Part 7 (1/2)

This is a problem As Frank Borman, the chief of Eastern Airlines, said back in the early 1980s, ”Capitalism without bankruptcy is like Christianity without hell” Unfortunately, the Fed's interventions have kept afloat both the illiquid and the insolvent; the one precious few bankruptcies Financial institutions that no aulatory forbearance can save remain in operation Like the infamous zombie banks that becao bankrupt, and the sooner they do, the better

But that will depend a great deal on another problem: how to unwind and dismantle the various special facilities that the Fed established in the midst of the crisis As early as January 2009, Bernanke spoke confidently about the Fed's ”exit strategy,” and he clearly believes that as credit conditions improve, the financial system's dependence on easy money will subside Perhaps But the rescue effort that he and other central bankers oversaw is on a scale never before tried Its extraordinarily large nu parts make it very difficult to kno attempts to wean one swath of the financial sector off easy ht affect other parts of the system Bernanke has reassured anxious lawmakers that there is a plan, but we're in uncharted waters here: this level of intervention has no precedent

The monetary policies pioneered by Bernanke have another, less noticed aspect: er purely athe money supply The Fed has instead stepped into the financial system and effectively subsidized its operations, potentially incurring losses that could ultimately fall on the shoulders of taxpayers Put differently, it's engaging in monetary policies that bleed imperceptibly into the traditional doovernatives of the legislative branch, but in this crisis Bernanke's policies have blurred that line, turning the Federal Reserve's power to lendranted many subsidies to the financial system in its time of need, and it has purchased potentially risky asset-backed securities Even its policy of purchasing long-ter money: when the time comes to sell it, the Fed may well have to unload these bonds at a loss

These encroachments on the terrain of fiscal policy, however, may have been inevitable After all, proposals to allocate taxpayer dollars to rescue the financial system have encountered tremendous political resistance, from the first, failed atterae in the spring of 2009 Fro of the crisis, there has been so fiscal policy to coovernment's ability to tax and spend, while not always immediate in its effect, is one of the most powerful weapons in the arsenal of crisis economics Still, its use carries plenty of serious risks, particularly in the recent crisis, when legislators disbursed taxpayer money notbut on bailouts, guarantees, and backstops of everything from banks to carnite the crisis in the first place

Chapter 7

Spend More, Tax Less?

When President Herbert Hoover gave the annual State of the Union speech in 1930, the United States was one year into ould become an enormous economic catastrophe But on that day he emphatically declared that ”econoislative action or executive pronouncement” and that ”economic wounds must be healed by the action of the cells of the economic body-the producers and consumers themselves” Hoover counseled that ”every individual should sustain faith and courage” and ”each should maintain his self-reliance”

Thanks to words like these, Hoover reovernment apathy and inaction The truth is actuallyIn the very sa on public works projects typically collapsed during economic downturns This tiovernments had deliberately spent ht to the Depression In fact, he bragged that ”as a contribution to the situation the Federal Governrahway, and airway i” president, the federal govern on such projects

Though Hoover supported such expenditures, he also believed in lily the absolute necessity to defer any other plans for increase of Governid econoe was clear: there would be no deficit spending on his watch

Pity Hoover: he lived at a turning point in the history of crisis economics His speech revealed athe crisis One, which looked to the past, prescribed patience and balanced budgets; the other, which beca and massive public works projects Hoover could see the future, but he was tethered to the past He wanted to reconcile contradictory aiovernment help in a time of crisis, and to maintain fiscal discipline This was iress, John Maynard Keynes articulated ould becoovernment would rely on fiscal policy to cushi+on the econooods and services, and to revive the ”anience In other words, the governressively spendthesethe econo the patient suffer In the succeeding decades, fiscal policy beca with economic downturns, whether caused by crises or not

If Hoover stood at one watershed in the history of fiscal policy, we rown fro array of devices that government uses to intervene in the econoovernments spend uaranteeing bank loans, debts, and deposits They have even used tax dollars to acquire significant ownershi+p stakes in industrial beheiant banks Just asand coantic-and expensive-bag of tricks

Contemporary policy makers now find themselves in a fix comparable to Hoover's They may want to hand out tax cuts and spend money to prop up the labor overnet deficits that are increasing public debt to unsustainable levels They want to force Hoover's ”producers and consu thereater expense And while they want to hold the line onhouseholds, financial institutions, and corporations with new incentives to behave in precisely the ways that contributed to this crisis in the first place

In short, a bundle of contradictions lie at the heart of twenty-first-century fiscal policy While our present predicament may not be as dire as it was in Hoover's day, the old way of doing things is no longer compatible with the new realities that loom on the horizon

