling that S&P wanted to show it was not intimidated. The episode highlighted the odd relationship between governments and rating agencies: Governments regulate the rating agencies, but the rating agencies have the power to downgrade governments’ debt.

The downgrade added to the stress in financial markets, already skittish because of Europe. From July 25, the Monday after the Greek debt restructuring announcement and amid growing concern about the debt ceiling, the Dow fell about 1,800 points, or 14 percent, in four weeks. Ironically, over the same period, despite fears of a default on Treasury securities, investors snapped them up, pushing down the yield on ten-year Treasuries from about 3 percent to a little over 2 percent, a substantial move. The appeal of Treasuries as a safe port in a storm (together with concerns about Europe and the U.S. economy) evidently outweighed default fears.

HOUSING IN THE United States continued to be a key recovery headwind in 2011. With my encouragement, Board members Betsy Duke and Sarah Raskin constituted an ad hoc committee to think about how we might bring it back to life. Their efforts were supported by the work of David Wilcox, who became the

Board’s research director in July 2011 after Dave Stockton retired, and a team led by economist Karen Pence, a specialist in consumer finance. The committee focused on new foreclosures, which had declined from a peak of 2.1 million in 2009 but remained quite high at 1.25 million in 2011.

Monetary policy had helped bring down mortgage rates from about 6 percent in late November 2008, just before we announced the first round of mortgage-backed securities purchases, to about 4.5 percent at mid-2011. With mortgage rates lower, homeowners with good credit records and equity in their homes could refinance and reduce their monthly payments. Unfortunately, about a quarter of homeowners remained underwater in 2011, owing more than their homes were worth, and could not refinance. The early results of the Home Affordable Refinance Program, introduced by the Obama administration to help underwater borrowers whose mortgages were owned by Fannie or Freddie, had been disappointing. But the administration liberalized HARP’s terms in October 2011, reducing fees and broadening eligibility, which greatly increased participation. Ultimately, the program facilitated about 3.2 million refinancings.

The administration’s other main anti-foreclosure initiative, the Home Affordable Modification Program, offered servicing companies incentives to lower borrowers’ payments—for example, by extending the repayment period for mortgages or lowering their interest rate. In practice, the program presented huge management challenges to the Treasury. Congress demanded close oversight of participating servicers and borrowers. That was understandable, but it led to operational demands on servicers that reduced their willingness to participate. And extensive documentation requirements dissuaded many borrowers from applying. In its first year, HAMP modified only 230,000 mortgages. As Treasury gained experience, it improved and expanded the program, allowing more mortgages to be modified.* But modifications did not always avoid foreclosures. Even with tight screening standards, 46 percent of the mortgages modified in 2009 re-defaulted, as did 38 percent of the 2010 modifications. The effects of the recession on jobs and family finances left many borrowers unable to make even moderate monthly payments.

Other than through our supervision of some lenders, housing fell largely outside the Fed’s jurisdiction. Nevertheless, we saw it as a critical factor in the recovery and jumped into the debate. In a white paper released in January 2012, we offered suggestions for improving the administration’s programs. We also analyzed alternative foreclosure-prevention strategies, such as onetime reductions in the amounts that borrowers owed, and we promoted alternatives to foreclosure such as short sales, in which lenders permit borrowers to discharge their debt by selling their homes for less than the loan amount. (A short sale is less costly than a foreclosure for both borrower and lender, and better for the surrounding neighborhood because the home doesn’t sit vacant.)

Though we viewed our paper as constructive and even-handed, it drew strong criticism from several members of Congress. Senator Orrin Hatch of Utah, the senior Republican on the Senate Finance Committee, complained that we had intruded into fiscal policy. I don’t regret putting out the paper. Not all foreclosures are avoidable, but many are, and reducing unnecessary foreclosures—as difficult as it can be

—has many benefits, and not just for the borrowers and lenders themselves. The glut of foreclosed properties was an important reason for housing’s slow recovery and, consequently, the economy’s. But the reaction certainly showed that foreclosure prevention was as much politics as policy. Feelings ran strong, both among those who wanted more generous programs and those who believed the programs were already too generous.

