CoverStory

It's the recovery, stupid

After an impressive response to the economic crisis, the Obama administration has failed to adequately address the challenges that lie ahead.

By Michael Spence

In September 2008, the global economy and financial system experienced an earthquake, registering high on the economic Richter scale. The epicentre of this earthquake was the financial system in the United States. It was the end of the Bush presidency. The presidential elections were two months away. The timing from the point of view of crisis management could not have been worse.

With the failure of Lehman Brothers as the trigger point, the financial system started to freeze up. Debt-fuelled asset inflation suddenly reversed. Credit disappeared. Bank solvency was in question and interbank lending vanished. The payments system started to fail. The housing market went into freefall, taking with it household balance sheets and net worth. As a consequence, consumption dropped, taking down business sales and, with a short lag, employment and investment.

This had all the makings of a depression scenario, with credit freezes leading to indiscriminate destruction of businesses. By analogy, if all supermarkets announced, 
without warning, that they would be closed for an indefinite period, there would be a huge problem getting food from producers to consumers: the food is there but the channels are closed. In this case, the channels for providing credit were shutting down.

These conditions required fast, aggressive and unconventional responses on the part of the government and the US Federal Reserve.

The crisis response, mounted by the Bush administration and taken over by the Obama administration, was all of the above. A combination of direct injection of capital into banks and other systemically important financial institutions, rapid expansion of the Fed balance sheet through the purchase of unconventional assets, a variety of guarantees, taking over Fannie Mae and Freddie Mac and effectively AIG, and direct lending in the commercial paper market prevented a complete credit lock-up.

All of this had to be accomplished without a lot of time for reflection, debate and the weighing of options. It is hard to overstate the level of uncertainty about asset values, solvency and the connectedness of balance sheets that prevailed at the time. Along with the extreme uncertainty and lack of information came fear, and that in turn caused highly conservative, risk averse behaviour on the part of financial firms and households/consumers. The individually rational choices of individual entities were giving rise to collectively irrational results. The role of the government in such circumstances is to intervene at multiple points to break that damaging cycle. Both administrations understood this and acted accordingly.

Choices that were made were occasionally mistargeted and need to be changed. The Troubled Asset Relief Program, passed by Congress, originally targeted the purchase of complex securitised assets that had lost value and stopped trading. It had to be partially redirected to direct infusions of capital into banks. This caused friction with Congress. Further, it appeared to the public that the government was bailing out the Wall Street firms whose leverage and misestimates of risk had been major contributors to the crisis.

I noted at the time that in crisis circumstances, policy options often range from bad, to worse and on to truly dreadful. Wise decision-making is to select the least worse, do it quickly, and accept that there will be both anger and criticism.

The Obama administration picked up the ball, mid-crisis, with the early selection of an experienced economic team. It interacted with the Bush team and prepared ongoing crisis management plans between the November election and the inauguration. The most important item in the expanded plan was a large stimulus package whose purpose was to reduce the rate of decline of the real economy. It was passed in late February of 2009.

The downward plunge of the markets began to decelerate and then stabilise in March of that year. Following the capital injections and Federal Reserve programs, it was an important step, notwithstanding the debate and disagreements about size, effectiveness and targeting. The first priority was to stabilise before turning to the issue of recovery.

Communication of plans and intensions is a critical component of managing in a crisis environment. It could have been handled better at the start of the administration. With two months to prepare and monitor the evolving economic and market situation, a forceful and credible statement about the strategy for dealing with the effects of the crisis on day one, would have been helpful in reducing the fear factor and stabilising markets earlier. In normal times delays of a couple of months in both acting and communicating are not especially important. But when markets are plunging in a crisis environment, with ripple effects into the real economy via balance sheet deterioration, much damage can occur in a short period, damage that takes a long time to repair.

The crisis appeared to spring from nowhere. Certainly the vast majority of economists, investment analysts, financial firms and regulators failed to see the rising risk. But while the break point remains quite unpredictable, making the timing of the onset of the destructive dynamics almost impossible to predict, the period of rising debt and inflating asset prices, low savings and excess consumption go back over a decade in time. There were ample signals of rising risk and imbalance if participants, regulators and economists had taken the time to interpret them.

