Part 6 (1/2)
But the collapse of that fa else to focus the minds of policy makers on the reality that the risk of another Great Depression looot religion They started deploying all the weapons in their arsenal So interest rates, came from the standard playbook But many others seemed to come from another world, and in some cases another era To the uninitiated, the na,” ”capital injections,” ”central bank swap lines”-defy definition But these and many other unorthodox weapons came off the shelf and were mustered into battle Some had been tried before; others had not Some worked; souably prevented the Great Recession fro into another Great Depression Whether the cure will turn out to be worse than the disease is another matter, and it is to that question-and the risks and rewards of using unconventional policy measures to deal with financial crises-that we turn next
Chapter 6
The Last Resort
When the worst financial crisis in generations hit the United States in 2007, Ben Bernanke had just been appointed head of the Federal Reserve a year earlier It was a remarkable coincidence, for Bernanke was not just any central banker; he was one of the world's leading authorities on the Great Depression Fareconomist, Bernanke was acutely aware of the complicated dynamics behind this watershed event Over the course of his academic career, he had written influential articles that helped untangle the causes and effects of the worst depression in the nation's history
Bernanke self-consciously built on the pioneering work of monetarists Milton Frieds he first encountered in grad school Asin chapter 2, these two scholars had broken with earlier interpretations of the Great Depression by arguing that monetary policy-courtesy of the Federal Reserve-was to bla to this interpretation, the Fed's inaction and ineptitude not only failed to prevent the unfolding disaster but even contributed to the proble how the consequent collapse of the financial syste the nation into a brutal depression
Bernanke's keen appreciation of the burdens of history and his debt to Friedman were evident when he attended the venerable economist's ninetieth birthday party in 2002 By then Bernanke was a governor on the board of the Federal Reserve, and when he stood up to give a speech, he faard to the Great Depression: ”You're right, we did it We're very sorry But thanks to you, on't do it again”
This was the e of ly, he saw events through the prishty years earlier and acted accordingly Rules would be broken, and new tools tried There would be no repeat of the Great Depression As he told a reporter in the su to be the Federal Reserve chairman who presided over the second Great Depression”
To that end, Bernanke revolutionizedseries of interventions into the financial system that even today few people understand So; others he developed as the months passed and the threat of deflation and even a depression increased They ran the ga interest rates to zero, for exa a massive expansion of the Federal Reserve's power over the economy
These interventions probably did help avert a twenty-first-century Great Depression, but for the student of crisis econo issues Aside fro back Bernanke's policies once they're in place, rand scale The Fed, in its rush to prop up the financial system, rescued both illiquid and insolvent financial institutions That precedentrun, may lead to a collapse of er bubbles and even more destructive crises
No less problematic is the fact that soe on the traditional fiscal powers of elected government-namely, the power to spend money In the recent crisis, the Fed pushed the statutory envelope, assuovernment bonds for toxic assets and, more radical, to purchase toxic assets and hold them on its balance sheet Such measures, even if they prove effective, aislative process
Bernanke's response, orchestrated by hilimpse of the unorthodox ways in which monetary policy can be used-and perhaps abused-to prevent a crisis fro out of control
Deflation and Its Discontents
Since the end of the Second World War, the American business cycle has followed a fairly predictable path The econorow, and eventually boo the cycle to a close by hiking interest rates to keep inflation in check, andInevitably, the economy would contract; a recession would ensue
In some cases, most notably in 1973, 1979, and 1990, the recession was set off in part by what econoative supply-side shock All three tiered a sudden rise in oil prices that sparked inflation Here too, to control rising prices, the Fed her, after which the economy started to contract
Whatever their causes, these various contractions would inevitably ether The fall in output or the gross doe point or two-led to unpleasant but tolerable increases in unemployment and the familiar hardshi+ps of a recession
