The Best Monetary Policy Is Strict Financial Regulation

On Wednesday, in her first speech on monetary policy, Janet Yellen, the new Chairwoman of the Federal Reserve, pointed out a discouraging paradox: In recent years, private-sector forecasters have been surprisingly accurate at forecasting changes in the unemployment rate, but they have been equally inaccurate when forecasting changes in the federal funds rate, the baseline interest rate controlled by the Fed.

Since interest rates supposedly have a strong effect on unemployment, how can forecasters be so right about unemployment if they’re so wrong about interest rates?

Three economists at the Bank of International Settlements — Morten L. Bech, Leonardo Gambacorta, and Enisse Kharroubi — have been studying this question, and coincidentally their results were published this week in the journal International Finance.

Bech and his colleagues amassed a dataset of interest rates and economic output for 24 industrialized countries from 1960 to today. Over that time period, these countries experienced 78 recessions, of which 34 were the result of financial crises like the one we experienced a few years ago. In each recession, the BIS economists measured how much the central bank lowered interest rates to stimulate recovery — and then how long it took for the economy to recover its lost output.

Unsurprisingly, they found that “normal” recessions — the ones without a financial crisis — were much less severe. On average, they resulted in an output loss of 1.9 percent, which it took the country 3.8 years to recover. Financial crises, on the other hand, resulted in an output loss of 8.2 percent, which it took 5.1 years to recover.

Monetary Policy in Different RecessionsWhat was perhaps more surprising was the fact that “accommodative” monetary policy — i.e. lowering interest rates — had no effect on the economy after a financial crisis. This wasn’t the case with normal recessions. Typically, the more the central bank lowered the interest rate, the faster the economy recovered its lost output. But not so with financial crises.

In times like these, interest rates simply don’t matter as much as they normally do.

That doesn’t sound like good news for Janet Yellen. What’s a central banker to do?

Fortunately, the BIS economists did find one thing that accelerated recovery from financial crises: private-sector deleveraging. After a normal recession, it doesn’t seem to matter whether households and firms pay down their debt, but after a financial crisis, it significantly speeds up economic growth.

As luck would have it, the Federal Reserve has a tool at its disposal that can reduce the economy’s reliance on debt. It’s called the “capital requirement,” and it refers to the difference between what a bank owns and what it owes.

When a recession strikes, asset prices fall, and since banks own a lot of assets, their value goes down. If they go down too much, they can fall below what the bank owes to its lenders and depositors, meaning it’s basically bankrupt. It doesn’t own enough to pay what it owes.

So the Fed sets a minimum capital requirement. The more capital a bank is required to have, the more it has to own relative to what it owes. It’s a buffer. The bigger the buffer, the more room asset prices have to fall before the bank becomes bankrupt.

Unfortunately, banks don’t like high capital requirements. They want to rely on debt. Why use your own cash when you can use somebody else’s cash? Lower capital requirements are cheaper — but they’re also more dangerous because it’s easier to go bankrupt when you owe so much relative to what you own.

Banks argue that high capital requirements restrain lending because they can’t borrow as much debt to fund their loans, but another paper published in the latest issue of International Finance debunks this myth. In it, the German economists Claudia M. Buch and Esteban Prieto study the behavior of German bank lending for the past 44 years, and they find that banks with higher capital actually issue more business loans.

This doesn’t come as a surprise to those of us who understand how banks actually operate. They don’t lend based on how much debt they can borrow. They lend based on how many loans they can sell. The more, the better. The only question is, will they fund the loans with cash or debt?

Janet Yellen may have her work cut out for her in this post-financial-crisis economy, but there is a way to stimulate the economy and prevent future crises. It all starts with financial regulation.


This op-ed was published in today’s South Florida Sun-Sentinel and Huffington Post.

The Fault Lies Not in the Stars But in Our Politicians

As I predicted on this page at the beginning of the year, the housing market has turned the corner.

The Zillow Home Value Index experienced the first year-over-year increase since 2007, the fourth consecutive month of increasing value. The Federal Housing Finance Agency also reported the fourth straight month of rising home prices in May.

At their current rate, new home sales are on track to beat last year’s numbers by 17 percent. Compared to a year earlier, the inventory of unsold existing homes has been declining for sixteen consecutive months. In fact, this month we saw the biggest drop in inventory ever reported.

Last month, housing starts reached their highest level since October 2008. This month, home builder confidence reached the highest level since March 2007. Foreclosures in distressed markets like California have reached their lowest level since 2007.

In other words, our long national nightmare is over.

And yet, our malaise has only deepened. Output growth is weak, unemployment remains stuck at 8.2 percent, and the twin engines of growth — exports and manufacturing — have stalled. If the cause of our discontent has reversed course, what fresh hell is holding us back?

Some of the blame belongs to the European Union, whose weakness has driven the euro down, making the U.S. dollar more expensive. As a result, exports have flatlined, along with the manufacturing sector that depends on them.

But the real sand in the wheels has been the cutbacks in Washington.

No, that’s not a typo. Despite all the news you’ve heard about the big bad budget deficit, the truth is that the government has been retreating, leaving the private sector to fend for itself.

In the two and a half years since the end of the recession, government spending, adjusted for inflation, has fallen by 2.6 percent. Government purchases have also fallen by 2.6 percent. Government employment has fallen by 2.7 percent.

