Tuesday, September 15, 2015

Remembering 2008: It Could Have Been Another Depression

Imagine that you take an action to prevent an event from happening, and as it turns out, the event doesn't happen. Did your action prevent the event, or was your action unnecessary--at least to some extent?

For example, the US spends about $100 billion per year in fighting terrorism. It's very difficult to figure out if the anti-terrorism spending was justified, or some of it was over-the-top.  All we know is that we have not had a major terrorist attack on US soil since September 11, 2001. Or imagine that those concerned about climate change were able to enact a comprehensive anti-carbon agenda. Say further that the costs of doing so were high, and that the standard of living both in high-income and low-income countries was lower as a result, but the predicted perils of climate change didn't occur. It would be difficult to figure out if the actions were justified, or excessive. All we would observe is that a potential harm did not occur.

Seven years ago in September 2008, the US economy suffered what I think of as a near-meltdown. Some key events of that month included the Lehman Brothers investment bank going broke; the government-sponsored mortgage enterprises Fannie Mae and Freddie Mac going broke; the insurance company AIG getting an $85 billion credit line; a huge money market fund, the Reserve Primary Fund, announcing that it had lost money, leading to a run on money market funds; and the Troubled Asset Relief Program (TARP) being introduced in Congress (and being enacted in early October).
The policy response in the months that followed included a number of extreme actions: for example, the Federal Reserve holding its target interest rate at near-zero levels for seven years, while buying several trillion dollars of Treasury bonds and mortgage-backed debt; monumentally large budget deficits by the US government; and bailout loans and investments extended to certain banks, insurance companies like AIG, and auto companies like GM and Chrysler.

The claim is that these and other extreme actions were needed to avert what could have turned into another Great Depression. But although the US economy experienced a Great Recession from 2007-2009 and what is sometimes called the "long slump" of sluggish growth that has followed, a Great Depression didn't actually recur. So how can we judge whether the extreme actions were indeed necessary?

Jason Furman, chair of the Council of Economic Advisers, takes a shot at this question in a September 9, 2015 speech, "It Could Have Happened Here:The Policy Response That Helped Prevent a Second Great Depression."  Furman writes:
With the unemployment rate at 5.1 percent it has become easy to forget just how close our economy came to the brink seven years ago. But during the Great Recession, comparisons to the Great Depression were by no means hyperbolic. I remember sitting in my West Wing office in early 2009 looking each day at a chart comparing the U.S. stock market in the wake of the financial crisis to previous corrections. And each day added a new point to the graph heading directly on the same trajectory as 1929 and considerably worse than every other episode. 
Furman offers a series of graphs showing the stock market, household net worth, housing prices, bond yields, unemployment rates, and flows of international trade to back up his argument that for a time in late 2008 and into 2009, the US economy appeared to be on a Great Depression track. But during the Great Depression, unemployment reached 25% and the rate of deflation (that is, negative inflation) was more than 9% in 1931 and 1932, and 5% in 1933. By comparison with that catastrophe, the Great Recession has been mild.

Furman offers an argument that the various monetary, fiscal, and other policies enacted since 2009 are responsible for avoiding a Great Depression. I fear that in some places, his argument comes close to this syllogism: 1) Steps were taken; 2) A Depression didn't recur; 3) The steps worked. As noted above, this case is very difficult to prove. My own sense is that some steps were more defensible than others at the time, and that some steps that made good sense in the few months after September 2008 might not have continued to make sense several years later.

But my point here is not to parse the details of economic policy over the last seven years. Instead, it is to say that I agree with Furman (and many others) on a fundamental point: The US and the world economy was in some danger of a true meltdown in September 2008. Here are a few of the figures I used to make this point in lectures, some of which overlap with Furman's figures. The underlying purpose of these kinds of figures is to show the enormous size and abruptness of the events of 2008 and early 2009--and in that way to make a prima facie case that the US economy was in severe danger at that time.

