Part 6 (1/2)

But the collapse of that famous firm did more than anything else to focus the minds of policy makers on the reality that the risk of another Great Depression loomed. At the end of 2008 they looked into the abyss and got religion. They started deploying all the weapons in their a.r.s.enal. Some tactics, like cutting 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 names of these tactics-”quant.i.tative easing,” ”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; some did not.

Nonetheless, their collective effect arguably prevented the Great Recession from turning 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. .h.i.t 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. Far more than almost any living economist, 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 Friedman and Anna Jacobson Schwartz, whose writings he first encountered in grad school. As we saw in 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 blame for the disaster. According to this interpretation, the Fed's inaction and inept.i.tude not only failed to prevent the unfolding disaster but even contributed to the problem. Bernanke elaborated on that thesis, showing how the consequent collapse of the financial system threw sand in the gears of the larger economy, dragging 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 famously turned to the elderly man and said, with regard to the Great Depression: ”You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

This was the man in charge of monetary policy when the crisis. .h.i.t. Not surprisingly, he saw events through the prism of what had happened nearly eighty 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 summer of 2009, ”I was not going to be the Federal Reserve chairman who presided over the second Great Depression.”

To that end, Bernanke revolutionized monetary policy, directing a stunning series of interventions into the financial system that even today few people understand. Some of these moves Bernanke had antic.i.p.ated making; others he developed as the months pa.s.sed and the threat of deflation and even a depression increased. They ran the gamut from conventional monetary policy-slas.h.i.+ng interest rates to zero, for example-to unprecedented measures heralding a ma.s.sive 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 economics they raise a host of unsettling issues. Aside from the difficulty of scaling back Bernanke's policies once they're in place, many of them may prove conducive to moral hazard on a grand scale. The Fed, in its rush to prop up the financial system, rescued both illiquid and insolvent financial inst.i.tutions. That precedent may be hard to undo and, over the long run, may lead to a collapse of market discipline, which in turn may sow the seeds of bigger bubbles and even more destructive crises.

No less problematic is the fact that some of Bernanke's monetary policies infringe on the traditional fiscal powers of elected government-namely, the power to spend money. In the recent crisis, the Fed pushed the statutory envelope, a.s.suming various powers, implied and otherwise, to swap safe government bonds for toxic a.s.sets and, more radical, to purchase toxic a.s.sets and hold them on its balance sheet. Such measures, even if they prove effective, amount to an end run around the legislative process.

Bernanke's response, orchestrated by himself and other central bankers, offers a glimpse of the unorthodox ways in which monetary policy can be used-and perhaps abused-to prevent a crisis from spiraling 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 economy would emerge from a recession, grow, and eventually boom; the Federal Reserve would then begin to bring the cycle to a close by hiking interest rates to keep inflation in check, and more broadly, to keep the economy from overheating. Inevitably, 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 economists call an exogenous negative supply-side shock. All three times, a geopolitical crisis in the Middle East triggered a sudden rise in oil prices that sparked inflation. Here too, to control rising prices, the Fed moved interest rates higher, after which the economy started to contract.

Whatever their causes, these various contractions would inevitably moderate inflation, without eliminating it altogether. The fall in output or the gross domestic product-typically a single percentage point or two-led to unpleasant but tolerable increases in unemployment and the familiar hards.h.i.+ps of a recession.

In some instances, the economy would grow again of its own accord; in others, policy makers facilitated a recovery by resorting to a time-honored tool: they would cut interest rates, effectively making it cheaper for households and firms to borrow money. This would nudge people to spend more, driving up demand for everything from houses to factory equipment. Cutting interest rates often had the added effect of driving down the value of the dollar, making exports more attractive, making imports more expensive, generating demand for domestic goods, and contributing to an eventual recovery. Fiscal stimulus was also used to restore growth.

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 Islamic Revolution, the Federal Reserve used high interest rates to slay inflation, resulting in a far more unpleasant recession. While brutal, that campaign proved successful and set the stage for the much-celebrated Great Moderation. As a consequence, recessions in 1991 and 2001 lasted a mere eight months each, and while these downturns brought pain aplenty, they ended with renewed growth and optimism, thanks in part to varying doses of monetary easing, 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 moderated but in some cases registered declines for the first time in fifty or sixty years. This was deflation, a phenomenon that unnerved policy makers across the ideological spectrum. Its recurrence ”gives economists chills,” reported The New York Times in the fall of 2008. The following spring Bernanke explained, ”We are currently being very aggressive because we are trying to avoid . . . deflation.”