Compare that to the two and a half years after the end of the 1982 recession, over which Ronald Reagan presided. By this point in Reagan’s term, government spending had increased by 10.2 percent, government purchases had increased by 11.6 percent, and government employment had increased by 3.1 percent.

Or we could compare to George W. Bush. From 2000 to 2007, government spending grew faster than it has from 2007 to 2011.

Any way you measure it, government spending growth has been very weak.

From 1980 to 1984, real government spending increased over 14 percent. From 2008 to 2012, in contrast, it has increased only 6 percent. And, since the beginning of last year, it has turned negative. In fact, this year, real government spending per capita is falling faster than it has since the aftermath of the Korean War.

But the real bloodbath is yet to come. On January 1st, $110 billion in automatic spending cuts are scheduled to kick in, followed by over $1 trillion more in spending cuts and tax increases over the next decade — unless, of course, Congress enacts a new law to postpone them.

Republicans are particularly concerned about this so-called “fiscal cliff,” not only because they abhor tax increases, but especially because half of the spending cuts will come from the Pentagon. Democrats are equally concerned about the possible extension of the Bush tax cuts for the rich, which are scheduled to expire at the end of the year.

So Democratic Senator Patty Murray made them an offer: We will agree to postpone the “fiscal cliff” if you will agree not to extend the Bush tax cuts for household incomes above $250,000.

Senate Democrats held up their end of the bargain on Wednesday, passing a bill to extend all the Bush tax cuts below $250,000. But Washington insiders say that the bill is as good as dead in the Republican-controlled House.

House Republicans, it seems, are determined to hold the economy hostage to the selfish interests of the rich — yet again.

But it doesn’t have to go down like this. Weak economic growth is not a fait accompli. The fundamentals of our economy are improving. The recovery will accelerate…if the government steps up like it did in previous recoveries.


This op-ed was published in today’s South Florida Sun-Sentinel.

Government Isn’t the Problem…and Austerity Isn’t the Answer

I have a friend who witnessed about half of the Supreme Court arguments on the Affordable Care Act. When he walked out of the courtroom, he wasn’t surprised to find a sea of people protesting the law. What did surprise him was how many of the protest signs were anti-Europe. Apparently, the protestors were worried that universal health insurance was the path to “becoming European” and all the nefarious consequences that implies.

If asked for their opinion on government spending to stimulate the economy, I imagine they’d give roughly the same answer.

But the truth is that fiscal irresponsibility has little to do with Europe’s current crisis.

Just before the recession hit, the European governments with the highest public social spending (relative to the size of their economy) were France, Austria, Belgium, and Germany — none of the so-called “PIIGS” nations that are in trouble. In fact, many conservatives have anointed Germany as the role model that its neighbors should emulate.

Even if you measure all government spending in the middle of the crisis, there is no correlation between a country’s public spending and the interest rates on its sovereign debt (which is the key indicator of financial distress).

From 1999 to 2007, the European government with the highest budget deficit (again, relative to economic output) was Slovakia, hailed by conservatives for its flat tax. France’s budget deficit was about as big as Italy’s, and Germany’s was close behind. Spain and Ireland actually had budget surpluses.

Besides, if government spending were the problem, then the crisis should be over by now. The EU and the IMF have forced the PIIGS nations to slash public expenditures — and the recession has only gotten worse.

Compare that strategy with what happened in the United States, where we took the opposite approach and increased public expenditures.

In the fourth quarter of 2008, real GDP contracted at an annual rate of 8.9 percent in the U.S. In January 2009, nonfarm employment declined by over 800,000. That was the lowest point both statistics — growth in economic output and jobs — would reach.

On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (ARRA), better known as the “stimulus” package.

In the first quarter of 2009, real GDP contracted by 6.7 percent. In February 2009, nonfarm employment losses were closer to 700,000. The recession was clearly not over, but the bleeding had slowed.

On March 6, 2009, the Dow Jones reached its cyclical low of 6,626.94. The next day, it began a strong recovery.

By the third quarter of 2009, when the stimulus money was starting to be spent, the economy was growing again. By March 2010, job growth was positive again. (Job growth always lags behind economic output.) By February 2011, two years after Congress passed the ARRA, the Dow Jones cleared 12,000.

Clearly, the ARRA was the turning point. Its passage was the beginning of the end of the Great Recession.

Coincidence? Perhaps.

But isn’t it odd that none of the critics’ predictions came true? They warned that interest rates would skyrocket with the government borrowing so much money. Instead, interest rates plummeted. They warned that inflation would soar. Instead, it’s been low and stable.

And that’s not all. Several economists have measured the effect of the stimulus since it was spent. Two Dartmouth researchers, for example, compared jobs growth in each state and county to the amount of stimulus funds spent in that state or county. They found that every dollar spent on the poor yielded two dollars in increased economic output, and every dollar spent on infrastructure yielded $1.85 in output.

Another study compared jobs growth in each state to the amount of federal Medicaid matching funds spent in that state. They found that each dollar spent yielded two dollars in output. A similar study found that the ARRA “created or saved about 2 million jobs in its first year and over 3 million by March 2011.”

So it’s no surprise then that Europe continues to flounder while America continues to grow. You can’t beat a recession by cutting government spending. Even Mitt Romney said so.


This op-ed was published in today’s South Florida Sun-Sentinel.