Let's start with a couple of figures related to real estate. The blue line shows a national index of home prices, and how they rose with time. The red line shows the inflation rate. These two lines are set so as to have a base value of 100 in the year 2000, and then to change relative to that base year. The figure shows that housing prices rose pretty much in line with overall rates of inflation in the 1970s, 1980s, and 1990s. But around 2000, the jump in housing prices relative to inflation rates--followed by the subsequent fall--stands out.

With these changes, the value of household owner's equity in real estate rose from about $6 trillion in 1999, to $13,3 trillion in the first quarter of 2006, and then fell back to about $6 trillion by the first quarter of 2009. The value of household owner's equity in real estate stayed around $6 trillion through 2011, before starting to rise again. My preference is to put these numbers in the context of the broader economy: that is, to divide the total value of household owner's equity in real estate by the size of the GDP. That calculation produces this figure, which shows that relative to GDP, the value of household equity rose well above its usual historical levels during the bubble, then fell below its usual historical levels, and now is back in more-or-less the historical range. But look at that precipitous drop!

The fall in housing prices meant problems for the banking sector. It was clear that many housing loans previously viewed as safe weren't going to be repaid. Moreover, economic prospects looked grim. Banks were terrified to lend. Here's a graph of net lending by the financial sector taken from the CBO's January 2011 Budget and Economic Outlook: Fiscal Years 2011 to 2021 (p. 33). Net lending is new loans minus repayments and write-offs of bad loans. The historical pattern is that during recessionary periods in the past, there was sometimes a quarter or two where lending turned negative for US banks or for money market funds. But for the US financial sector as a whole, net lending was positive every single quarter from 1950 up to 2008, when it veers wildly from more than 10% of GDP on the positive side to a decline of 10% of GDP on the negative side. This enormous change shows an almost paralyzing fear of lending in the US financial sector.

A similar near-vertical decline happens at the international level. Here's a figure showing the net inflow of capital into the US economy since 1995. The US economy had become used to inflows of foreign capital. During the seemingly easy money to be made in the US economy during the go-go days of the housing market bubble, the inflows exceeded $700 billion per quarter for a time in early 2007.  Again, watch the capital inflows plummet and then turn negative into capital outflows. The world was pulling its money out of the staggering US economy, too.

Finally, a standard measure of fear in the banking and financial sector is known as the TED spread. You calculate this measure by subtracting two interest rates. One interest rate is called the London Interbank Offer Rate, or LIBOR for short. It's the interest rate at which big international banks borrow overnight from each other. Because these are big banks and the loans are extremely short-term, such loans are usually viewed as very safe and the LIBOR rate is usually low. The other interest rate is the 3-month Treasury bill rate--that is, the rate paid by the US federal government for short-term borrowing. These two interest rates are usually pretty similar. The LIBOR interest rate is a bit  higher, because borrowing by a bank, even a well-established bank, has larger than US government borrowing. However, the two rates usually move pretty closely.

But in fall 2007, and then again in September 2008, a large gap suddenly emerges between the LIBOR interest rate and the three-month T-bill interest rate. The risks of lending between big banks, even on a very short-term basis, are suddenly looking larger and rising. If you are staring at this graph in September 2008, as it shoots up, it looks frighteningly like it could be heading toward a breakdown of the global financial system, loosely defined as a situation where banks become unwilling to deal with each other without high transactions costs, because all other banks are perceived as too risky.

As I've said several times already, these kinds of graphs don't prove that a Great Depression definitely would have happened in 2009 or 2010 without the government interventions that did occur. When something doesn't happen, you can't prove that it would have happened.  But consider the situation of September 2008 as a matter of probabilities. Say that there was "only" a 10% chance of global financial meltdown, or a 20% or 30% chance. For me, that risk is plenty high enough to justify some extreme policy actions. It's why I'm reluctant to criticize too strongly the decisions made by policy-makers from September 2008 through mid-2009. It's impossible to know how close the US economy came to a true Depression, but it was a genuine and legitimate worry at the time.