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Recession?
Chapter 9
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In this chapter I explain why monetary stimulus is not enough in a severe recession. To avoid misunderstanding, I want to underline the important role of the Federal Reserve in helping to combat a severe recession. As I emphasized in chapter 3, in a severe recession the Fed must act as a lender of last resort by aggressively performing financial rescues and unfreezing credit markets, and must cut interest rates to zero in order to help maintain borrowing and spending by households and firms. These actions are essential, but they are not sufficient to overcome a severe recession because cutting interest rates to zero cannot fully reverse the plunge in aggregate demand that caused a severe recession. To raise aggregate demand all the way to normal, the Fed needs substantial help from fiscal stimulus.
There is another channel by which standard monetary stimulus—the buying of Treasury bonds in the open market by the Fed—can work: the portfolio rebalancing effect. If the Fed injects money into the economy by buying Treasury bonds, it will raise their price and reduce their yield. In response, financial investors will try to shift their portfolios toward other
assets—stocks and bonds—thereby bidding up their prices. The rise in the prices of stocks and bonds should have a positive effect on consumer and business confidence and on actual consumption and/or investment spending. But in a severe recession, the increase in demand from this effect will not be enough. In this chapter I will evaluate the strength of both channels of standard monetary stimulus—lower interest rates, and higher prices for stocks and bonds—in a severe recession.
Although the Federal Reserve, along with many others, underestimated how much the bursting of the housing bubble in 2007 would jolt the entire economy, in the fall of 2008 the Federal Reserve finally recognized the acuteness of the financial and credit crisis and the magnitude of the plunge of the economy. The Fed then acted aggressively to pump reserves into the banking system with two objectives: first, to provide liquidity to banks to withstand the financial crisis and the freezing of credit markets, and to assist the Treasury in rescues of failing firms; second, to lower interest rates by injecting reserves into the banking system in the hope of stimulating substantial borrowing and spending to combat the recession. The provision of liquidity and financial rescues certainly played a key role in overcoming the financial and credit crisis and thereby preventing a full-scale Great Depression.
But the Fed was unable to achieve its goal of stimulating substantial borrowing and spending on goods and services despite pumping a huge amount of reserves into the banking system. The injection of reserves failed to stimulate enough borrowing and spending to generate a strong recovery from the deep recession. Thus, after helping prevent a Great Depression in late 2008 by cutting interest rates to zero and assisting financial rescues, the Fed still faced an economy in 2009 and 2010 that showed no signs of recovery, as the unemployment rate continued to rise gradually towards a peak of 10% in late 2009 and then stayed well
above 9% through the end of 2010. Why didn’t the cut in interest rates to zero in 2008, 2009, and 2010 induce enough borrowing and spending by households to generate a solid recovery by the end of 2010? The answer is that many households had run up excessive debt between 2000 and 2007 and were now (2008–2010) trying to avoid taking on more debt, even when offered low interest rates to borrow more. When most households are determined to avoid taking on more debt, cutting interest rates to zero induces only a small increase in borrowing and spending.
Why Cutting Interest Rates Is Not Enough
In a severe recession, aggregate demand for goods and services is much too low, and in response to low customer demand, producers have little choice but to cut production and employment. To combat a severe recession, there must be a large increase in customer demand for goods and services. When the Fed buys Treasury bonds from private bondholders through its standard open-market operations, the private bond sellers deposit their Fed checks in their banks. The bond sellers have money instead of bonds, so their wealth is largely unchanged and there is no reason to expect them to significantly increase their demand for goods and services. Their banks have excess reserves that they would like to lend provided borrowers will be able to repay them. But in a severe recession, banks may doubt that borrowers will be able to repay, and even if banks offer to lend at a very low interest rate, consumers and businesses will be reluctant to borrow and spend because they don’t believe they will be able to repay the principal plus interest on the loan. So the Fed’s standard open-market operations will be unable to lift aggregate demand for goods and services nearly enough to propel a strong recovery from the severe recession. The same is true if the Fed
makes loans to banks. Even if the banks offer to lend at a very low rate, consumers and businesses will be reluctant to borrow. Thus, the Fed’s standard open-market operations will inject reserves into banks, but will only modestly increase demand for goods in services in the economy. Even if the Fed offered to make loans directly to consumers and businesses, few consumers and businesses would be willing to borrow.
Recall that in chapter 3 I paraphrased what Nobel laureate Paul Samuelson (1948) wrote in the first edition of his enormously influential college textbook (which went through many editions for decades). Samuelson explained that monetary stimulus alone can’t overcome a severe recession because “You can lead a horse to water, but you can’t make him drink.” The central bank can buy bonds with new money, but it can’t make the recipients of new money spend that money in a deep recession. The central bank can get banks to lower the interest rates they charge households and firms by injecting money into the banks, but it can’t make households and firms borrow and spend in the deep recession.