In soain of its own accord; in others, policyto a time-honored tool: they would cut interest rates, effectivelyit cheaper for households and fire people to spendfro interest rates often had the added effect of driving down the value of the dollar,ioods, and contributing to an eventual recovery Fiscal stirowth
The first ten recessions in the postwar United States largely followed this script Most lasted less than a year, save for a nasty recession in the wake of the oil shock of 1973, which was triggered by the Yom Kippur War; and after a second oil shock in 1979 caused by the Iranian Islah interest rates to slay inflation, resulting in a far n proved successful and set the stage for the much-celebrated Great Moderation As a consequence, recessions in 1991 and 2001 lasted a ht pain aplenty, they ended with renewed growth and opti, fiscal stimulus, and tax cuts
The twelfth postwar recession, which took hold in the wake of the recent financial crisis, has been different Prices not only istered declines for the first time in fifty or sixty years This was deflation, a phenoical spectruives economists chills,” reported The New York Ti Bernanke explained, ”We are currently being very aggressive because we are trying to avoiddeflation”
To the uninitiated, the fuss seeood thing? Consuoods cost less; people can buy more with every dollar they ohat's not to like? In fact, in a handful of episodes sone hand in hand with robust econoical advances drove down the price of goods Between 1869 and 1896, for exa techniques helped push down prices by some 29 percent a year At the sarew at an average annual rate of 46 percent
This episode re of a curiosity for econoenerally not corowth Why? In ical revolution; it's caused by a sharp fall of aggregate deoods and the productive capacity of the economy
This more common kind of deflation can have all sorts of peculiar effects on the day-to-day functioning of the econo-ticket ite a car or a house, for exa knife Si some capital investments may prefer to re Unfortunately, postponing spending, far frorowth, does precisely the opposite
A bout of deflation born of a financial crisis is of a different order altogether and erous and destructive Such bouts were relatively common in the wake of the perennial crises of the nineteenth century, then became lobal depression of the 1930s, it largely disappeared after that watershed event Only in the 1990s did it resurface, first after the collapse of japan's asset bubble, and then during the brutal recession that hit Argentina in 1998-2001
During the recent crisis, the prospect of this kind of deflation hat gave economists the chills They kneell that its ill effects could rahout the econoht depression, deflation can suffocate growth for years, leading to a condition that -deflation, in which econonation and even recession are combined with deflation In such a condition, the usual tools ofFisher was one of the first economists to understand the dynamics of deflation While Fisher re, shortly before the market crashed in 1929, that stock prices would reh plateau,” he redee theory of the connection between financial crises, deflation, and depression, or what he called the ”debt-deflation theory of great depressions” Put sireat because of two factors: too much debt in advance of a crisis, and toothat some of the worst crises in American history-1837, 1857, 1893, and 1929-followed on the heels of an excessive accuhout the economy When the shock cain calls led to frenzied attempts to pay down debt Fisher believed that this rush to liquidate debt and stockpile liquid reserves, while rational, daer economy As he explained in 1933, ”The very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidatethe more debtors pay, the more they owe” Fisher famously noted that from October 1929 to March 1933, while debtors frantically reduced the nominal value of their debt by 20 percent, deflation actually increased their re debt burden by 40 percent
Why? The rush to liquidate assets at fire-sale prices, Fisher argued, would lead to falling prices for everything from securities to commodities Supply would far outstrip demand, and prices would fall At the same time, people would tap money deposited in banks in order to liquidate debts or as a precaution against bank failures These withdraould lead to a reduction of what economists call ”deposit currency” and, by extension, a contraction of the overall money supply This contraction would depress prices still further As prices continued to fall, the value of assets across the board would drift doard, triggering a commensurate decline in the net worth of banks and businesses holding those assets More fire sales andto less liquidity in theof cash, anddeflation would have perverse consequences As borrowers oods started to fall in a severe recession), the lowered prices of goods and services would paradoxically increase the purchasing power of the dollar, and by extension, the real burden of their re debt In other words, deflation increases the real value of no ahead of their debts, people fell behind Fisher called this the ”great paradox”-the h them down