My point here is not to enter into an analysis of how or why the warning signs were missed or ignored by all but a few insightful contrarians, however interesting that subject may be. The point is rather that the distortions were real, and a long time in the making. The crisis in fact did not spring out of nowhere, notwithstanding the fact that it came as a nasty surprise. The economy was building up distortions, imbalances and structural problems. Restoring balance and eliminating the distortions is going to take considerable time. And it should be thought of as the central focus of the post-crisis economic policy agenda.

The household sector is of particular importance. Counterfactually, if the main problem had been confined to excess leverage and risk-taking within the financial sector, the shock would have been large, but the recovery quicker.

It was the huge loss of net worth in the household sector that brought down the real economy, aided by the non-availability of credit to smaller businesses. That cannot be fixed overnight without a dangerous re-inflation of asset values, including housing. That is not going to happen any time soon. The elevated savings (and reduced consumption), relative to the negligible pre-crisis levels, are likely to be permanent even after a period of frugality as retirement savings are restored and leverage reduced. The restoration of savings by US households has removed about $1 trillion from the demand side of the economy. Reduction of excess savings and surpluses in countries like China, Germany and Japan can fill some of the shortfall in global aggregate demand. But in the best of circumstances that will take time and will require a major success on the part of the G20 in negotiating a coordinated rebalancing of global demand.

This and related structural conditions led the giant bond manager PIMCO, in its widely read 2009 secular outlook, to characterise the direction of movement of the post-crisis economy as a journey to a 'new normal', not a reversion to pre-crisis conditions. Put bluntly, Americans were living beyond their means for a decade or more before the crisis, making up the difference with foreign borrowing. The economy as a whole expended (including real investment) more than it produced and more than its income. The economy ran a trade deficit in the course of buying the rest from other countries and borrowed the money to do it from them. The excess consumption and supporting financial activities simultaneously hid and caused structural problems in the economy. The main post-crisis challenge is not to return to the old normal, which was not sustainable. And it isn't just to recover from a deep, balance sheet recession. Rather it is to make a structural transition from the old abnormal, to a new normal that is sustainable.

With the balance sheet resets that have already occurred and the elevated savings, it seems very unlikely we will go back to where we came from.

The economic relevance of this analysis is that the period of deficient consumption and stubbornly high unemployment are likely to be with us for some time. Unfortunately, this is not how the future prospects were sold to the country. Until recently, financial markets acted as if the recovery would be sharp and relatively quick. The bounce you tend to get and that we did get at the bottom when the freefall stops and inventories run out, causing output to pick up a bit, was misinterpreted as evidence of what is sometimes called a V shaped pattern of the recovery—sharply down and sharply back up.

The administration and the Fed in their communications did nothing until recently to shift views towards the more pessimistic side—even in the face of stubbornly high unemployment and slipping growth. Whether that was because the new normal was ignored or regarded as incorrect, or because public officials in a fragile economic environment have an incentive to cheerlead a bit by dwelling more on the positive indicators, is hard for outsiders to know. But the result is that public and market expectations were out of line with reality.

The implication of this set of assessments is fairly clear. The administration should not be held accountable for the poor economic performance in the immediate post-crisis period. Under the prevailing conditions, that was predetermined and pretty much inevitable. But by letting the flawed expectations stand, the administration left itself open to the charge that poor policy was the reason for the poor economic performance.

The missed opportunity was to fail to understand and to tell the public that the next few years would be painful, that the government has limited ability to shorten the recovery period, that the destination was new, not a return to the pre-crisis configuration, and that the focus of policy needed to be largely on restoring medium and longer term growth and employment and on protecting those who had been side-swiped by the crisis, particularly the unemployed. That might not have been a political smash hit, but over time, it would have been borne out by experience and gained credibility and perhaps support.

To restore growth and employment, structural imbalances and distortions needed and still need to be addressed. And it will take time. The economy is structurally out of balance as a result of a prolonged period of excess consumption. Competitiveness in the tradable sector—think of it as competing for exports and against imports without resorting to protectionism—is deficient. Infrastructure investment is below optimal. Education continues to have problems. The financial sector is too big and is shrinking.

By treating the great recession as similar to others in the recent path, deeper than most but still a mean-reverting event, expectations deviated from the reality, and the political pressures on the policy agenda pushed towards fixing the problem or blaming people for not fixing it. The period of excess consumption caused by debt-fuelled asset inflation masked the structural and competitive problems. They are now all too visible. The administration needed to see and to say that the pre-crisis economy was on a dangerously unsustainable path and that the challenge now, having averted a depression in the eight months of real crisis, is to make a difficult transition to a new path.

