Chapter 2
The Federal Reserve, Congress, and the Use of Context in Economic Policy*
This chapter discusses where context is currently used, such as Federal Reserve policy, and where context isn't used or, worse, is misused, such as in formulating tax policy and producing budgets.
In the previous chapter, we made the case that neither individuals nor executives look at the world the same way under all sets of economic circumstances. That we had to argue that context matters when it comes to the economic decisions of the average person is also a commentary on the way the world of economics sometimes works. It is just as odd that there are some who believe businesspeople think the same way whether their companies are booming or collapsing. But that is the way it is. We know, though, that context does matter to households and businesses.
But the reality that decisions have to be different given the context in which they are made is not limited to individuals and executives. Context is probably the most important concept in all aspects of the economy, especially public policy. That includes fiscal policy, which is the result of the many strange ways that Congress and the president come to an agreement on spending and taxing levels, as well as monetary policy, which is made by the Federal Reserve.
Public Policy Spreads a Wide Ripple
The importance of public policy is that it has a major impact on businesses and households. A healthy, vibrant private sector makes the U.S. economy hum, which even the most government-oriented person has to admit. Businesses create the jobs and the wealth in the economy.
But public policy has a major effect on how corporations operate. Whether it is through regulation, spending, and tax policies or the management of interest rates, the manner in which the government and Federal Reserve operate influences the ability of companies to grow and thus create the economic conditions where unemployment will be low and income and wealth gains strong.
Unfortunately, not every decision made by our elected officials or monetary authorities have the outcome that is desired. Indeed, fiscal and monetary policy sometimes winds up doing more harm than good. Whether they were implemented with good intentions or to impose a political or economic point of view does not matter: bad policy still creates real problems.
The reason that some policies, even those that appear sensible on the surface, miss the mark usually stems from a failure to develop and implement them in the context of where the economy is and where it is going. That is not to say we don't want the government or the Federal Reserve to try to help. We do. But if context is secondary to economic or political philosophy it may be better for our policy makers to just stand there and do nothing.
Consider the debates and disagreements about the budget deficit that have been going on for decades. These have not been trivial arguments over whether the government should or should not spend more than it takes in. They are discussions about the priorities of government policy.
More recently, the political parties have gone to war over the need or desirability or necessity of “balancing the budget” or reducing the deficit. Some members of Congress have simply refused to vote for any budget that does not contain a reduction in the deficit. Others argue that deficit reduction should be done over time and fight for every penny of spending.
But the effectiveness of any decision on budget policy will depend on the shape of the economy at that time. Nothing brings that more clearly than a debate on February 26 and 27, 2013, between Federal Reserve Chairman Ben Bernanke and members of Congress when the Fed chairman testified before Congress as part of the semiannual Humphrey-Hawkins hearings to discuss monetary and economic policy.
The Fed chairman's testimony preceded the March 1 implementation of automatic budget cuts because Congress and the White House could not agree on ways to reduce the federal budget deficit. As a result of the impasse, $85 billion in cuts—known in Washington as sequestration—were scheduled to take place at the Department of Defense as well as such agencies as the Federal Aviation Administration (air traffic controllers), Department of Agriculture (meat inspectors), and the Commerce Department (National Oceanic and Atmospheric Administration and economic statistics), among other government agencies.
Since most entitlement programs and pension plans were excluded from the reductions, the impacts on the remaining programs were significant.
Bernanke, in his prepared remarks, thought the timing of the automatic spending cuts (which took place) was bad. Instead, he told lawmakers that they should consider replacing the near-term cuts with polices that reduce the federal deficit more gradually in the near term, but more substantially in the longer run.1
“Such an approach could lessen the near-term fiscal headwinds facing the recovery—while more effectively addressing the longer-term imbalances in the federal budget,” explained Bernanke.
Earlier in his testimony, he pointed out what seems logical, cutting spending and reducing the deficit, might not turn out to be the case in the real world: “. . . besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run.”