This is debt deflation To understand it better, let's consider its counterpart, what ine that you are a firm or a household, and you take out a ten-year loan for 100,000 at an interest rate of 5 percent At the time, inflation hovers around 3 percent If inflation stays at this rate, you'll really be paying interest at 2 percent per year-that's what's left after inflation eats away at the nooes up to 5 percent a year, it will effectively wipe out the interest rate entirely, and you will have the equivalent of an interest-free loan But if inflation runs out of control, hitting 10 percent, you're not only getting an interest-free loan; your principal is eroding as well These examples show you how to calculate the ”real interest rate”-the difference between the nominal interest rate and the inflation rate
Confused? Let's think about a ine that you take out that same 100,000 loan-and inflation runs coes soar to astonishi+ng levels It used to cost a dollar to buy a loaf of bread; now it costs a thousand dollars At the sae job that once paid peanuts now pays several ood” job pays a hundred o back to that 100,000 debt you incurred It's still sitting there, denominated in those older, more valuable dollars The aed with inflation It's nowroceries
The key here is that the dollars you're using to pay off the debt are worth less than when you incurred the debt in the first place For this simple reason, inflation is the debtor's friend: it effectively erodes the value of the original debt
Deflation, however, is not the debtor's friend Let's go back to our original example of a ten-year loan at an interest rate of 5 percent Contrary to expectations, the economy experiences deflation of 2 percent That7 percent interest a year If deflation hits 5 percent, your real borrowing costs have doubled to 10 percent a year In other words, the dollars you're using to pay off your debt are worth more than they hen you incurred the debt in the first place Unfortunately, even though each dollar is worth es have declined
The upshot of debt deflation is that debtors-households, fir costs rise above and beyond what they originally anticipated And during apanic, and a general unwillingness to lend-anyone es ood on his debt or, alternatively, refinancing it on less onerous ter liquid and safe assets like cash and government bonds People hoard cash and refuse to lend it, which only exacerbates the liquidity crunch As credit dries up, inal cycle of deflation, debt deflation, and further defaults
The end result is a depression: a brutal economic collapse in which a nation's economy can contract by 10 percent or more In the Great Depression that both trau Fisher, the collapse was unprecedented Froh, the stock market lost 90 percent of its value, the economy contracted by close to 30 percent, and 40 percent of the nation's banks failed Uneed to close to 25 percent And deflation? Prices fell off the cliff A dozen eggs that cost 053 in 1929 cost 029 in 1933, a drop of so froas
It's no surprise that Fisher's vision was a dark one As he wrote fro cause co to prevent the fall in the price level, such a depressiontends to continue, going deeper, in a vicious spiral, for many years There is then no tendency of the boat to stop tipping until it has capsized” While Fisher acknowledged that things ht ultiht this to be ”needless and cruel” Instead, he counseled that policy makers ”reflate” prices up to precrash levels As he put it, ”If the debt-deflation theory of great depressions is essentially correct, the question of controlling the price level assumes a new importance; and those in the drivers' seats-the Federal Reserve Board and the Secretary of the Treasury-will in [the] future be held to a new accountability”
Those words likely haunted Ben Bernanke, Henry Paulson, and Timothy Geithner as they confronted what looked like a reprise of the Great Depression Unfortunately, like al a reflation-or to put itinflation-is not as siained momentum, conventional ainst other ills that accompany financial crises Other weapons must be developed and thrown into battle
The Liquidity Trap
When economists talk about the futility of ordinary monetary policy, they refer to a ”liquidity trap” Policy makers dread this state of affairs, and to understand e must examine how central banks exercise control over the money supply, interest rates, and inflation
In the United States, the Federal Reserve prih ”open market operations”: that is, it can wade into the secondary overnment debt When it does so, it effectively adds or rees what is known as the ”Federal funds rate,” the interest rate banks charge each other for overnight loans for funds on deposit at the Federal Reserve In normal times, the Federal funds rate is a proxy for the cost of borrowing at any nu it is one of the most effective tools at the disposal of the Fed