The GEM Project, by intuitively generalizing rational exchange, has considerably strengthened our capacity to model macro instability. This post begins a series of essays on the policy implications of that breakthrough, with special attention to how best to deal with the class of market failure that ravaged the U.S. economy in 2008-09.
Policymakers have two basic, not mutually exclusive, strategies to guide their efforts to prevent a repeat, or worse, of the massive welfare loss of the Great Recession:
- Prevent future financial disruptions that significantly damage the economy’s capacity to recycle saving into investment spending.
- If such disturbances do occur, prevent their propagation by effectively intervening to halt and reverse contracting nominal demand.
The GEM Project puts meat on the bones of the two strategies. Its crucial first step is to separate nominal demand disturbances, which are shown to be at the center of instability macrodynamics, into two types. Stationary demand disturbances (SDD) reflect the contained, temporary weakening of total spending associated with garden-variety recessions. Nonstationary demand disturbances (NND) are the unchecked spending collapses associated with acute instability and depression. (Chapters 5) NDD overwhelms the automatic stabilizers and central-bank purchase of short-term treasury debt that are effective in ameliorating SDD. An especially important difference between the two classes of spending disturbances concerns prevailing investor/lender perceptions of the macro future. In NDD circumstances, investors/lenders are sufficiently uncertain about the credibility of stabilization authorities’ trend real-side objective to become rationally inactive, moving to the sidelines to await credible bottoms in collapsing asset markets. (Next week’s blog elaborates on this macro externality.) Containing NDD requires the more aggressive use of the central-bank balance sheet, supporting the crisis-imposed roles of buyer and guarantor of last resort in downward-spiraling markets, in order to restore effective recycling of saving into spending adequately to reverse the contraction of nominal demand.
Crisis-prevention strategy. In response to 2008-09, U.S. policymakers have chosen to rely on the first strategy to thwart, somehow, future episodes of extreme instability. They have focused on preventing breakdowns in the functioning of the financial system, largely by sharply increasing capital and liquidity that the largest banks are required to hold while additionally restricting activities and instruments that are judged to be too risky.
Limiting attention to crisis prevention is itself excessively risky. First, as noted, the increased capital, liquidity, and product regulation are largely restricted to federally regulated banks. Yet, the relative importance of banks in the recycling of savings into spending has, for a long time, been shrinking. Nonbank institutions and securitization, in their many manifestations, are playing an increasingly critical intermediary role. By 2008-09, breakdowns in money-market mutual funds, the commercial-paper market, the GSE mortgage market, nonbank asset-backed lending, CDO conduits, hedge funds, etc. greatly damaged the economy’s capacity to maintain total spending. By its nature, the shadow banking system is nimble, fast evolving, and difficult to regulate. It is no surprise to veteran Washington watchers that reform efforts have emphasized traditional, stable, easy-to-regulate banks. Congress and financial regulators have demonstrated relatively little taste for taking on the shadow system, despite knowing that is where capital and liquidity are most inadequate and the riskiest practices, products, and instruments are developed. Providing a home for lightly supervised risk is why the shadow banking system exists and thrives.
Second, and related, is that financial crises, as documented by Reinhart and Rogoff (2009) and Romer (2014), are relatively frequent, finding ever-novel ways to happen. The lesson of history is that financial disruptions will occur and that putting all our eggs into the crisis-prevention basket is an inadequate, head-in-the-sand strategy. Third, there is no requirement that costly macroeconomic crises must always arise from the financial system. Preparing only for that class of acute instability is surely a dangerous crisis-response strategy. Finally, there is the very real risk that regulators, in the aftermath of an episode of costly instability, will set cost-benefit considerations aside and go too far in eliminating risk in federally regulated banking. Attempts to eliminate risk would do debilitating damage to the economy’s capacity to efficiently recycle saving to investment, hobbling the economy’s capacity to generate rising living standards. Especially in a competitive global economy, attention must be paid to efficiency.
Crisis-propagation strategy. Fortunately, there is no need to be ostrich-like in our approach to managing extreme instability. We can instead combine broad-based regulation that is carefully constructed to be efficient with effective government tools to intervene in total spending. Such tools would be capable of halting and reversing NND that rapidly propagate financial crises that will continue to occur. After all, we know that the lion’s share of the welfare cost in episodes of acute instability does not result directly from the crisis itself but, instead, from its propagation.
The GEM message is that in the aftermath of the Great Recession the closest attention should be given to preventing financial-crisis propagation. The Federal Reserve should be building on Bernanke’s virtuoso performance in 2008-09 by carefully identifying tools made available by its unique balance sheet that are effective in halting and reversing collapsing total spending. (There will be more on this in the coming weeks.) The Fed must also convince Congress of the necessity of building up a powerful demand-intervention capacity. Despite there being an extraordinarily good case to be made, the Fed hasn’t been making it. In a related task, global investors and lenders should be convinced of the power of the expanded toolkit and the Fed’s institutional resolve to use it to contain any NDD-propagation of future macro shocks. The campaign of persuasion is a natural companion to central banks’ earlier successful effort to convince market participants of their commitment to low inflation and will be considered further in the coming weeks.
Final word. The GEM Project has, at least partially, integrated the two basic strategies cited above. The Project demonstrates that the existence of powerful toolkit for total spending intervention directly contributes to averting acute instability. In a financial crisis, investors/ lenders are less likely to become inactive, damaging total spending, if they are confident that the central bank can deliver on its trend real-side stabilization objective. (Chapter 6) The reality of a well-understood powerful toolkit substantially helps prevent episodes of significant breakdowns in the economy’s capacity to recycle saving into total spending.
Blog Type: Policy/Topical San Miguel de Allende, Mexico