But some fiscally conservative Republican members of the congressional committees pushed back irrespective of whether the timing of the cuts was good or bad.
At the Senate hearing, several senators took issue with whether there was a problem with cutting spending and whether the sequestration would hurt the economy. They argued that the cuts were necessary as a signal that Congress would deal with the budget deficit. That could help growth, if markets and businesspeople wanted cuts right now rather than over time.
Senator Toomey felt that even if the spending restrictions were implemented, nothing significant would happen to economic growth.
In the House, some of the representatives were also skeptical of the Fed chairman's comments.
Rep. Randy Neugebauer of Texas told Bernanke, “I found it was kind of interesting when you said that we need to take a slower approach to deficit reduction and that the economy, you know, couldn't withstand a major reduction in government spending. Don't you find that a little disconcerting that we have let the government become so much of the economy that cutting our deficit so that we don't mortgage the future of our children and grandchildren—should be even a consideration in deficit reduction?”2 The Fed chairman's advice met with an even larger outcry from Republican Rep. Sean Duffy of Wisconsin who worried about rising interest rates once the Fed stopped being so accommodative. This could cause the federal budget to rise as interest payments climbed.
“So, we'd have an additional $200 billion to $300 billion of additional dollars going to service our current debt. Fair to say?” asked Duffy.
“That's right,” replied Bernanke.
Suddenly, Duffy, with a hand going around and around, said he could see lights going off, sirens blaring over the prospect of additional trillions of dollars needed over 10 years to service the nation's debt as interest rates rise.
“And I'm almost setting a proverbial can on my counter and you're kicking it, saying, ‘Listen, don't worry about $85 billion in cuts; do it a different day.’”
Pointing to his own chest, Duffy concluded, “I listened to what you are saying and I think you are giving cover to a set of policies that aren't responsible and we are all going to pay the price for the fiscal irresponsibility. And instead of encouraging responsibility, you come in and say, ‘Listen, to cut 2 percent of our budget, you can't do it; it's going to have a great impact on our economy. Mr. Chairman, that doesn't make sense to me.’”
Bernanke replied that the cuts taking place in the spring of 2013, at a time when the economy was growing slowly, would cost a lot of jobs. The Congressional Budget Office (CBO) predicted sequestration could result in the loss of about 750,000 positions.
The prospect of fewer jobs did not seem to faze Duffy very much. Instead, he told Bernanke he thought there was already too much fat in the budget.
“And so on that point, how many jobs are lost if we cut the $27 million that go to Moroccan pottery classes? Or the $2.2 billion in free cell phones? We pay $700 billion (sic) to see how long shrimp can run on a treadmill. I believe we pay for the travel expenses for the watermelon queen in Alabama. There is fat in the budget.”3
Of course, one man's fat is another man's job, and the effectiveness of any decision on budget policy will depend on the shape of the economy at any given time.
Clearly, government spending and taxing decisions, which economists call fiscal policy, cannot be made in an economic vacuum. Yet many still argue that all you have to do to balance the budget is to either cut taxes or raise taxes.
The problem is that there exists a disconnect between spending and taxing decisions and the impact on general economic activity.
We are acutely aware that tax policies affect how much money we have left in our paychecks at the end of the month. Households also clearly recognize that government spending decisions determine whether the roads are paved or filled with potholes. But the next step, relating the paycheck problems and the building of the park up the block to the rate of growth of the economy, is just not there.
So how do Congress and the administration actually figure out the budget?
The View from the Hill
In Congress, the budget process usually starts in late fall and early winter when the individual departments draw up their budgets and receive guidance from the Office of Management and Budget, which is responsible for devising and submitting the president's annual budget proposal.
By mid-January, the nonpartisan CBO has locked in its economic forecast for both the fiscal and calendar years, and by the first week of February the president's budget usually is revealed.
On the Senate side of Congress, the Senate Finance Committee has jurisdiction over tax, trade, and social welfare. The Senate Budget Committee's budget resolution sets the broad parameters for existing and proposed legislation.