On the analysis and communication of the nature of the recovery problem and on concrete steps for dealing with the transition, the performance falls short of the high standard set by the immediate crisis response.

In early 2009, shortly after taking office, the administration made a very significant strategic decision. It had to do with the scope and breadth of the political and legislative agenda. There were two options. One was to defer a number of important policy initiatives (in healthcare, energy and the environment, including climate change) and focus political capital and fiscal resources on restoring growth and employment. The second was to pursue a full policy agenda aligned with the priorities and commitments that the president had enunciated in his campaign.

Each option carried benefits and risks. The narrower agenda is, to put it bluntly, boring. It deals with financial reform, stabilising the housing market, restoring balance sheets and structural deficiencies. It is not designed to capture the imagination of the public and almost certainly likely to disappoint the enthusiastic supporters of the administration coming out of the election. But, if adopted, it would have had the advantage of clarity and focus in an area of central importance to everyone. And if successful over time, it might have made the rest of the agenda seem less overwhelming and more affordable.

The second option, the full agenda, has more or less the reverse characteristics. Benefits become risks and conversely. The president and the administration chose the second option. The advice from the business and investment side ran the other way. The latter was informed by lessons learnt about focus and limited agendas in business, but not particularly by political realities. In truth these are among the hardest and most important choices political leaders make.

The chosen second option would have been much easier to implement successfully if the assumptions about the nature of the recession and the likely path of recovery had been accurate. But they weren't. The economic agenda is shifting now to a more central focus on restoring employment and employment growth. But it risks getting bogged down in declining economic performance relative to expectations, and waning support. With the benefit of hindsight, the economy might have been further along if the focused sequential strategy had been adopted with a focus on employment and growth.

The Federal Reserve has played a major role during the crisis in averting a depression scenario. It acted quickly to restore credit to the economy, using unconventional means that took it way out of its comfort zone, and in the course of doing so, more than doubled its balance sheet. The fact that financial support was provided to the villains on Wall Street did not make people happy—well it made them furious—but no one has come up with a better alternative that would have got the job done. Central bank autonomy as it has evolved over time undoubtedly served us well in this instance—because it allowed them to take unpopular but necessary steps that would have been politically problematic.

The Fed has come under additional criticism for its role in events leading up to the crisis, under two headings. One was the low interest rate environment that was maintained for an extended period after the internet bubble and 9/11, a policy choice that may have contributed to the excess use of leverage. An irony that will occupy historians is that interest rates were rising as the crisis drew nearer, when debt levels were already high. That timing may have contributed to accelerating the onset of the crisis. Generally it is now accepted that a narrow focus on inflation targets is not sufficient. Either the central bank or some other entity has to monitor and make judgments about balance sheets, leverage and potential instability.

The second line of attack was lax oversight of lending practices by banks and other entities, a responsibility that it shares with a number of other entities with regulatory mandates in the financial sector. Generally this is fair, not confined either to the Fed or to the recent past, and forms part of the basis of the 
financial regulatory reform agenda that the administration has pushed forward along with Congress.

In the post-crisis period, the Fed has enjoyed administration support (to the credit of the latter) as it carries out a difficult balancing act. It has maintained low interest rates even as credit conditions have eased, there being no sign of inflation on the horizon and at least some risk of deflation, a dangerous condition in which general price levels fall, causing real interest rates to rise even as nominal rates are at or near zero. It is understood that these low interest rates are causing some distortions in the global economy. Funds are flowing into the higher growth emerging markets, causing inflation pressures and asset bubbles, which in turn require policy attention. But with a very fragile market, raising rates could cause a major downturn in housing prices, bringing down the economy again via the balance sheet effects.

In the aftermath of the crisis, the autonomy of the Fed has been questioned and largely successfully defended, with credit going to the administration for its strong support of that principle.

The administration has had to deal with a general phenomenon that makes implementing pragmatic, centrist policies more difficult. There appears to me to be a widespread and understandable loss of confidence in what are sometimes called elites. These would include academia, policy analysts, Wall Street, business leaders and politicians. This trend precedes the crisis. But the crisis has certainly contributed additional momentum. In various combinations, we failed to see the crisis coming and take steps to prevent it, and appear to have benefited from the crisis response. Regulatory failures allowed excessive risk-taking and inappropriate lending practices in both the banking and the shadow banking sectors. Post-crisis, profits are up and employment is not. The rising inequality in income distribution (a longer term trend) has been widely discussed but left largely unattended. There appears at times to be an excessive faith in markets to provide beneficial outcomes (domestically and globally) and a general lack of concern for distributional issues.