Samuelson expressed the view of traditional Keynesian economists. Many economists today, however, reject this view. New Classical economists and even many New Keynesian economists reject the basic tenets of traditional Keynesian economics. New Classical economists argue that the economy will automatically recover promptly from recession as long as the central bank keeps the money supply from falling; fiscal stimulus is unnecessary, ineffective, and harmful because it generates large government deficits and debt. New Keynesian economists are Keynesian in their view that keeping the money supply from contracting is not enough to generate a quick recovery from a deep recession; but until the Great Recession, many New Keynesians believed that active standard monetary stimulus—cutting interest rates—would be sufficient to generate a satisfactory
adequate recovery from a severe recession, and that fiscal stimulus was unnecessary, or ineffective, or harmful, or undermined by politics. The Great Recession caused some New Keynesians to reconsider one crucial tenet of traditional Keynesian economics as they realized that fiscal stimulus is essential for overcoming a deep recession (Romer 2011).
Even if monetary stimulus alone could overcome a severe recession, I contend it would be better to rely mainly on tax rebates to households than on cutting interest rates. With tax rebates, households can spend more on goods and services without going deeper into debt by borrowing. By contrast, interest rate cuts will only boost spending if households are willing to take on more debt during a deep recession. With tax rebates, household demand for goods and services is spread across all goods and services. With interest rate cuts, the increase in demand is concentrated on interest-sensitive sectors, a much smaller portion of the economy. Moreover, relying on monetary stimulus alone means interest rates must be cut to zero and kept there for a long time. This causes an unfair burden on retirees who built up savings in their bank account during their work years, hoping that in retirement their bank would pay a normal interest rate. With tax rebates restoring demand for goods and services, interest rates would stay normal instead of being cut to zero.
In a speech to the annual Jackson Hole conference on August 31, 2012, Chairman Bernanke (2012) set out his view of how Fed purchases of long-term government securities stimulated spending on goods and services. Bernanke said that these Fed purchases lowered long-term interest rates and also induced
the private sector to rebalance its portfolio by purchasing corporate stocks, thereby causing a rise in stock prices and private sector wealth, which in turn induced more consumption and investment spending. After referring to the Fed’s purchases of long-term government securities, Bernanke said these purchases would stimulate demand for goods and services through a portfolio balance channel noted by Nobel laureates Tobin, Friedman, and Modigliani. For example, Fed purchases of mortgage-backed securities (MBSs) should raise the prices of those securities; as investors rebalance their portfolios by replacing the MBSs sold to the Federal Reserve with other assets, the prices of the assets they buy should rise. These rising asset prices should raise wealth, resulting in more spending on goods and services. Bernanke contended that Fed bond purchases had led to rising stock prices, wealth, and spending on goods and services. Thus, even if households don’t borrow more just because interest rates have been cut to zero, a rise in the value of their corporate stocks, which raises their wealth, may increase their consumption. Even if business managers don’t borrow more just because interest rates have fallen to zero, a rise in the value of their corporation’s stock may increase their investment.
Bernanke then cited simulations with the Federal Reserve’s FRB/US model of the economy that found that the first two rounds of asset purchases by the Fed during the Great Recession raised the level of output by almost 3% and increased private payroll employment by more than two million jobs relative to what otherwise would have occurred. However, in my view it is likely that the Fed’s model overestimated the impact of the Fed’s stimulus in the Great Recession because its estimates use data from all past quarters, capturing the response to a cut in interest rates on stock prices and spending in a normal economy, when household and business confidence is normal; the response in a severe recession when confidence has plunged would surely
be smaller. Bernanke conceded this point when he noted that the impact in a deep recession might be less than a model with coefficients estimated mainly from nonrecession US data.
But even if the Fed’s estimate of an increase in employment of 2 million was accurate, 2 million was not nearly enough to overcome the severe recession, because from the first quarter of 2008 to the fourth quarter of 2009 employment fell 8 million, from 138 million to 130 million (and the unemployment rate still rose 4.9% from 5.0% to 9.9%). Without the Fed’s bond purchases employment would have fallen 2 million more to 128 million, but to overcome the severe recession the portfolio rebalancing effect would have had to increase employment by 10 million, not 2 million.