To the uninitiated, the fuss seemed a bit mystifying. After all, aren't falling prices a good thing? Consumer goods cost less; people can buy more with every dollar they own; what's not to like? In fact, in a handful of episodes small, steady rates of deflation have gone hand in hand with robust economic growth, as technological advances drove down the price of goods. Between 1869 and 1896, for example, the spread of railroads and new manufacturing techniques helped push down prices by some 2.9 percent a year. At the same time, despite recurrent crises, the economy grew at an average annual rate of 4.6 percent.

This episode remains something of a curiosity for economic historians because deflation is generally not compatible with economic growth. Why? In most cases, deflation isn't caused by a technological revolution; it's caused by a sharp fall of aggregate demand relative to the supply of goods 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 economy. It can deter consumers from spending on big-ticket items: buying a car or a house, for example, becomes a bit like catching a falling knife. Similarly, a factory contemplating some capital investments may prefer to remain on the sidelines until prices stop falling. Unfortunately, postponing spending, far from stimulating economic growth, does precisely the opposite.

A bout of deflation born of a financial crisis is of a different order altogether and may be far more dangerous and destructive. Such bouts were relatively common in the wake of the perennial crises of the nineteenth century, then became much rarer in the twentieth. While deflation accompanied the global depression of the 1930s, it largely disappeared after that watershed event. Only in the 1990s did it resurface, first after the collapse of j.a.pan's a.s.set bubble, and then during the brutal recession that hit Argentina in 1998-2001.

During the recent crisis, the prospect of this kind of deflation was what gave economists the chills. They knew well that its ill effects could ramify throughout the economy. Even if it doesn't end in an outright depression, deflation can suffocate growth for years, leading to a condition that might best be described as stag-deflation, in which economic stagnation and even recession are combined with deflation. In such a condition, the usual tools of monetary policy cease to have much effect.

Irving Fisher was one of the first economists to understand the dynamics of deflation. While Fisher remains infamous today for claiming, shortly before the market crashed in 1929, that stock prices would remain on a ”permanently high plateau,” he redeemed himself by subsequently articulating a compelling theory of the connection between financial crises, deflation, and depression, or what he called the ”debt-deflation theory of great depressions.” Put simply, Fisher believed that depressions became great because of two factors: too much debt in advance of a crisis, and too much deflation in its wake.

Fisher began by observing that some of the worst crises in American history-1837, 1857, 1893, and 1929-followed on the heels of an excessive acc.u.mulation of debt throughout the economy. When the shock came-the stock market crash of 1929, for example-margin calls led to frenzied attempts to pay down debt. Fisher believed that this rush to liquidate debt and stockpile liquid reserves, while rational, damaged the health of the larger economy. As he explained in 1933, ”The very effort of individuals to lessen their burden of debts increases it, because of the ma.s.s effect of the stampede to liquidate . . . the 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 remaining debt burden by 40 percent.

Why? The rush to liquidate a.s.sets 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 withdrawals would 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 a.s.sets across the board would drift downward, triggering a commensurate decline in the net worth of banks and businesses holding those a.s.sets. More fire sales and more deflation would result, leading to less liquidity in the markets, more gloom and pessimism, more h.o.a.rding of cash, and more fire sales.

The resulting deflation would have perverse consequences. As borrowers moved to pay off their debts (and as aggregate demand for goods 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 remaining debt. In other words, deflation increases the real value of nominal debts. Instead of getting ahead of their debts, people fell behind. Fisher called this the ”great paradox”-the more people pay, the more their debts weigh them down.

This is debt deflation. To understand it better, let's consider its counterpart, what might be called ”debt inflation.” Imagine 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 nominal, or original, rate of interest. If inflation goes 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 princ.i.p.al 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 more extreme example. Imagine that you take out that same $100,000 loan-and inflation runs completely out of control. Prices and wages soar to astonis.h.i.+ng levels. It used to cost a dollar to buy a loaf of bread; now it costs a thousand dollars. At the same time, a minimum-wage job that once paid peanuts now pays several million dollars a year; a ”good” job pays a hundred million. Now go back to that $100,000 debt you incurred. It's still sitting there, denominated in those older, more valuable dollars. The amount of the princ.i.p.al has not changed with inflation. It's now much easier to pay off your loan. Heck, it's nothing more than a month's worth of groceries.

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. That means you're effectively paying 7 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 were when you incurred the debt in the first place. Unfortunately, even though each dollar is worth more, you now have fewer of them because your wages have declined.

