Stock prices were largely left free to seek their own level as the 2008 crisis unfolded.* To be sure, the Federal Reserve’s more than doubling of its balance sheet in the fall of 2008 (QE1) appears to have lowered real long-term interest rates that, other things equal, would tend to lower the earnings yield and raise the price of common stocks. However, given the already nearly unprecedented heights of economic angst following the Lehman default, no further explanation of this classic selling climax and subsequent price rebound seems necessary. Nonetheless, having observed the impact during the years 2000 to 2005 of falling long-term interest rates on the subsequent global asset price boom (see Chapter 3), there is always doubt in such matters.
The month-long stock selling climax that ended on March 9, 2009, absorbed the market disequilibria and defined the price bottom.23 Unencumbered, the price level has since doubled and recouped all of its losses from its historic peak of October 2007. The extent to which markets, if allowed to adjust, will self-correct is at the core of the political debate. Free market imbalances are addressed either by allowing markets to correct themselves through a selling climax or through government intervention that delays the adjustment and, from my perspective, makes the ultimate adjustment even more problematic. In my experience, extensively regulated markets and those rife with crony capitalism have eviscerated, or at a minimum, significantly impaired, the automatic stabilizers of the market process.
SELLING CLIMAX LIMITS
Government policies that endeavor to prevent market liquidation are based on the implicit premise that market declines not countered by intervention would feed on themselves virtually without limit. That would be true if fear could rise indefinitely in a self-reinforcing cycle. But it does not. Accordingly, markets do not fall indefinitely, as the stock market selling climax of March 2009 and the experience of the Resolution Trust Corporation two decades earlier demonstrate. At the height of a fear-driven selling climax, asset prices invariably fall to levels consistent with a level of extreme fear that our psyches rebel against and to which they eventually adjust. As I note in Chapter 4, fear inevitably lessens and stock prices rebound. Were it otherwise, markets would not recover as rapidly as they do from “oversold” bear market lows.
Today, the political pressure on government officials to respond to every perceived shortcoming in economic performance has become overwhelming. I observed it build over my more than two-decade stretch in public office. Even if policy makers acknowledge that allowing market declines to exhaust themselves may indeed return markets to balance, there always exists some uncertainty of how long an unimpeded market decline will persist or how deep it will go.24 Accordingly, in recent years policy always has seemed biased toward activism when, more often than not, allowing markets to rebalance and heal is the most prudent policy.
It has been my regrettable experience that the political response to policy makers’ actions heavily biases the policy makers toward catering to short-term benefits, largely disregarding long-term costs. As I note in Chapter 6, policy makers who intervene to support market prices but do not succeed are nonetheless praised for trying. But the policy maker who allows markets to liquidate and prices to fall is less fondly treated, even if, as Paul Volcker, my predecessor as chairman of the Federal Reserve Board, experienced in 1981, he is vindicated in the end. And as I also note in Chapter 6, President Gerald Ford, who took a principled stand against more-than-token intervention to counter the sharp recession of 1975, was accused by AFL-CIO head George Meany, just as the American economy was finally stabilizing, of reckless policies. So was the Resolution Trust Corporation when it allowed the real estate properties of defaulted savings and loans (S&Ls) to be sold at auction in 1989 at “bargain” prices far below their price at mortgage origination. While that act was instrumental in saving American taxpayers tens of billions of dollars, it was quickly forgotten.25
THE CONSEQUENCES
Preventing overbought markets (bubbles) from liquidating will create an overhang of market offers of undesired inventories in both product and financial markets that frustrates a normal rebound out of recession, or worse. Until, for example, the 2006 glut of single-family vacant homes for sale began to shrink substantially, U.S. home prices had difficulty recovering from their suppressed levels. It is hard to visualize a housing recovery in which higher home prices do not play a, if not the, key role. I suspect that had the government stood by and allowed foreclosures to proceed without mediation, the housing crisis more than likely would have been deeper but far shorter. I have always thought that giving cash assistance or a voucher to financially troubled homeowners is a far more efficient policy than distorting the foreclosure process. It is revealing that more than 60 percent of mortgages modified in the third quarter of 2008 re-defaulted within a year of modification. Despite the rise in prices, however, the re-default rate, after declining, has apparently remained above 20 percent (Exhibit 7.8).
But while bailouts of financial institutions and even intervention into mortgage markets could, with a stretch, be nonprecedential, the bailout of General Motors and Chrysler was clearly new ground.26 There are now no areas of the economy that are beyond the responsibility of the federal government. Had General Motors and Chrysler been forced into bankruptcy court, union contracts would almost surely have been revised, and the companies financially restructured and doubtless scaled down. The number of dealerships would have been reduced, and I have no doubt that non-American car brands would have gained market shares. That would have meant a larger share of foreign nameplate vehicles assembled in nonunionized American plants. But aggregate purchases by American buyers probably would have changed only marginally, if at all, and domestic automakers’ balance sheets would have emerged unencumbered by toxic debt.