In their book House of Debt (2014), Atif Mian (professor of economics at Princeton) and Amir Sufi (professor of finance at the University of Chicago) explain why the cut in interest rates to zero in 2008, 2009, and 2010 failed to generate a solid recovery by the end of 2010. They make the case that excessive consumer borrowing from 2000 to 2007 in the United States led to an unsustainable rise in the ratio of household debt to household income. When overindebted households finally cut sharply their consumption in 2008 in an attempt to pay down some of their debt, the sharp fall in aggregate demand for goods and services generated a severe recession, and a cut in interest rates to zero in 2008, 2009, and 2010 was unable to induce overindebted households to resume borrowing and spending again.
They begin their book with the fact that the United States saw an exceptional rise in household debt between 2000 and
2007—total debt doubled from $7 trillion to $14 trillion, and the household debt-to-income ratio shot up from 1.4 to 2.1. From 1970 to 2000 this ratio rose very gradually, but then accelerated dramatically from 2000 to 2007. Mian and Sufi cite studies by economists who present evidence that a similar huge runup of household debt relative to income occurred in the 1920s prior to the Great Depression that began in 1929. From 1920 to 1929, there was an explosion in mortgage debt and installment debt for cars and furniture. Mortgages tripled. The spread of an innovation, installment financing, revolutionized how people bought washing machines, cars, and furniture. According to Martha Olney, an economic historian of consumer credit, in her 1999 article entitled “Avoiding Default: The Role of Credit in the Consumption Collapse of 1930,” the 1920s were the turning point in the history of consumer credit. For the first time, many consumers were going into debt to buy durable goods, made possible by the availability of credit. As a consequence, consumer spending in the 1920s rose faster than income, and consumer debt as a percentage of household income more than doubled. One scholar wrote in 1930 that the prosperity of the 1920s was propelled by a huge expansion in credit by retailers and debt by households. Like the Great Recession, the Great Depression began with a large drop in household consumption. Mian and Sufi (2014) cite the economic historian Temin, who wrote that the consumption decline at the start of the Great Depression was too big to be explained just by falling income and prices; Mian and Sufi believe the consumption decline was mainly due to a decade of debt accumulation by households.
They point out that other countries in other periods have followed the same sequence, and severe recessions abroad have often been preceded by a large run-up of household debt followed by a sharp drop in household spending. Moreover, there is evidence that the bigger the increase in debt, the sharper the
fall in spending. Mian and Sufi cite a 2010 study of the Great Recession in the 16 OECD countries showing that countries with the largest increase in household debt from 1997 to 2007 were exactly the ones that suffered the largest decline in household spending from 2008 to 2009.
They dispute the view that the failure of Lehman Brothers in September 2008 was the main cause of the US recession. Instead, the main cause was the overindebtedness of households that peaked in 2007. They say that the decline in spending was in full force before the fall of 2008. The National Bureau of Economic Research dates the beginning of the recession in the fourth quarter of 2007, three quarters before the failure of Lehman Brothers. The collapse in residential investment and durable consumption was dramatic well before the events of the fall of 2008. What happened in the fall of 2008 intensified a recession that was already well underway.
Mian and Sufi emphasize that the plunge in residential investment began in 2006. Starting in the second quarter of 2006, residential investment declined substantially. Spending on durable goods started declining before September 2008. They compare consumer spending in January through August 2008 to January through August 2007 and say a clear pattern emerges. In 2008, auto spending was down 9%, furniture spending was down 8%, and home-improvement expenditures were down 5%. These declines all occurred before the failure of Lehman Brothers. Hence, the sharp cut in household spending on durable goods had to have been triggered by something other than the financial crisis in September 2008. The timing suggests that the decline in household consumption spending, not the financial crisis, was the main cause of the recession. Job losses rose because households stopped buying. The decline in business investment was a reaction to the massive decline in household spending. When businesses see no demand for their products, they cut back on investment.
With households finally determined to reduce their debt in 2008, monetary policy had little power to induce them to spend more by borrowing more. Cutting interest rates can induce more borrowing and spending when consumers are willing and able to take on more debt, but not when they are determined to reduce their excessive debt. Nor can cutting interest rates induce firms to invest more when consumers are cutting their spending. Recall that in chapter 3 I cited the survey of small-business managers by the National Federal of Independent Business (NFIB) reported by Mian and Sufi; it found that the most important concern of managers during the Great Recession was low customer demand, not access to credit or lower interest rates.
The Weakness of Monetary Stimulus in a Balance-Sheet Recession
The phrase “balance-sheet recession” is used by Richard Koo in three books (2003, 2007, 2015). In his most recent book, Koo (2015) asserts that the bursting of a stock market or housing market bubble results in a balance-sheet recession. In such a recession, the private sector is determined to avoid taking on more debt because debt incurred during the bubble remains, while the value of assets bought with borrowed funds collapses when the bubble bursts, leaving balance sheets underwater. With most households and firms trying to pay down debt, even zero interest rates won’t induce much borrowing and spending.