On the House side, the Constitution requires all tax legislation to originate with the Ways and Means Committee, which also handles trade, health, and social welfare legislation. The House Budget Committee also tackles broad questions of federal spending and taxation.
In Washington, scores of vongressional staff members work to try to make sure the various committees meet their deadlines and adhere to the law, but a joint budget resolution has not passed Congress since April 29, 2009, and congressional leaders have often bypassed committees.
One former staffer who follows Congress for Wall Street is Pete Davis, who first started working on the Joint Committee on Taxation in 1974 only two years out of the University of Rochester where received a BA in economics. In 1981, he shifted over to the Senate Budget Committee for three years.
When Davis started working on Capitol Hill, he had no expertise in the federal budget. But his knowledge of computers led to his hiring to run the U.S. Treasury income tax model.
Becoming a staffer on the Joint Committee on Taxation put Davis into the center of the budget process.
Congress established the committee in 1921 when the lawmakers realized they needed some expertise to handle the implementation of the modern income tax, which had been created in 1913. At first, the income tax affected only a few very rich people but gradually it started applying to business and then to a larger segment of the population.
The committee, says Davis, became a repository of tax lawyers and economists who did nothing but work on tax bills.
But, Davis says Congress, in its wisdom, was also concerned that there might be some political favoritism in the way the tax laws were applied and some taxpayers might be getting some large refunds that they did not deserve. So, early on, Congress gave the committee the authority to audit any tax refund over a certain amount—an effort that continues to this day.
Congress's concern about budgeting came to the fore soon after Davis joined the committee.
In 1973, President Richard Nixon became upset with what he perceived as Congress's spendthrift ways. He refused to spend money in appropriations bills he had signed. Congress challenged this “impoundment” and eventually reached a compromise with Nixon. The end result was the 1974 Budget and Impoundment Act, which established the modern-day budget process.
To try to avoid making the economic forecast and cost estimates a political tool, the new law established the nonpartisan CBO to support the budget process.
“They have a really good group of outside economic advisers, top economists from Wall Street, and top economists from academia, who meet with them quarterly, and these are some of the least covered news events in Washington,” says Davis. “But they matter because it is the beginning of the budget process.”
Why the Economic Forecast Matters
The economic forecast is critical because it sets the starting line for the congressional budget process. Based on its economic assumptions, the CBO estimates what is termed the baseline, which is basically the amount of spending and revenue current law will produce over the next 10-year period.
A weak economy may mean tax receipts will be lower. In theory, lower tax receipts might be a constraint on spending. An economic forecast showing the economy with more zip might allow more spending or perhaps a tax cut.
“Once you've decided on the economic assumptions and the baseline that goes with those assumptions, you have effectively made most of the policy decisions,” he explains. “And that's why these things are so hotly debated, which is why on occasion the committees will adopt their own modified economics and not the CBO's.”
How can Congress or the administration make economic assumptions that affect the budget?
“When I was on the budget committee and we needed some more money to balance the budget, maybe we decide we're going to have a good year in corporate profits even if the economy is not doing too well,” he recalls. “And, if you have more corporate profits, you have more corporate income tax.”
In 1981, newly elected President Ronald Reagan assumed the economy would boom because of his record-breaking tax cuts, but interest rates would remain low. This became known as the “Rosy Scenario.”
“No macro economist would agree you would have low interest rates with that much growth,” says Davis. “With strong growth you get higher interest rates because there is greater demand for funds.”
But, with low interest rates, Reagan could put together a budget with a low public debt component. This made it easier to argue that the budget was closer to balanced.
Economic Assumptions Matter: The Rosy Scenario
In hindsight, the Rosy Scenario did not play out as advertised. The budget deficit soared, rising from $78 billion in FY1981 to $127 billion the following fiscal year and $207 billion in FY1983.
