Economic Notes: When the Facts Change
8/17/2009
By Patrick O'Keefe, Director of Economic Research, J.H. Cohn
“When the facts change, I change my mind. What do you do?” - John Maynard Keynes
At its August meeting, the Federal Reserve’s policy arm observed that “economic activity is leveling out” but “is likely to remain weak for a time.” Accordingly, it retained its commitment to low rates, high liquidity, and targeted lending, a policy that Fed Chair Ben Bernanke characterizes as “highly accommodative.” The full statement is available here.
The Fed’s decision had one supremely redeeming virtue: there was no alternative. To begin with, the evidence of stabilization (i.e., “leveling out”) remains tenuous. But even if the data were more robust, stabilization at extraordinarily low levels is acceptable only as an alternative to continued deterioration.
More relevant, however, is that the primary impetus for the current policy mix was not mitigation of an economic downturn, but rather preemption of a financial meltdown – and its apocalyptic implications.
It was the meltdown, not a slowdown, that required the Fed to launch special facilities, expand currency swaps, and double its balance sheet. The meltdown persuaded a reluctant Congress to provide Treasury with a $700 billion gift card called TARP.
The Fed began aggressively cutting rates in response to the Credit Crisis that erupted in August 2007 – well before the economy fell into recession – and undertook several dramatic (some would say radical) actions in response to the Panic of 2008, which was spawned by the nearly simultaneous collapses of Lehman, AIG, and Reserve Primary.
After almost a year, the Panic of ‘08 has dissipated and the financial system is out of the ER. It remains in intensive care, however, sustained by the Fed’s liquidity facilities and government guarantees.
Nevertheless, attention has turned to the “exit strategy” whereby the Fed will shift to a more conventional posture. Described in numerous speeches containing elaborate explanations, the strategy comes down to one word: incrementalism (i.e., tactical adjustments as conditions warrant).
That approach may not be as elegant as policy wonks might like, but it is the only viable option. There was no “entrance strategy,” no grand plan on how the Fed – abetted by Treasury and FDIC – would nationalize risk (not risk takers) by extending a multi-trillion-dollar safety net to the financial system.
Instead, policymakers met “unprecedented” conditions with “unprecedented” solutions. From the beginning of the Credit Crisis of ’07 through the Panic of 08’s frenzied peak, as the global financial system suffered serial seizures, policymakers applied theory to reality – and made adjustments on the fly.
Like an episode of TV’s House, the early part of the drama involved hastily crafting responses to rapidly deteriorating conditions. The doctors focused on saving the patient rather than debating its future.
They experimented and, eventually, their combined treatments stopped the downward spiral. The meltdown, with its dire implications for the broader economy, was averted.
Now, two years after the Credit Crisis of ’07 began, there are indications that credit markets have regained their balance, including: diminished use of at least some of the Fed’s facilities; and declines in key credit spreads (e.g., Libor-OIS and the TED Spread) which are tipping renewed confidence within the financial markets.
The progress has been significant, but is not yet sufficient to suggest unwinding the array of interventions that undergird today’s markets. The halo effect of government guarantees and facilities is invaluable. Even where their use is low or declining, their presence bolsters systemic confidence, which sustains credit flows at levels higher than they would otherwise be.
In that context, incrementalism is the strategy du jour—but it risks interfering with longer-term recovery.
As both the economy and the financial system stabilize, albeit at sickly levels, their paths to full health diverge.
On the one hand, the financial sector (which involves far more than the Stress-Tested Too-Big-to-Fail-Twenty) still needs to recapitalize and restore asset quality. Therefore, credit will be less readily available and more expensive than in the past. And, at the same time, rising public sector borrowing will command a larger share of the market.
On the other hand, however, economic expansion will require renewed spending and investment by businesses and households. For them, restricted credit at higher costs will deter borrowing, thereby constraining their spending and investment.
This divergence is not irreconcilable. It is what markets do invisibly, using prices to allocate resources (including credit)—within an established policy framework.
The current framework is anything but established, however. It was cobbled together to halt a meltdown and fulfilled that purpose. But longer-term growth requires something more coherent, something more than salary caps and bigger bureaucracy.
The fundamental issues involve the degree to which risk is to be socialized and, consequently, capital allocation nationalized. They are not “either/or” choices, but rather involve a range of options. On those, the facts have changed but not the minds.
If long-term stability is to be regained, the minds—and policies—must change.
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The statements, opinions, and conclusions contained herein are based solely upon the author’s own studies, research, and personal experience. Neither J.H. Cohn LLP nor the author makes any representation or warranty as to the accuracy or completeness of this information. J.H. Cohn LLP and the author expressly disclaim any liability for any loss or damage which may be incurred, of any kind whatsoever, as a result of or arising from the use of any of the information contained herein or reliance on the accuracy or completeness of it.