There is, regrettably, an understandable considerable difficulty in allowing icons that have historically been the symbols of America’s rise to global economic hegemony to fall by the wayside. We cannot emotionally easily countenance the demise of so symbolic an American icon any more than we would contemplate the obsolescent grandeur of the U.S. Capitol being replaced with a modern building. But American Woolen and Kodak, icons in their day, scaled back without economic disruption. Of the original names that made up the Dow Jones Industrial Average more than a century ago, only General Electric is still on the list.
As I discussed in Chapter 5, because firms designated as “systemically important” are accorded an implicit government guarantee of their liabilities, investors perceive those firms as near riskless and grant them interest rate subsidies. That accords them a competitive advantage not achieved through enhanced productivity. Savings are being directed to the politically powerful, not the economically efficient. Future productivity gains and standards of living are being put at risk.
HISTORY
Between the end of the Civil War and World War I, America was plagued with financial crises that at the time seemed everlasting. To this day there is a dispute as to whether the waves of crisis were fostered by the inelastic currency that arose from provisions of the National Bank Act of 1863. But in all cases, we liquidated the toxic assets and returned to full employment, often quickly.27 These crises are the regrettable result of our natural propensity to swing between euphoria and fear. And short of going to a rigid collectivized (and stagnant) economy, we have never been able to keep animal spirits from swinging between extremes.
I do not doubt that in the post-2008 climate of severe uncertainty, demand for longer-lived assets—homes—was always doomed to be depressed. But if policy activism had not been so unremitting, I strongly suspect that the pall of uncertainty would have lifted sooner and the severe discounting of long-term investments would have been far less—and it would have long since been over.
The major political problem in allowing markets to liquidate is that this was precisely the remedy for recessions supported by Andrew W. Mellon, President Herbert Hoover’s long-serving secretary of the Treasury. Because he is so associated with
the boom and bust of the 1920s, such advice is promptly rejected.
POLICY ACTIVISM
Policy activism is the propensity of government, by fiscal, monetary, or regulatory policies, to alter the path of market outcomes from what would otherwise emerge from the unrestrained interplay of competition. To those policy makers who extol competition, activism threatens to widen the variance of expected outcomes of the projections of rate of return on prospective new private investments for both business and households. But perhaps just as inhibiting is the threat of arbitrary intervention perpetually overhanging a market.
To those policy makers who view competitive markets less benignly, governments must be on alert to address “market failures.” The massive stimulus program initiated in early 2009 (the American Recovery and Reinvestment Act), the bailout of General Motors and Chrysler, the extensive and largely futile effort to prevent the home mortgage foreclosure process from running its course, and the vast and troubled financial regulations mandated by the Dodd-Frank Act are prime examples. The Dodd-Frank Act restructures the financial system presumably based on how legislators believe markets should work. And indeed it largely provides goals of regulation to be implemented. But in the three years since the act was signed into law in 2010, it has become apparent that its remedies to the undisputed overreach of financial institutions have been based on an uninformed view of the role of finance and how it actually works. What is most disturbing about the current period is that it echoes the policy disputes of the 1930s.
NEW DEAL ACTIVISM
While the degree of activism brought on by the New Deal was far more intense than any of the interventions of the last five years, there are distinct parallels in initiatives to jump-start the private economy. The Great Depression’s National Industrial Recovery Act (NIRA) viewed excessive competition as the cause of falling prices, and the Roosevelt administration did everything it could think of in response, from raising the price of gold to propping up crop prices (the Commodity Credit Corporation). As Harold Cole and Lee Ohanian point out,28 the NIRA attempted to cartelize firms composing four fifths of private nonagricultural employment. It led to huge economic distortions until it was declared unconstitutional by the Supreme Court in May 1935. But the level of economic rigidity remaining until wartime subjected virtually the whole U.S. economy to government controls. From 1932 to 1940, the monthly unemployment rate averaged 19 percent and never fell below 11 percent. Nonfinancial business capital investment as a percent of cash flows fell to 48.2 percent in 1934 and 59.8 percent in 1938 but rallied in 1937 and 1941. (For 2012, the percentage, by comparison, was 79.6 percent.) The business cycle had ups and downs in the 1930s, but the level of activity for the decade, on average, was suppressed, a state consistent with today’s persistently high degree of risk aversion to illiquid long-term asset investment. The enemy of economic recovery, now as then, is uncertainty.
EIGHT
PRODUCTIVITY: THE ULTIMATE MEASURE OF ECONOMIC SUCCESS
The early stages of what became known as the dot-com boom were evident in late 1993. By February 1994, we at the Federal Reserve had become sufficiently concerned about the pace of the expansion and the associated risks of inflation that we decided to press down on the monetary brakes. We continued to tighten for a year with some success. Our cumulative increase of 3 percentage points in the federal funds rate brought a nascent stock market boom to a halt (temporarily, as it would turn out), and we were preparing ourselves for the first soft landing in our collective monetary policy memory. “Soft landing” is a term that economists have borrowed from aviation to describe the aftermath of a period of monetary tightening that would ease an economy onto a glide path of noninflationary growth. The Federal Reserve’s previous experiences with aggressive tightening had often led to recession or, even worse, to a recession that did not succeed in restraining inflation.