Comics joked that Rosy Scenario was the highest-ranking woman in the Reagan administration. However, rankled conservatives maintained that the forecasts were simply different from those of the CBO and perhaps not that much different in terms of economic gimmickry than later presidents.4
Davis thinks the battle over Rosy Scenario marked the first time there was serious policy debate over economic assumptions in Washington. “And the media was pretty much of the opinion that Rosy Scenario was a fabrication,” he says. “And, they were right but I can't prove it even though I was on the inside of it.”
Rosy Scenario may have led to a loss of trust in the economic projections, says Davis. “So, thereafter, economic assumptions became a matter of partisan politics.”
In some ways, Davis believes the debate over the economy is skewed in the administration's favor because the various departments are the main source of economic information to Congress. Although few people think the data are politically slanted, the interpretation of the data has a political effect.
For example, major data such as the Labor Department's monthly unemployment statistics and the Commerce Department's releases on the gross domestic product are delivered to the White House the night before they are released to the public. The Council of Economic Advisers quickly writes a summary of the data and an analysis.
“So the administration is the first one to put their spin on the economic numbers,” says Davis. Of course, the opposition political party is quick to respond, issuing their own press releases.
But the importance in terms of economic context is that the economic view of members of Congress is up for grabs. “It's now a debate,” says Davis.
“Prior to 1981 (Rosy Scenario) when the numbers came out, they came out. And the administration would basically put their spin on it, but you didn't get too much debate over the numbers or the economics or what the policy was.”
From his 11 years working on budgets and even more watching the Hill for Wall Street clients, he thinks most members of Congress have a desire to show a balanced budget, which was last done in 2001 under President Clinton. “I can't count the number of times we put out balanced budget resolutions, after which we didn't actually get anywhere near balance, and in fact we went in the opposite direction.”
Despite the members' desire to spend more than the United States collects, Davis says they generally understand economics.
“First of all, they are all lawyers,” he explains. “And these are all smart people, but they have learned from hard political experience that if they accept the basic laws of economics, it will get them unelected. I can't count the number of times when very intelligent people have looked at me as if I were crazy when I told them something I thought was the most plain vanilla, nonpartisan, technically accurate statement you could make about the economy in one way or the other.”
In late 1992, Davis began his own consulting firm, Davis Capital Investment Ideas, which advises clients on what goes on at his old stomping ground. From his perspective of being a part of or watching Washington, he thinks the battle over interpreting economic information—critical to understanding the context of the economy— has become far more intense in recent years.
“Now everything is debated and there is always a lot of spin over what caused any change in employment or economic growth or whatever,” he says.
Does One Policy Fit All?
One of the biggest reasons there is confusion on the part of the public about fiscal policy is that too many of our elected officials have proposed and implemented policies that sound good when put into sound bites but don't stand the test of logic or economic analysis.
If there is one thing that encapsulates the whole absurdity of government policy, it is the view that one policy fits all. On one side you have a whole political point of view that has managed to simplify the world by saying there is a solution to our problems, and it is to simply cut taxes or cut spending. Got a problem with growth, cut taxes. Got a problem with the budget deficit being too large, cut spending. Got a problem with the economy not operating as efficiently as you would like it, cut taxes. Having a bad hair day? Cut taxes. Okay, the last one is pushing it a bit, but you get the point.
In contrast, there is a whole political strategy that takes the exact opposite approach to cutting taxes. Got a problem with growth, spend more. Got a problem with the budget deficit, raise taxes, especially on the wealthy. Got a problem with efficiency, reform the tax code by raising taxes, especially on the wealthy or special interests. Having a bad hair day . . . forget that one.
As we all know, the United States is a consumer nation, and we have built our economy on a thriving middle class that likes to spend money. So the logic is that a tax cut, which gives people more money, translates into more spending. But cutting taxes and having those tax cuts generate large increases in economic activity are two different things.
What we saw after the tax cuts in 2001 and 2009 was that reductions in taxes don't necessarily generate a whole lot more spending. The reason is obvious: While people or businesses may have more funds to work with, when you are worried about the future, you save instead of spend. Especially in 2009, while we were in the middle of the worst recession since the Great Repression, there were not many individuals or business managers who thought that taking the additional funds and going out and buying goods or investing or hiring made a whole lot of sense. Survival, not growth, was the operating plan. Consequently, the money was squirreled away, and the tax cuts did little to increase growth.
