In a companion article, I examined how the current recession compares with previous U.S. recessions, and explored the reasons why the economy is in its current state. In this article, I describe and explain the various remedies by which the federal government is attempting to slow the economy’s downturn.
What is being done to turn things around?
[1] When housing prices fell in 2007 and 2008, the banks that had invested heavily in mortgage-backed securities (see Part 1 of this article for a detailed description) and other investments like them learned that their net worth was far less than they had thought. In their simplest form, banks get money by borrowing and taking deposits and use that money to make loans and other investments. Banks make profits by earning higher returns on the loans and investments than they pay as interest on the deposits and loans. They keep a fraction of all the deposits in the bank at any given time so that they can give money back to any depositor who asks. If banks are not able to pay off their depositors, or if they cannot pay back other banks from which they borrowed, they must go out of business—they are insolvent.
[2] When the nation’s large banks learned that their investments were worth far less than they thought, many of them became worried about their own survival. They needed to increase the fraction of their deposits that they kept rather than lent out. This meant they had to do less lending. Furthermore, each bank knew that the other banks had invested in these securities, but did not know how badly the other banks had been hurt. This uncertainty made banks very unwilling to lend to each other.
[3] When the banks do not lend, firms cannot make their payroll or pay their suppliers, and cannot make investments in their own businesses. People who lose their jobs as a result have less money to spend, which in turn hurts other businesses. These businesses then look to borrow to make it through tough times, and lay off workers to cut costs. Obviously, when banks are not working properly, the entire economy suffers. Furthermore, when the economy slows down, people naturally react by saving more to protect themselves in case things get worse. The resulting reduction in spending means businesses sell fewer of their goods and services and are at a higher risk of failing. The increased risk associated with businesses shutting down makes banks less willing to make them loans.
[4] The health of the nation’s economy is dependent on the health of the nation’s banks. And the reverse is true, which explains why the public policy proposals to stop the economic decline are of two main sorts: those aimed at curing the ills of the lending market and those aimed at stimulating the broader economy through increased federal government spending. Let us first remain with the banks, and then turn to the government spending remedy.
[5] The reduction in the value of the banks’ assets meant that they were at increased risk of failure. Three types of solutions were proposed. The first type of solution involved the federal government “capitalizing” the banks. The banks’ problem was that they did not have enough money (i.e., capital), so the thought was that if the federal government gave them enough money they would cease to be worried about being insolvent and would begin to lend to worthy borrowers. In return for this capital, the federal government took some ownership share in the banks (in the form of shares of the banks’ stock). Some argue that this action was a failure because the banks are not currently lending, but it is hard to know what would have happened if the government had not infused this capital in these banks.
[6] The second type of solution involves the federal government buying all the assets that are causing the banks so much trouble. The thinking behind such a plan is that the banks are afraid to lend money because they simply do not know how much their assets are worth. Buying them resolves that uncertainty and allows the banks to make lending decisions free of the burdens of these past mistakes. Such plans must address the difficult question of what the government should pay for these assets, many of which are the mortgage-backed securities discussed above. The problem the government is trying to solve is that there essentially is no market price for them right now. Should the government pay more than it believes the assets are worth as a way of ensuring the banks have enough capital to lend? Or, should the government pay what it believes the assets are worth? If doing so causes some large banks to fail, should the government allow this to happen or are the banks too important to the economy right now? A related question is whether bankers who made the bad investments that arguably caused the banking crisis should be helped. In some sense capitalism works because those who make smart decisions are rewarded while those who take on too much risk lose out in the end. Governmental leaders are wrestling with whether in this case the rest of the economy would be hurt too severely if the banks that made the decision to invest in these risky securities were made to suffer the consequences of their choices.
[7] The third policy involves the federal government intervening in individual mortgage loans. In this policy, the government would give courts the authority and private lenders incentives to renegotiate the terms of mortgages for borrowers who are at risk of defaulting. The recently described policy would do a number of things. One provision would give lenders an incentive to lower the monthly payments for borrowers whose mortgage payments are now more than a certain percentage of their monthly income. In general, such renegotiations can benefit both the borrower and the lender. The borrower avoids losing the home, while the lender avoids having to foreclose on the property. Lenders often do not recover a significant fraction of the value of the home in foreclosure since the process takes time during which the lender receives no payments. Furthermore, after foreclosure proceedings are begun the resident has little incentive to maintain the property – another example of moral hazard. A second provision in the plan would allow borrowers to refinance even if the value of their home has fallen low enough that they do not qualify under current refinancing rules. The motivation for each of the included provisions is to attack the problem at its root, to reduce the number of home loan defaults and therefore foreclosures. In addition to the benefits to the borrowers and lenders directly involved, the reduction in default rates should help neighbors whose home values are depressed by foreclosures on their block, and the banks that invested in the real estate market.
