Once Lehman Brothers failed, we were in a different world. Large global banks simply stopped doing business with each other, fearful of counterparty risk. This was a frightening time, much worse than the general public seemed to appreciate at the time. The Federal Reserve and other central banks lowered short-term interest rates and made other efforts to promote liquidity in a number of financial markets (asset-backed commercial paper, the money markets, etc.). The Fed also began its credit easing program, ultimately buying $1.25 trillion in mortgage-backed securities and $300 billion in long-term Treasury securities. Some observers feared that the Fed’s moves would stoke inflation. However, inflation in the U.S. has fallen, not risen, since these steps were taken. The Fed does not take these efforts lightly. Considerable effort has been made this year to clear the exit paths, should the economy pick up more substantially and inflation start to rise.
The bank rescue was not well received politically, but was an essential step in stabilizing the financial system. Without it, the economy would have weakened a lot more than it did.
The $800 billion federal fiscal stimulus, approved a year and a half ago, was also controversial. Presumably, the President’s Council of Economic Advisors had pushed for a larger plan, around $1.2 trillion, but administration officials did not think that was feasible, following on the heels of the unpopular bank rescue package. In addition, the stimulus plan was made less effective to get three Republican senators to vote for it (that is, added government spending was replaced with tax cuts, which are more likely to be saved than spent in a severe economic downturn). Fiscal stimulus was meant to be large, targeted, and temporary, functioning like a bridge, supporting growth while the private sector recovers. In hindsight, that bridge likely needed to be longer. Some of the federal fiscal stimulus was offset by contractionary policies in state and local governments. Evaluating the effectiveness of the stimulus is not entirely straight forward. Counterfactuals (how much worse would things have been if we hadn’t had the stimulus) are based on models which implicitly assume that such policy is effective. Yet, in 1Q09, we were losing 750,000 private-sector jobs per month. This year, we’ve seen a return of private-sector job growth. That turnaround might have happened by itself, but the fiscal stimulus seems like a more likely explanation.
In a “typical” recession, consumers postpone purchases of homes and motor vehicles. As the economy recovers, you get a slingshot effect as that pent-up demand comes back into play. However, that’s not going to happen this time. The key element in this recovery is time. Fiscal and monetary policy can help limit the downside, but there’s no miracle cure. Ultimately, the recovery is dependent on the private sector.
Copyright (c) Dr. Scott Brown, Raymond James