These trends need to be reversed. An extended lack of focus and commitment to the distributional issues will lead to a gradual but damaging breakdown of the social contract, and increasing polarisation of the politics surrounding economic policy choices.

There has been, as I see it, a lack of clarity about means and ends. Markets, regulatory structures and policies, and public sector investments, are means to attain shared goals. The administration, supported by political and policy elites, and private sector leaders need to be clearer that the main goal of domestic economic policy and strategy is re-establishing a pattern of inclusive growth and employment. The president needs to take the lead in focusing the agenda.

Government deficits in many countries have widened substantially as 
a result of the crisis. Although the media commentary and political discourse might lead one to think that this is the result of a large discretionary increase in spending as a crisis response and recovery strategy, in fact, recent IMF studies indicate that a large fraction of the deficit increases are occurring more or less automatically in most advanced countries, the result of declining tax revenues as incomes fall, and unemployment insurance expenditures as unemployment rises. The question now is whether to rein that in through tax increases or expenditure cuts or both.

The Obama administration has been on the aggressive side of the fiscal stimulus debate. Europe was more hesitant in the crisis because of different initial conditions and larger external leakages. Europe then stiffened its stance in the spring of 2010 as the periphery sovereign debt problems caused contagion and distress more broadly in the euro zone.

The appropriate timing of the restoration of fiscal balance is, in fact, a hard issue. On one side is a concern about another downturn and deflation. On the other there is the risk of excessive debt, instability in the dollar, which is the reserve currency, and questions about the benefits of additional stimulus in a situation where the unemployment is structural.

My own view is that the fiscal stimulus materially helped in the crisis itself, but is experiencing diminishing impact. At this stage, the best course would be the adoption of a credible multi-year plan, using reasonable but conservative growth assumptions, to reduce deficits to sustainable levels and limit the accumulation of public debt.

It is interesting to note in passing that, unlike in the past, fiscal deficits have become politically salient, in part I suspect because they are attached by association to the larger ideological divide on the question of the appropriate size and role of government.

Given the initial conditions, the economy's two-year performance has been about as good as it could have been. Preventing a much more serious downturn in the crisis is a major achievement, with credit going to both administrations and the Fed. The recovery was destined to be long and difficult. But expectations for a sharp recovery in the past year-and-a-half were overly optimistic and hence unlikely to be fulfilled, leading to disappointment. With a new and unknown configuration in Congress, and with members of a new economic team on board, the leadership challenge will be to build a consensus around a medium- and long-term recovery strategy, with an intense focus on growth and employment.

On the fiscal side, advanced countries, including the United States, have dug themselves into a fairly deep hole. It is not yet a trap of the type one finds in Greece, where the restoration of fiscal balance is probably inconsistent with restoring growth, without a restructuring of public debt. But it needs urgently to be addressed. It will be difficult and painful. The limited fiscal resources that are available need to be focused on factors that affect competitiveness in the tradable sector, a key component of restoring growth and employment. That means forgoing some government services.

On the positive side of the ledger, the restoration of household balance sheets is slow but under way: it doesn't take forever. Barring another major downturn in housing values, domestic consumption will start to come back, not to pre-crisis levels, but enough to expand employment, stimulate business investment and begin to contribute to growth.

The best forecast, I think, is a bumpy and difficult journey to a new normal. That means volatile capital markets, abnormally high uncertainty, high unemployment declining gradually, and a non-negligible risk of another downturn. The journey is pretty much set. But the destination, three to five years out, is not pre-determined. It ranges from an extended period of slow growth and high unemployment, to a restoration of sustainable growth. Policy and investment choices now will affect the dynamism of the economy by then. These are complex choices and the answers are not simple, obvious or clear-cut. Persistence, pragmatism, and some willingness to experiment will help along the way. The answers will not be found in a highly polarised political environment engaged in a debate about the appropriate role and size of government.

Is this the direction policy will take? Hopes and expectations are not always the same. On the latter, it is too soon to know.