Conventional Fiscal Policy

John Maynard Keynes was the first overnment should use its powers to tax and spend in order to ameliorate econohtforward: in an econooods and services falls far below the supply, triggering une in the shadow of the Great Depression, Keynes concluded that this cycle, if perot bad enough, the ”animal spirits” of the economy would perish, and fearful entrepreneurs and consu more than was justified by weakened incomes and economic woes Despite a surplus of desperate workers and idle factories, a vicious circle of ever-falling derip the economy in a deflationary spiral and result in a pernation

Keynes believed that the econoe froovernment stepped into the breach and directly or indirectly picked up the slack in delut of excess supply and idle capacity could the economy stabilize itself, let alone return to prosperity That would require deficit spending, but it was better to spend , Keynes et could wait until after the crisis passed In fact, Keynes believed that a premature return to fiscal discipline would likely throttle any nascent recovery

Though Keynes first published his ideas in 1936, government policies instituted earlier in the decade anticipated his reco with Hoover's early experi with Roosevelt's New Deal, public works projects large and soods and services The amount of construction undertaken then remains impressive even today The Public Works Adress Administration, and the Civilian Conservation Corps built 24,000 es, 780 hospitals, 572,000 hways, and upwards of 15,000 schools, court-houses, and other public buildings

The results, though hardly miraculous, were dramatic: from 1933 to 1937, unemployment fell from approximately 25 percent to a little under 15 percent In 1937 a renewed co relapse into a severe recession, whereupon the Roosevelt ad the New Deal with deficit spending The outbreak of World War II, which necessitated govern on an even ering effects of the Great Depression and brought about a rowth

Keynes became the preeminent economist of the postwar era, and his prescriptions became the standard response not only to crises but to econoe and small Keynes eventually fell into disfavor in the 1970s But in the early 1990s, after the collapse of the japanese real estate bubble left that econoovern decade, it instituted no fewer than ten separate stiether cost more than a trillion dollars These efforts raised japan's deficit to record levels and left behind a acy: plenty of welcome improvements to infrastructure but also many wasteful and pointless projects in rural areas Econoue ad nauseam as to whether any of it was useful Many believe the policy's failure lay not with the idea of public works spending but with the choice of specific projects Others overnment spent too little, or pulled back too soon

But this kind of fiscal stimulus is but one of several approaches available to policyto stimulate demand, fiscal policy also encoe consu the-or so the theory goes This strategy wasn't part of the playbook in the 1930s: Hoover raised taxes, and so did Roosevelt, even if the burden fell largely on the wealthy and the middle class But in the postwar era, tax cuts and credits have becoral part of fiscal policy in times of recession and crisis japan, for example, used tax cuts as part of its postcrisis response

A third variant on fiscal policy is a ”transfer payovernroups (the poor, the uneovernments Transfer payments have been a mainstay of fiscal policy since the 1930s, when roups Like tax cuts, they are part of the standard arsenal for dealing with econoarden-variety recessions Transfer payments can come in myriad forms, such as une

The recent crisis saw a heavy reliance on all three conventional fiscal strategies In January 2008 law a 152 billion package of tax breaks aimed at individuals and businesses The Economic Stimulus Act of 2008 was overshadowed by the American Recovery and Reinvest 787 billion-aiet of fiscal policy Governht-up spending on infrastructure and energy projects topped 140 billion; afroot billions islation also dedicated plenty of money for tax credits and transfer paye, as individuals received breaks worth some 237 billion Some applied across the board to broad swaths of the population; others, like the tax credit for first-time homeowners and the one for the purchase of new fuel-efficient cars (cash for clunkers), targeted specific segments of the economy Finally, the bill directed billions to the unemployed, the elderly, and other vulnerable populations It also steered billions overnments

Countries around the world adopted coes The European Economic Recovery Plan, adopted in the fall of 2008, earmarked some 200 billion euros to a variety of projects; individual countries folloith their own smaller plans japan initially planned a e, but it ran afoul of politics, and the government ultimately instituted ameasures China's far more ambitious plan totaled 586 billion, the bulk of which went to public works: rail lines, roads, irrigation, and airports; soion of Sichuan Smaller countries as diverse as South Korea and Australia also adopted stimulus measures

These fiscal interventions certainly helped arrest the slide toward depression, but a feords of caution are in order For starters, fiscal policy isn't a free lunch: if a govern a recession, when tax revenues decline-the budget deficit will soar The government will have to issue more debt, which it will eventually have to pay If it doesn't pay the debt, and its deficits grow larger every year, then it will have to entice investors to buy her returns will then coes, consumer credit, corporate bonds, and auto loans-and can drive up the cost of borrowing for everyone else, thus reducing debt-financed capital spending by fir public debt ultio too high as fears of a possible default intensify At that point, the government has limited options It can opt to ”cheat” and printas the public debt is issued in local currency, a tactic known as ”” the deficit The , except that buying up debt has nothing to do with defeating deflation; it's about oods and pushes their prices higher, inflation is the inevitable result That her interest rates all around, and evenup the public sector