In July 1995, we lowered the Fed funds rate by 25 basis points, and did so again in both December 1995 and January 1996 when we read the data as suggesting that a soft landing was taking hold. But no sooner had we stopped patting ourselves on the back for adroit monetary policy than we were confronted with a seeming reeemergence of the boom. By the spring of 1996, there was clear evidence that cyclically sensitive manufacturing activity was picking up, and the pressing question of whether renewed policy restraint was warranted was again on the table. The unemployment rate had been falling since mid-1992. Wage rates and prices, however, remained remarkably subdued—a condition that ran contrary to prevailing policy wisdom that as labor markets tightened and unemployment fell below the presumed “natural rate” of 5.5 percent, inflationary pressures would mount. They didn’t.
By late 1997, wage rates finally did begin to accelerate but price inflation remained contained despite stable corporate profit margins.1 The only way that could happen was for output per hour to rise at least in tandem with wage costs. Rising productivity and profit margins would also explain why new orders for capital equipment and software had risen persistently from 1993 forward. It had been my experience in the private sector that such a prolonged upswing in orders and capital spending would not have continued unless corporate management had judged the rate of return on newly installed equipment to be attractive and the improvements in productivity as real and sustainable.
Given stable prices, rising wage rates, and expanding profit margins, output-per-hour growth, by my arithmetic, almost surely had to be accelerating.2 The problem was that the published statistics gave no hint of an acceleration in productivity. The most reliable independent measure of output per hour, our conventional proxy for productivity, was that produced by the Bureau of Labor Statistics (BLS). Between the fourth quarter of 1993 and the fourth quarter of 1995, nonfarm productivity exhibited a tepid annual growth rate of only 0.75 percent.3
My optimistic productivity message was thus not universally cheered at the Federal Open Market Committee (FOMC). As Governor Larry Meyer years later described the atmosphere in the meetings, “the staff were skeptical, and they didn’t mind saying so. For example, at the August 1996 meeting, Mike Prell4 bluntly told the Committee: ‘There simply isn’t any statistical evidence to suggest that productivity is taking off.’ I wouldn’t say the staff abandoned the Chairman in this matter, but they came close.”5 The FOMC remained split on this issue for quite some time. Our monetary policy, of course, had to consider whether inflation was under control. If inflation was viewed as a looming threat, the FOMC would need to contemplate tightening policy, perhaps aggressively. This was especially true given that a number of members of the FOMC noted that the Fed had made considerable progress on the maximum employment component of its dual mandate.
Finally, our path became unambiguous in early 1997 when the BEA’s nonfarm business productivity measure finally accelerated, reflecting the realities of a burgeoning technological boom. The federal funds rate reached 6 percent in February 1995, and for the next five years it fluctuated between 4.75 percent (November 1998) and 6.5 percent (May 2000). Inflation remained subdued over this period and the unemployment rate continued to decline. It finally dipped below 4 percent in April 2000, without inflation visibly gaining traction.
The acceleration of productivity was obviously a welcome development after its lackluster performance in the 1970s and 1980s. As financial markets digested the accompanying implications for the expected path of earnings, stock prices provided a further boost to the economic expansion. However, as so often occurs, animal spirits transformed a rational capitalization of improving fundamentals into an “irrational exuberance” that ultimately manifested itself in the so-called dot-com bubble. Even the substantial acceleration of productivity could not fulfill the unrealistic expectations for earnings growth that had become embedded in equity valuations.
So eventually, the dot-com bubble burst, resulting in a substantial decline in equity markets and household net worth. Nonetheless, the macroeconomic consequences of that destruction of perceived wealth were, by late 2000
and into 2001, surprisingly muted.6 Indeed, the accompanying recession, at that point, was rated as the mildest in postwar history.
THE LONGER VIEW
Productivity is arguably the most central measure of the material success of an economy. The level of productivity ultimately determines the average standard of living, and is a defining characteristic that separates the so-called developed world from the developing world. Innovation, a critical determinant of productivity’s rate of growth, reflects how quickly new ideas are effectively implemented and absorbed into the production process.
Economists’ main problem with productivity is that it has been devilishly difficult to forecast. Conventional forecasting wisdom with respect to productivity growth is probably best epitomized by the five-year forecasts of the Congressional Budget Office. Exhibit 8.1 shows clearly that these five-year projections of output per hour are more accurately characterized as moving averages of the recent past.7 Merely projecting that the future will replicate the recent past may not be very edifying. But there are nevertheless some important stabilities in long-term trends in productivity, as I note later, apparently largely rooted in human nature and culture,8 that afford us some confidence in using the past to predict the future.
Between 1870 and 1970, America’s annual rate of increase in nonfarm output per worker hour, the key measure of the productivity of our nonfarm workforce,9 averaged 2.2 percent.10 Given that the accumulation of knowledge is largely irreversible, we would expect a persistently rising level of productivity.11 And, indeed, over any fifteen-year period since 1889 (the first year of annual data), average yearly output-per-hour growth has never exceeded 3.2 percent or fallen below 1.1 percent (Exhibit 8.3). But why does the long-term growth ceiling in the United States seem limited to a 3 percent rate, and why was long-term productivity growth relatively stable for more than a century?
The Map and the Territory Page 14