In another chastening experience, we would learn firsthand the practical difficulties of addressing foreclosure problems. One of the appalling crisis-era mortgage practices involved “robo-signing,” when servicing company employees signed millions of foreclosure documents (as if they were robots) without properly reviewing them. In 2011 and early 2012, the Fed and the Office of the Comptroller of the Currency ordered sixteen mortgage servicers, who together serviced more than two-thirds of all mortgages, to hire independent consultants to review every foreclosure initiated, pending, or completed in 2009 and 2010. Servicers would have to compensate borrowers who had been subjected to robo-signing and other unfair treatment. It soon became apparent, however, that the cost of reviewing millions of files would far outstrip the compensation paid to harmed borrowers. After many complaints from Congress and consumer advocacy groups, the Fed and the OCC stopped the process. A new system compensated borrowers based on relatively simple criteria. The goal was to achieve rough justice for borrowers without paying huge fees to consultants. Eventually, fifteen of the sixteen servicers agreed to pay $10 billion ($3.9 billion in cash and $6.1 billion in other forms of relief, including mortgage modifications). Direct payments were sent to 4.4 million borrowers.

THE RESURGENT FINANCIAL stresses emanating from Europe and the debt ceiling follies—along with long-standing headwinds such as housing—exacted an economic toll. By the end of the summer of 2011, the guarded optimism that I described at the April press conference had faded. Once again the economy looked to be approaching stall speed. We had ended QE2 at midyear as promised. I believed the program had helped create jobs and avert the deflation threat we saw in the fall of 2010. But now it was over, and FOMC participants were projecting only very slow progress toward full employment through 2013, with inflation remaining low. What else could we do?

We could start buying longer-term securities again, further expanding our balance sheet. But the FOMC’s appetite for another round of full-blown quantitative easing seemed limited, at least for the moment. The criticisms of our policies were often exaggerated or unfair, particularly since we were receiving so little help from the rest of the government. But that didn’t mean there weren’t legitimate questions. Were our securities purchases effective? Our internal analyses suggested that they had been, but evidently not enough, on their own, to achieve an adequate pace of economic growth and job creation. Even if purchases had been effective in the past, with interest rates now so low, were we reaching the point of diminishing returns? Were credit market problems reducing the benefits of low rates?

Other questions concerned possible unwanted side effects. Besides inflation risks, FOMC participants

were most concerned that additional purchases might threaten financial stability. Sheila Bair, after leaving the FDIC in July 2011, had warned that the Fed was creating a “bond bubble” by pushing down longer-term interest rates. She and others argued that artificially depressed bond yields might spike unexpectedly and send prices tumbling for existing bonds with yields that suddenly were sharply lower than yields on newly issued bonds. The resulting large and widespread losses might destabilize the financial system. We had in fact closely monitored the risks associated with a large jump in interest rates, particularly at banks and life insurance companies, both of which hold lots of bonds, and believed that they were manageable. But if the last few years had taught us anything, it was that we had to be humble about our ability to detect emerging threats to financial stability.

WITH SUBSTANTIAL NEW securities purchases and balance sheet expansion unlikely to win the Committee’s support in the near term, it was once again time for blue-sky thinking. I had been discussing a wide range of monetary policy options internally since the previous summer. The conversations continued through 2011 and into 2012. I mentioned some ideas in public remarks, but many saw the light of day only in staff meetings and memos.

In my Jackson Hole speech in 2010, I had raised the possibility of reducing the interest paid on bank reserves from 1/4 percent to zero—or even slightly below zero. In effect, that would require banks to pay for the privilege of letting their liquid funds sit idle at the Fed rather than lending them out. But cutting the rate paid on reserves to zero likely would reduce market short-term interest rates by only a very small amount, perhaps between 0.10 percent and 0.15 percent. I had no strong objections to trying it; perhaps it would signal to the market that we were prepared to do whatever we could to aid the recovery. However, there were good arguments against the step. It could hurt money market funds and disrupt commercial paper and other financial markets, including the federal funds market. For example, if interest rates were lowered all the way to zero (or below zero), money market funds would have difficulty recovering management costs. If, as a result, the funds began to shut down, they would have to sell their commercial paper, closing an important channel of funding for that market.

Date: 2016-04-22; view: 698