The lesson that should have been learned is that tax cuts that are implemented when households and businesses are uncertain about their future have limited capacity to move the economy. However, when the economy is getting better, it is likely that much of the newfound money in the paychecks or the corporate tills will wind up being spent on lots of new things. You have to pick and choose when to cut taxes, and that means context is critical.
The point is that when the our elected officials look at policy, they rarely look at it from the point of view of what will work best given the economic circumstances. Instead, they take a very limited view that their policies always make sense. Can you really argue that cutting taxes doesn't add to growth? Doesn't it make total sense that if you don't have enough money to pay your bills, you need to get more money and the best way to do that is to raise taxes? Well, the answer is “not necessarily,” and that is not something that policy makers like to hear.
The misused concept that tax cuts increase growth has caused some unfortunate decisions on the part of our political leadership. Take the nugget that if you want to reduce the budget deficit, reduce taxes. The logic: Tax reductions get the economy growing faster and increase tax revenues. Using simplistic economic analysis, that actually seems to make sense.
What is wrong with that thinking? Well, it does not take context into account. Even if household purchases and business investment rise, there is no certainty that the added growth will make up for the loss of revenue that result from a tax cut.
What is forgotten is that everyone receives the tax break but not everyone spends more. Yes, growth may improve, but it may not do so by enough to compensate for the lower tax rates. The result would be rising budget deficits, not narrowing shortfalls. Indeed, economic studies have shown that at least over a period of two or three years, just about all tax cuts have led to lower tax revenues.
After the massive tax cuts in 2001 and 2003, projected budget surpluses turned into huge and rising budget deficits. Essentially, the economy did not respond strongly enough to the tax breaks to offset the loss of revenue from lower rates and special tax deals.
The reality is that there is no such thing as a free tax cut. You have to take the good parts, the reduction in taxes taken out of the private sector and the resulting higher spending, with the bad—the loss of revenues—which means you have to balance the two. And the extent of the loss of public-sector revenues and private-sector spending increases will be determined by the decisions of businesses and households, and that will depend on the context of the changes.
Similar discussions can be made about tax increases, spending cuts, and spending increases. While on the surface you would expect a tax increase to slow growth and thus cause deficits to rise, that just may not be the reality. Who gets taxed and how they react to those increases is what matters.
For example, the tax increase on individuals with family income over $450,000 may lead to relatively modest cutbacks in their spending. In contrast, the ending of the payroll tax holiday, which increased taxes on everyone, was a worry. When you raise taxes on lower-income households who don't have the savings to offset the higher taxes, something has to give. Usually, that is spending.
Similarly, spending increases don't necessarily cause the economy to surge. Clearly, there will be more growth as the government buys more goods or services or hires more people. But once the additional government spending ends, there may not be any new private-sector activity that is created to pick up the slack.
The total impact of the spending increases also depends on how the money is spent and what is done with the money by those firms who benefit from the new spending. Do firms hire more people, or do they simply work the employees already on their payrolls more. Companies that are still concerned about the future and that have employees who are underemployed because of a weak economy will not hire lots of additional workers, so the impact on growth will be limited. Finally, if goods and services are purchased from companies that outsource their production to foreign countries, the additional labor growth will occur outside the United States.
As for spending cuts, you need to know what spending is cut before you can even make the first statement about their impacts. A reduction in foreign aid assistance or subsidies for firms might lead to limited cuts in demand for U.S. products. Yet it is also very possible that a tax increase, spending increase, or spending cut could cause large changes in the economy, but that will happen only when conditions warrant it.
While fiscal policy has become a hostage of political theory, where context frequently gets trumped by philosophy, the other side of government action, monetary policy, has generally gone the opposite route—but not all the time.