Koo says that Japan’s recession that began in 1990 sheds light on the Great Recession in the United States and Western Europe in 2008. He points out that Japan’s recession that began in 1990 with the bursting of a massive debt-financed bubble. Koo explains why Japanese firms in the 1990s, following the 1990 plunge in the prices of real estate, sharply reduced borrowing
and spending despite zero interest rates. After the bubble burst, commercial real estate prices plunged 87% from their peak. Stock prices also plunged. Koo says the loss of national wealth amounting to three full years of GDP. The money borrowed by households and businesses to acquire real estate and corporate stocks assets remained intact, sending many households and firms underwater—their debt exceeded the new value of their assets.
Koo points out that the bursting of Japan’s real-estate and stock-market bubble in 1990 should have caused a sharp fall in GDP. But it didn’t. Why, then, did Japan’s GDP never fall below its bubble-era peak? Koo says the answer is that the government decided to borrow and spend. Government spending kept GDP above the bubble-era peak in spite of a dramatic cutback in spending by households and firms. The boost in government spending despite low tax revenue required substantial government borrowing year after year and left Japan with a huge public debt. But if the government had not stimulated the economy in this way, Koo argues, GDP would probably have fallen to half or less than half its peak. Consider that the crash in US asset prices during the Great Depression destroyed wealth equivalent to a year of 1929 GDP, and as a consequence output plunged 46%. Japan lost wealth equal to more than three years of 1989 GDP, so the resulting hit to the economy would almost certainly have been substantially greater. But this disastrous outcome was averted only because the government administered fiscal stimulus early on and continued to do so over an extended period of time. Japan’s fiscal stimulus, Koo concludes, was therefore extremely successful.
Koo contends that when the central bank buys bonds in the open market, and sellers of bonds deposit central bank checks in their bank accounts, the banks are forced to hold the funds because there are few willing borrowers. The problem is not that
the banks are unwilling to lend, but that potential borrowers are unwilling to borrow because of the debt already weighing down their balance sheets. When the private sector stops borrowing money even at an interest rate of zero, any funds supplied to financial institutions by the central bank remain within the financial system because there are no borrowers. That is why growth in private credit and the money supply has been so sluggish postLehman despite dramatic expansion of the monetary base by central banks. The key implication here is that the effectiveness of monetary policy diminishes dramatically as the private sector tries to reduce its debt.
Koo hastens to add that monetary stimulus can play an important role in a financial crisis. He emphasizes that after a bubble bursts, monetary policy has a vital role to play. When a bubble collapses, two problems arise that must be carefully distinguished. The first is a balance-sheet recession, which is a borrower-side problem. The second is a financial crisis, which is a lender-side problem. A financial crisis occurs when the value of assets owned or held as collateral plunges after a bubble bursts, leaving many financial institutions holding loans unlikely to be repaid. These institutions take defensive actions by hoarding cash and avoiding any new loans or investments. As fear spreads among these institutions, the financial system freezes up. During such a panic, the financial system can collapse unless the central bank steps in as a lender of last resort and provides institutions with the funds they need for settlement. Providing liquidity at such times is an essential function of a central bank. After the Lehman failure, the Federal Reserve rightly injected funds to rescue the US financial system and succeeded in preventing its collapse. These Fed rescues deserve great praise.
Once the financial crisis was over, however, Koo believes, the Federal Reserve should have recognized that it was unable to solve the first problem: the balance-sheet recession. Instead
of insisting it could cure a balance-sheet recession by making huge bond purchases and lowering interest rates, the Fed instead should have repeatedly asked Congress to extend the two-year fiscal stimulus that had been enacted in 2009.
Blinder and Zandi’s Estimates of the Impact of Policies
Blinder and Zandi (2015) use a macroeconometric model developed by Zandi (chief economist of Moody’s Analytics) to estimate the impact of monetary stimulus and fiscal stimulus on the economy using quarterly data from the past several decades. Blinder and Zandi agree that their study does not attempt to estimate stimulus impacts by studying data generated during the Great Recession. Instead, given their estimates of stimulus impacts from past data, and the assumption that these past stimulus impacts continued to hold during the Great Recession, they infer how much worse the economy would have been during the Great Recession if the stimulus had not been implemented. I agree with them, and most other users of macroeconometric models, that estimating policy impacts using past data, and then assuming these policy impacts continued during the period of interest (for example, the Great Recession years beginning with 2008), is one reasonable way to make inferences about the impact of stimulus policies during the period of interest.