[8] The other sort of governmental reaction to the economic downturn has been to increase government spending and reduce taxes. On February 17, 2009, President Barack Obama signed a bill authorizing $787 billion in spending and tax cuts aimed at stimulating the economy. The motivation for this sharp increase in federal government spending is that it might make up for the spending that is not being done by private citizens. This idea is due to John Maynard Keynes, an early 20th century British economist. Keynes’ prescription for getting an economy out of extraordinarily bad situations, such as the Great Depression, was for the government to spend money as a way to get it into private citizens’ hands. These private citizens, the theory goes, would then have money that they could spend on the things they were not able to afford due to the poor general economic conditions. Spending would spur more spending and the economy would return to health. Keynes’ ideas have been debated ever since he first wrote about them in The General Theory of Employment, Interest and Money in 1936. Many economists dispute the wisdom of using government spending to counterbalance ups and downs in the economy, preferring what is called monetary policy. In this alternative strategy, the central bank (the Federal Reserve in the U.S.) works to counterbalance these ups and downs by adjusting the amount of money in circulation and by lowering and raising the interest rates at which banks borrow and lend from each other. Because the Federal Reserve has already lowered that rate essentially to zero, there is little scope for monetary policy to address the current economic problems.
[9] So will the stimulus spending work? No one knows for sure, but it is instructive to work through the logic underpinning the idea. To see this logic it is useful to think of the economy on a large scale as combining resources—e.g., labor, capital, land—to produce output. When the economy is working well, it combines these resources to generate the level of output that is valued the most by the collective public. If the government were to increase spending when the economy was at this optimal level of output, private spending must decline by an equal amount. If the economy were already producing as much as it possibly could, government spending could not logically increase production beyond that amount. Economists call this phenomenon “crowd out” because the government spending crowds out private spending. If however the economy is not producing at its highest level, then there can be room for government spending to add to private spending. When the economy is producing below its optimal level this means that there are some resources that are not being used to produce goods that people value. The increasing unemployment discussed at the beginning of this article is one outward sign of resources sitting idly when they would like to be used in production. Similarly, there is likely to be “unemployed” capital right now.
[10] The argument goes that if the government were to pay some of that unemployed labor and capital to produce things that people value, it would increase total production. The rate of increase in output generated by a dollar of government spending is called the multiplier. If the government spending generated output produced only with previously idle resources (and if those resources did not spend the money they earned from working on the government projects), then the multiplier would be equal to 1. If the workers employed by the government projects were to spend the money they earned and that spending induced other companies to hire some of the unemployed workers (or capital), then the original dollar spent by the government could even increase output by more than one dollar. In other words, the multiplier would be greater than 1. In fact, in its projections of the effect of the stimulus spending, Christina Romer, the Chair of the President’s Council of Economic Advisors uses estimates of the multiplier in the range of 1.5.
[11] Some economists believe that the multiplier is lower than this, however. If any of the projects included in the stimulus package produce output using resources that were already being used to produce other things, then government spending would take away from private production and the multiplier would be reduced. For example, some of the stimulus money is allocated to projects that are intended to have laudable long term benefits like medical and climate change research. However, much of that money will go directly to scientists who already are working on other projects. Redirecting their research time may lead to valuable scientific discoveries in the long run, but it will not have direct immediate stimulative effects on the economy unless the scientists spend the money on products that are produced with unemployed labor and capital.
Concluding remarks
[12] Encouragingly, public and political discourse concerning the state of the economy is focused directly on the situation, on understanding its causes and on searching for solutions. The government is trying to attack the problems in a number of different ways, struggling with questions of how to help the overall economy without protecting those who made irresponsible decisions from the consequences of their actions. Unfortunately, in many cases these two goals are at odds. It is too soon to tell whether any or all of the solutions will work as planned either in the short or long run.
[13] As a parting thought, there is one minor benefit of the dire condition of the economy. From this terrible situation we might learn which of the remedies we try work and which do not. Hopefully this knowledge will allow us to turn around future downturns more quickly and efficiently, and to avoid the pain felt by families that lose their incomes and savings when labor and financial markets turn downward. Better yet would be that, with the luxury of hindsight, we learn what caused the current economic situation and work to reduce the chances it happens again.