Two campaigns ended this week. In one, a hostile electorate reshaped Congress, to create a foil to Barack Obama’s policy ambitions. In the other, the Federal Reserve has spent the past few months trying to convince investors that it retains relevance even after its policy rate has lingered at zero for two years. Now the campaign season is over, further swift actions are needed to boost the fitful recovery of the American economy.
All campaigns are full of inflated promises. The build-up to the Fed’s latest quantitative easing has been no exception. The problems overshadowing expansion will not be lifted by inflating the Fed’s balance sheet. In particular, the hard job of addressing the unresolved problems in the mortgage market remains unaddressed.
Financial authorities have to end the charade that the problematic loans made as the real-estate bubble inflated will be repaid. Those loans and the securities using them as collateral had dicey prospects when first made and have only gone further south. After all, since the balloon popped, real estate prices have fallen 35 per cent on average, and unemployment is near 10 per cent.
These unresolved legacy assets are dragging down households’ spirits, clogging intermediaries’ balance sheets, and impeding the clearing of the real estate market. The private sector will not borrow, banks will not lend, and the fiscal prospects of the US government will be clouded.
A repeated pattern in financial crises is that government debt swells because the state has to take over private obligations as part of its rescue of the financial system.
Ireland was running a government budget surplus and had debt outstanding of about 13 per cent of its gross domestic product only three years ago. Now the 50 percentage point increase in its debt load, in proportion to its income, is due mainly to the assumption of the private obligations of its financial champions. In the US, the official tally of public-sector liabilities rose by $4,000bn early this year once the fiscal accountants appreciated that the obligations of the two housing giants, Fannie Mae and Freddie Mac, should be listed on the books of the government that owns them.
Ending the current counterproductive policy of denial will raise the already bloated fiscal deficit, through some combination of higher resolution costs and further capital injections. But acceding to the inevitable is never optional, only the timing has an element of discretion. That said, the longer it takes to recognise financial losses, the larger they ultimately become. This was the case with the savings and loan debacle in the 1980s, or Japan of today.
Managers of financial institutions always put off such recognition if they can.Previous stress tests avoided mention of the overhang of legacy losses in favour of the brighter prospects of flow profits. Moreover, the funding of legacy losses can be done on the cheap because of monetary accommodation.
Movement on the issue of housing loans is crucial for the recovery but it alone will not be enough. To do that, Mr Obama and Congress have to find common ground on new stimulus. A payroll tax cut would put income into households and boost spending. But stimulus has to be paired with discipline. Elected officials should latch on to the advice of the National Commission on Fiscal Responsibility and Reform, as an exhausted swimmer to a lifebuoy. Adopting the top few might not be a coherent rethinking of fiscal strategies, but it would point in the right direction.
The Fed also has to show its latest QE can get traction in markets. To do this the Fed chairman, Ben Bernanke, will have to bend over backwards to ensure market participants are not worried that monetary policy has become dominated by fiscal policy.
The most effective way to do this would be to create new rules to prove that the Fed’s policies are entirely driven by its outlook for the economy, for instance by using the Fed’s own surveys as the means to link its QE actions to the state of the economy. As the economic outlook improves, the Fed would have a convenient justification to taper off and then stop its purchases. The same process of comparing the outlook with its mandate would allow the Fed to throw its asset-purchase machine automatically into reverse when inflation threatens.
The stakes are high and the headwinds to recovery are substantial. Following severe financial crises, the historical record suggests that economies tend to grow about 1½ percentage points slower, on average, in the decade that follows. Only coherent action can help America avoid the same fate again.
Carmen Reinhart, co-author of ‘This Time Is Different’ (with Ken Rogoff), is a senior fellow at the Peterson Institute for International Economics. Vincent R. Reinhart is a resident scholar at the American Enterprise Institute
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