The direction and impact of monetary policy—the setting of interest rates—is as dependent on the condition of the economy as is fiscal policy. In most cases, the Fed's decision on what to do about interest rates has been entirely a consequence of the monetary authorities' reading of the economic tea leaves.
Examples abound as to how monetary policy has not been held a prisoner of theory, but instead uses theory in a contextual manner. The actions of the Fed in fostering growth once the Great Recession ended and in taming the threat of high inflation in the early 1980s illustrate that monetary policy can be quite flexible.
A Bank Loaded with Economists
How does the Federal Reserve use context to set policy? Economist Bob McTeer got to experience the process firsthand when he became president of the Federal Reserve Bank of Dallas in February 1991.
When McTeer arrived at the Dallas Fed that winter, the U.S. economy was just barely recovering from a recession that was partially caused by the Fed's raising interest rates because of inflation worries and an oil price that had jacked up after Iraq invaded Kuwait in the summer of 1990.
On top of all that, savings-and-loan (S&L) associations that specialized in making home mortgages had cratered, which was particularly affecting the Lone Star State. “In the aftermath of the S&L banking crisis, Texas was undergoing what some people called a credit crunch,” recalls McTeer. “And the officers and directors of the Dallas Fed seemed to be much more aware of that than the rest of the country, and so the Dallas Fed was sort of a leader in the system in being concerned about that and talking about it at system-wide Fed forums.”
McTeer's initial experience at the Dallas Fed illustrates one important way the Fed keeps track of the economy: it uses its 12 district banks and their branches as windows on the national economy.
“At each meeting of the Reserve Banks and each meeting of the branches' board of directors, the directors talk about what they see in their communities,” says McTeer, who guided the Dallas Fed for 14 years and had a total of 36 years working for the Fed.
“It's sort of like the canary in the coal mines; eventually, all this stuff will become part of the statistical apparatus, but before it has a chance to do that, it is sort of like an early warning system.”
The Importance of the Beige Book
At the same time, each district reserve bank has a research staff that eight times a year calls local area businesses to ask about business conditions.
“This is an ongoing dialogue, not just choosing a different business every time,” explains McTeer. “Research assistants in the research department will have 10 to 15 businesses that they regularly call and ask questions like: Are you adding workers, or are you shedding workers? Are your sales rising or falling? Are your inventories in line with where you want them to be?”
The information from all the calls ends up in a research product called the Beige Book (for the color of its cover), which typically runs about three pages per district. A typical Beige Book covers everything from ticket sales for Broadway plays to the level of the Mississippi River, important for shipping.
Although some economists consider the Beige Book to be of marginal value since it is anecdotal, McTeer says its importance is that the Beige Book sometimes captures early turning points in the economy before the statistical data catches up.
Some of the anecdotal information will also flow to the Federal Open Market Committee (FOMC), which decides interest rate policy and formally meets eight times per year. Each of the district presidents attends the FOMC meetings, but most only get to vote every third year.
Going into the meetings, the Fed's staff puts together a Green Book, which McTeer describes as a summary of what's going on in the economy, and a Blue Book, which outlines policy options. Those books are put together by one of the largest repositories of economists in the world.
According to the Federal Reserve Board web site, as of March 2013 there were over 300 PhD economists. They write about arcane issues such as the Anderson-Moore Algorithm, which the Fed's Web page describes as “a fast and reliable method for solving linear saddle point models” (basically a mathematical way to solve large computational models of the economy) to understandable surveys of small business.
From Beige to Blue and Green
The main discussions at the Fed's meetings are over the direction and intensity of the economy, particularly in how it relates to inflation and the rate of job growth.
“Traditionally, central banks are there to keep inflation down and to protect the value of the currency,” says McTeer. But he notes that the Employment Act of 1946 made it a government responsibility to stimulate employment to hold unemployment down. Eventually, it became a dual mandate for the Fed to keep unemployment down and hold inflation in check.