There's some evidence that taxpayers may be mindful of the risks as well In soes, consunized that whatever the short-terovern they had to save for that eventuality, consu in tandem with the introduction of a fiscal sti-ter and, in the process, nullified some of its benefits

Tax cuts, the other main tool of fiscal policy, can also run into obstacles Rather than going out and spending the money derived from tax rebates or permanent reductions in tax rates, households may save it or use it to pay off their debts That's what happened in 2008 and 2009, when two rounds of incoely went unspent-consumers parted with only 25 or 30 cents on every dollar they received fro household balance sheets While that was all well and good, such prudence did nothing to prop up demand It also shi+fted debt from one part of the economy to another: private debt went down, but public debt went up This was less a stiht of hand

Worse, certain kinds of fiscal measures can spur demand in the present at the cost of deeted tax cuts or subsidies that ai-automobiles, ho more than amplify demand beyond what's normal, then undercut it when the subsidies expire In other words, they steal demand from the future This seerah the roof, then fell back to earth, depressing future dee, at least in most democracies Unlike monetary policy, which can be implemented immediately by a central bank insulated from the pressures of voters, fiscal measures take time to initiate and coes to nowhere, and other inefficient allocations of resources A perfect sti for the buck, rebuilding a nation's dilapidated infrastructure and contributing to future econorowth But as japan's experience and some of the more dubious projects funded by the Aest, that's easier said than done It's perhaps instructive that China-an authoritarian state-ies in the wake of the recent crisis Mostly free of parochial political considerations, its governn to modernize its infrastructure Even in that case, however, so may yet turn out to be wasteful and inefficient or may foster future bubbles

In conventional fiscal policy, the government uses its powers to tax and spend in order to help the economy out of a crisis But tax cuts and public works are just the beginning; governainst a financial crisis in many other ways, which are far in

Governuarantee other people'staxpayers uarantees old and new played an i the recent crisis, even as they opened the door to the probleiven by a government is that it will protect h the idea dates back to the nineteenth century, the United States lacked national deposit insurance until 1933 That wasn't for lack of trying: between 1866 and 1933, Congress considered some 150 proposals for deposit insurance Some of them would have required banks to purchase surety bonds, a kind of third-party insurance; others called for the federal governuarantee the deposits directly Still others called for a common insurance fund out of which depositors' claims would be paid

In the Great Depression, the United States finally adopted deposit insurance that couarantee Conceived and born in the opening weeks of the New Deal, the institution that eventually came to be known as the Federal Deposit Insurance Corporation (FDIC) did not depend on taxpayer dollars; rather it operated by assessing fees on the commercial banks that were its members Those assessments went into a fund that reiovernment staffed and administered the FDIC, which also monitored the health of ed their takeover by better-capitalized banks A sis and Loan Insurance Corporation (FSLIC), was founded in 1934 to protect deposits in savings and loans thrifts

These two institutions operated without mishap until the 1980s, when the failure of s and loans overwhelmed the FSLIC Insolvent, it was subsequently taken over by the FDIC and recapitalized with taxpayer money to the tune of 153 billion As this episode a system can easily overwhelm funds set aside to overnment could have stood aside and let depositors lose their uaranteed the integrity of these funds and a bank run could have overwhelmed both solvent and insolvent banks

But the episode su out the banks, the governain should the need arise Bank ry depositors, and depositors didn't have to worry about losing theiras a bank was insured by the FDIC, theirthat deposits under its protection were ”backed by the full faith and credit of the United States Governain in 2008-9 Prior to the crisis, the FDIC insured deposits up to 100,000 Sih the ”ceiling” varied frorams could not cover all deposits: many people's accounts exceeded the maximum In the United States alone, upwards of 40 percent of the deposits remained uninsured and vulnerable, a point underscored by bank runs on Countrywide, IndyMac, and Washi+ngton Mutual

The threat of uarantees In September 2008, Ireland had to increase its deposit insurance to 100,000 euros, then fully guarantee all the deposits of its six largest banks In the United States, holding the line against moral hazard proved equally difficult Shortly after Ireland issued its blanket assurance, the FDIC raised the ceiling for insured bank deposits to 250,000 Two days later Geruaranteed all of its private bank accounts; the next day Sweden extended insurance to all deposits to the sum of 500,000 kronas, or approxido to 50,000 A week later Italy announced that none of its banks would be allowed to fail and that no depositor would suffer any loss The nexton deposit insurance Other countries folloith siuarantees

This dyna a blanket guarantee forced other countries to do the sa The reason was simple: depositors could readily shi+ft their uarantees and place it in safer havens As a result, governainst moral hazard It was a race to the bottoovernrams In the United States, the National Credit Union Administration (NCUA), a kind of FDIC for credit unions, took over two beleaguered ed 80 billion to cover the losses on all deposits in all credit unions throughout the country