The upshot of debt deflation is that debtors-households, firms, banks, and others-see their borrowing costs rise above and beyond what they originally antic.i.p.ated. And during a major financial crisis-with rising unemployment, growing panic, and a general unwillingness to lend-anyone who owes money has much more difficulty making good on his debt or, alternatively, refinancing it on less onerous terms. Investors shun risky a.s.sets, seeking liquid and safe a.s.sets like cash and government bonds. People h.o.a.rd cash and refuse to lend it, which only exacerbates the liquidity crunch. As credit dries up, more and more people default, feeding the original 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 traumatized and inspired Irving Fisher, the collapse was unprecedented. From peak to trough, 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. Unemployment surged to close to 25 percent. And deflation? Prices fell off the cliff. A dozen eggs that cost $0.53 in 1929 cost $0.29 in 1933, a drop of some 45 percent. Comparable declines. .h.i.t everything from people's wages to the price of gas.

It's no surprise that Fisher's vision was a dark one. As he wrote from the depths of the crisis in 1933, ”Unless some counteracting cause comes along to prevent the fall in the price level, such a depression . . . tends 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 might ultimately stabilize-after ”almost universal bankruptcy”-he thought 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 a.s.sumes 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 almost everything else with financial crises, engineering a reflation-or to put it more baldly, creating inflation-is not as simple as it seems. Once a deflationary spiral has gained momentum, conventional monetary policy tends not to work. Nor does it work against 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 why, we must examine how central banks exercise control over the money supply, interest rates, and inflation.

In the United States, the Federal Reserve primarily controls the money supply through ”open market operations”: that is, it can wade into the secondary market and buy or sell short-term government debt. When it does so, it effectively adds or removes money from the nation's banking system. It thereby changes 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 number of levels of the economy, and manipulating it is one of the most effective tools at the disposal of the Fed.

Here's how it works. Let's say that the Fed is worried about inflation and wants to keep the economy from overheating. The Fed therefore goes out and sells $10 billion worth of short-term government debt. By doing so, it effectively removes money from the banking system. Why? Because the purchasers of the debt have to write checks drawn on their respective banks, which the Fed then cashes and keeps. The banking system and the larger economy are now out $10 billion. Moreover, because banks use every dollar on deposit to create many more dollars' worth of loans, the real hit to the banking system-and by extension, the money supply-is something approaching $25 billion or $30 billion.

In this way, the Fed has tightened the money supply and made credit harder to obtain: it has effectively raised the cost of borrowing. Money, like any other commodity, responds to the laws of supply and demand, and now that the supply is lower, borrowing money costs more. Interest rates, in other words, go up because lenders can now command a higher rate. Whenever the media report that the Federal Reserve has ”raised” interest rates, it hasn't literally done so; rather, it has ”targeted” a higher interest rate-the Federal funds rate-via these open market operations.

Now let's imagine that the Fed is no longer worried about inflation; in fact, it's worried about the fact that the economy, instead of overheating, is headed toward a recession. The Fed therefore sets a lower target for the Federal funds rate and floods the economy with money, buying up short-term government debt. Where does it get the money? It creates it out of thin air. The Federal Reserve effectively writes a check for $10 billion and gives it to the sellers of government debt. These sellers deposit the money they've received from the Fed in various banks. Now those banks can use it to make loans worth several times that amount. Money is suddenly more available, and as a consequence, credit is easier to obtain. More to the point, it's cheaper: the net effect of adding money to the economy is that the Federal funds rate will fall, as will interest rates generally.

This is what takes place during normal times. A liquidity trap, by contrast, is not normal. It's what happens when the Fed has exhausted the power of open market operations. That dreaded moment arrives when the Federal Reserve has driven the Federal funds rate down to zero. In normal times setting that rate would pump plenty of easy money and liquidity into the economy and spur wild growth. But in the wake of a financial crisis, cutting interest rates to zero may not be enough to restore confidence and compel banks to lend money to one another. The banks are so worried about their liquidity needs-and so mutually distrustful-that they will h.o.a.rd any liquid cash rather than lend it out. In this climate of fear, the policy rate may be zero, but the actual market rates at which banks are willing to lend will be much, much higher, keeping the cost of borrowing expensive. Because it's almost impossible to drive policy rates below zero-you can't make banks lend money if they'll be penalized for doing so-policy makers find themselves in a serious quandary. They're in the dreaded liquidity trap.