As far as inflation is concerned, McTeer says the Fed prefers to use the Personal Consumption Expenditure price index, which is put together by the Bureau of Economic Analysis, a division of the Commerce Department. “Apparently, that is considered less distorted by housing than a couple of the others,” says McTeer. “But you also watch things that you believe cause inflation like excessive money growth, excessive expansion of bank credit, and so forth,” he says.
At the same time, the Fed monitors the employment situation. Although the Fed under chairman Ben Bernanke has set a target of reducing the unemployment rate to 6.5 percent, McTeer says the Fed usually monitors how many net new jobs are created each month as opposed to the unemployment rate.
“The Fed always believes the employment numbers are more sensitive to economic activity than the unemployment numbers,” says McTeer, who in recent years has become a blogger and a distinguished fellow at the National Center for Policy Analysis, a Dallas think tank that has a free market orientation.
Slow growth in job creation is one of the reasons that the Fed has acted differently than it might have in normal times.
Fed Policy
The economy grew consistently after June 2009, the end of the downturn. Normally, one would have expected that monetary policy would have turned from aiding the economy through keeping interest rates to watching out for inflation and raising interest rates. That was the normal course of action, and interest rates tended to rise not that long after growth reappeared. But that didn't happen. Instead, the monetary authorities determined that there were special circumstances that arose from the collapse of the housing and financial sectors that were holding back the economy from reaching its potential. Therefore, more help than normal was needed.
In essence, the Federal Reserve treated the Great Recession as a special situation, and uncharacteristic economic environments require nontypical monetary policy responses. In this case, it was determined that keeping interest rates extraordinarily low for an extraordinarily long period of time was the best course of action in order to insure a full economic recovery.
When it comes to interest rates, the Fed did the opposite in the early 1980s. After an extended period of high and rising inflation during the 1970s, Fed Chairman Paul Volcker decided there was no choice but to raise interest rates sharply if the inflationary cycle of higher wages and rising prices would ever be tamed. Monetary policy had to become extreme if inflation was to be tamed. He used what was ultimately nicknamed the “nuclear option” and drove short-term rates up to levels never seen before or since in this country.
The Fed policy worked and inflation was slowed in the early 1980s, setting the stage for better growth by the middle of the decade. It succeeded because Mr. Volcker recognized that circumstances, not theory, should drive policy. That is, it was not a matter of just raising rates enough to slow the economy, but maybe you had to burn the economy in order to save it. He may have caused a recession, but he also created the conditions for better growth in the future.
Obviously, there is no such thing as normal monetary policy. Yet not all monetary policies make sense. The Federal Reserve under Alan Greenspan came to the conclusion that it could not or should not do anything about an economic bubble. When tech stocks soared in the 1990s and housing costs skyrocketed in the 2000s, the monetary authorities did little to slow the rises. The assumption was that restraining economic growth would cost the economy too much; it was not clear if the policy would succeed or that it was even possible to recognize a bubble until it actually burst.
The philosophy that the market knew best and the Fed should not interfere with it cost us dearly. It is fair to argue that the Great Recession was in no small part a consequence of the Federal Reserve blundering about home price increases and the effects of a housing bubble on the economy.
From Bubbles to Fed Meetings
McTeer recalls that Greenspan used to say that real estate is a lot of local markets instead of one national market. And while Greenspan might agree that there was some froth in some of those markets, McTeer recalls Greenspan “once humorously defined froth as little itty bitty bubbles.”
McTeer thinks the reason the Fed misunderstood what was taking place in the economy in 2007 was that it did not understand how loans being made to people with less than stellar credit, termed subprime loans, could bring the entire economy down.
Many of these loans were collected together in packages and resold to global investors who wanted to beef up the return to their portfolios with the high interest rates being paid by subprime borrowers. Investors bought securities that were backed by assets—mortgages made to subprime borrowers. In theory, if the borrower defaulted, the home could be sold to cover the loan. However, no one figured that the default rates would drag home prices down by over 50 percent in some markets.