Zandi’s model is a traditional Keynesian macroeconometric model. In the 1960s, traditional Keynesian demand-oriented models were regarded by most economists as the best macroeconometric models. In the 1970s these demand-oriented models were initially unable to handle supply shocks like the oil price increase of the 1970s, but were soon modified to include supply shocks while retaining Keynesian demand. Since
the mid-1970s many macroeconomists have criticized these models for lacking an explicit microeconomic foundation and have tried to develop models built on such a foundation. But many of these microfoundation models have done a poor job of explaining and tracking the Great Recession—for example, some of these models assumed that any involuntary unemployment would be quickly eliminated by a fall in wages that would induce employers to hire everyone willing to work. By contrast, traditional Keynesian models did a good job explaining and tracking the Great Recession. Having studied the structure and specific equations in the Zandi model, I believe it is well suited to explain and track the Great Recession.
Blinder and Zandi estimate that if there had been no financial rescues, no monetary stimulus other than the usual cutting of short-term interest rates in a recession (no Fed purchase of long-term securities, “quantitative easing,” in an attempt to cut long-term interest rates), and no fiscal stimulus other than the usual automatic stabilizers, then the peak quarterly unemployment rate would have been 15.8% instead of its actual 9.9%, an increase of 5.9%, and in 2010 the unemployment rate would have been 15.0% instead of its actual 9.6%, an increase of 5.4%; 17 million jobs would have been lost, 9 million more than the actual job loss of 8 million; the peak-to-trough decline in real GDP would have been 14% instead of the actual decline of 4%; the economy would have contracted for three years instead of the actual contraction of a year and a half; and the budget deficit would have peaked at 20% of GDP instead of its actual peak of 10%.
They then isolate the impact of each policy. Removing rescues and monetary stimulus would have increased the 2010 unemployment rate 2.7 percentage points (from 9.6% to 12.3%); removing fiscal stimulus would have increased the 2010 unemployment rate 1.2 percentage points (from 9.6% to 10.8%); because of positive interaction effects, removing all policies would
have increased the 2010 unemployment rate 5.4 percentage points (from 9.6% to 15.0%). Dividing the policies into three categories—rescues, Fed purchases of long-term securities, and fiscal stimulus—each contributed roughly one-third of the mitigation of the severity of the recession.
But even with the significant improvement from these policies, the unemployment rate in 2010 was a still very high 9.6%. Which of these policies could have been significantly increased from 2008 to 2010 to achieve a significantly lower unemployment rate in 2010? Rescues in the fall of 2008 and winter of 2009 were sufficient to end the financial panic and credit freeze, so more rescues were not needed and would not have further improved the economy. Purchase of long-term securities under “quantitative easing” in 2009 and 2010 reduced long-term interest rates, so it is unlikely that more purchases of long-term securities would have induced much more borrowing and spending.
By contrast, large tax rebates (triple the size of the 2008 rebates) could have been sent out in 2008, 2009, and 2009, and this would have generated a significant increase in consumer spending even if a significant portion of the rebates were saved. There is no shovel-ready problem with tax rebates—the larger the rebate households receive, the more they will spend on goods and services. The only thing holding back the enactment of large tax rebates is concern about government deficits and debt. The key rationale for having the Federal Reserve give a transfer (not a loan) roughly equal to the federal expenditure on rebates—the stimulus-without-debt policy proposed in this book—is to make sure the rebates (or other fiscal stimulus) do not increase government deficits and debt.
Thus, the conclusion I draw from the Blinder and Zandi study is that rescues, monetary stimulus (through the purchase of both short-term and long-term securities), and fiscal stimulus
all kept the Great Recession from being significantly worse. But the Great Recession was still bad enough despite these policies, and more monetary stimulus would not have been able to make much more improvement. By contrast, fiscal stimulus (primarily tax rebates to households) could have been made much larger— tripled, for example—and could therefore have made a much larger improvement in the economy without increasing federal deficits or debt if the Fed gave a transfer (not a loan) to the Treasury that was roughly equal to the fiscal stimulus.
Conclusion
In a normal economy, when households have modest debt, monetary policy can stimulate substantial borrowing and spending by reducing interest rates. But monetary policy can’t stimulate substantial borrowing and spending in a severe recession when households have excessive debt. Monetary stimulus provided some help during the Great Recession, but it is clear that monetary stimulus alone is not nearly enough to overcome a severe recession. The Great Recession taught once again the lesson of the Great Depression: lowering interest rates to zero is simply no match for a severe recession.