Some members of the FOMC certainly underestimated what was taking place in the economy, which was entering a steep recession. According to the transcript of the September 18, 2007, meetings, released in 2013, some Fed district bank presidents were more concerned that the Fed was not adhering to its short-term interest rate target of 5.25 percent.
“I think allowing the fed funds rate to be so low for so long away from our target really creates a credibility problem for this committee,” said Dr. Charles Plosser, the president of the Philadelphia Fed. “It puts us in an awkward position now because, in effect, it hasn't gone unnoticed by the investment community.”
Plosser was not alone. Gary Stern, president of the Minneapolis Fed, added his view that “when we establish a target, we have an obligation to achieve the target.”
In addition, the Fed underestimated what the impact of the collapse in the markets would be on the banking system. According to the transcripts from that September FOMC meeting, Bill Dudley, then the Fed's manager of open market activities but soon to be the president of the Federal Reserve Bank of New York, told the members that the banks could have a potential earnings problem because of the disruption in their ability to syndicate loans.
However, Dudley told the committee, “I think the uncertainty about it will probably turn out to be more of a problem than the actual reality, but it's going to take time for us to find out what the actual reality is.
The Fed Goofs
As it turned out, the actual reality was far worse than anticipated. By October 2008, Congress had to authorize a $700 billion fund called the Troubled Asset Relief Program (TARP), which added capital to the banking system, helped prevent the collapse of the auto industry, and had to invest in the giant insurer AIG.
“From my perspective, one of the reasons people didn't get what was going to happen is that they never connected very well in their minds the subprime loans that were being made to securitization,” says McTeer.
McTeer confesses he did not understand what was happening. “I remember in the early 1990s occasionally somebody would say banks are making loans that they know can't be repaid. And I remember thinking, ‘Well, why would they do that?’ I did not fully understand . . . that they would sell these loans as part of the securitization process. They just moved the risk to someone else.”
McTeer says people in the Fed did in fact worry that there was a real estate bubble. But he says the view was that “what goes up can go back down, and there was no reason to expect it to be so catastrophic.”
But the Fed may have also failed to judge the housing market in the context of the broader economy. What the Fed failed to recognize is that while it might be good when housing or stock prices rise sharply just after a major economic slowdown, it is not necessarily good when that happens after the economy has been expanding strongly for an extended period. That is, it was not a threat that home values finally started to jump in 2012, as it allowed the long recovery in the housing market to continue.
But in 2007, those home price gains were occurring after the housing market had reached record levels and the economy had been expanding solidly for an extended period. Then, the price surge represented a level of exuberance and irrational expectations that could not be sustained. The price bubble was a threat that had to be dealt with but wasn't. The context of price changes matters, and it should have made a difference on how monetary policy was conducted. Unfortunately, it didn't, and the bubble burst and the Great Recession followed.
The public policy disasters that have resulted from the failure to recognize context are legend. The huge budget deficits in the 1980s and 2000s were in no small part the result of the thinking that tax cuts can cure all. The Great Recession was set in motion by the Federal Reserve's misreading the economic landscape and trusting markets to work without the necessary oversight. The sluggish growth at the end of the Great Recession was at least in part a result of muddled thinking about what a stimulus bill should look like. In all those cases and so many more, simplistic thinking failed to recognize that policies work only when they are implemented in the context that makes sense.
Public policy failures usually result from not recognizing that the consumer and business reactions to the same policies differ according to their perceptions about current and future conditions. As we will see in the next chapter, people shape their actions based on the economy as they see it.
Notes
* All quotations not attributed to published sources are from personal interviews conducted by the authors.
1. Federal Reserve Board transcript of Bernanke testimony.
2. www.gpo.gov/fdsys/pkg/CHRG-113hhrg80869/html/CHRG-113hhrg80869.htm, January 9, 2014.
3. Ibid, January 9, 2014.
4. For example, on April 4, 2011, Kevin Hassett, director of Economic Policy Studies at the American Enterprise Institute, argued that Reagan's forecasts were ridiculed because they were unconventional, not wrong.