![1. From the breadth and depth of the economic downturn, it was
clear that no one single policy action would address the
problem. Briefly discuss how the various actions taken by the
Treasury and the Fed served to work together or possibly
against one another to address the problems.
2. How did the backgrounds of both Geithner and Bernanke
serve to assist or hinder them in understanding and acting to
solve the problems?
3. "The biggest problem we now face is how the Treasury and
Fed can withdraw from the heavy level of financial support that
they’ve provided without plunging the economy back into a
recession." Please comment on this proposition.
UV3957
November 10, 2009
This case was prepared by Associate Professor Frank Warnock.
It was written as a basis for class discussion rather
than to illustrate effective or ineffective handling of an
of Virginia Darden School Foundation, Charlottesville, VA. All
rights reserved. To order copies, send an e-mail to
[email protected] No part of this publication may be
reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any
means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of the Darden
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- 1. 1. From the breadth and depth of the economic downturn, it was clear that no one single policy action would address the problem. Briefly discuss how the various actions taken by the Treasury and the Fed served to work together or possibly against one another to address the problems. 2. How did the backgrounds of both Geithner and Bernanke serve to assist or hinder them in understanding and acting to solve the problems? 3. "The biggest problem we now face is how the Treasury and Fed can withdraw from the heavy level of financial support that they’ve provided without plunging the economy back into a recession." Please comment on this proposition. UV3957 November 10, 2009 This case was prepared by Associate Professor Frank Warnock. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.
- 2. GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS Valentine’s Day 2009 had just passed, and the financial crisis that had gripped the country for the past year and a half was threatening to put a quick end to the American public’s honeymoon with President Obama. The crisis, and the Obama administration’s response to it, had the potential to determine whether the Obama presidency would be a success. When it came to the course of U.S. economic policy, two of the top decision-makers were Tim Geithner and Ben Bernanke. Treasury Secretary Geithner and Federal Reserve (Fed) Chairman Bernanke had the eyes of the world on them as they sought policies to help get the United States—and the world—through the mess that began as a financial crisis and had morphed into a full-fledged recession and, potentially, a severe depression. In this time of crisis, at least one thing was certain: Geithner and Bernanke would not require time to get to know one another. Indeed, they had been working closely together since November 2003, when Geithner became president of the Federal Reserve Bank of New York (FRBNY), the branch that is the Fed’s primary connection to
- 3. financial and credit markets (and the large banks that reside in the New York district). Since then, except for a brief period in late 2005 when Bernanke served as head of the Council of Economic Advisors, Bernanke and Geithner had served together on the Federal Open Market Committee (FOMC), the committee that sets U.S. monetary policy. Throughout this crisis, they had been in continuous contact; Bernanke (at times almost daily, it seemed) was implementing new, nonstandard policies, and Geithner, from his previous post as head of the FRBNY, was gauging the impact on credit markets. On this day in mid-February 2009, the news was grim. The U.S. economy had been in recession since December 2007. If the downturn lasted into early spring, as seemed likely, it would become America’s longest post-war recession. The economy had shed 3.5 million jobs over the previous 12 months, the worst 12-month period on record (employment data went back to 1939). Bank lending was plummeting; the few banks with funds available were holding onto them. With this massive shift into liquid assets (cash and cash equivalents) and away from lending of any sort (even for productive uses or, in many cases, the working capital firms needed to survive), Geithner and Bernanke knew the economy would grind to a halt. While they tried not D o
- 4. N ot C op y or P os t UV3957 -2- to focus on the stock market, its spectacular drops were hard not to notice. In October, the stock market fell 20%, its worst monthly loss since a 23% loss in April 1932 (when the Great Depression was just getting started), and November was hardly any better (a 9% loss). The market had stabilized a bit from mid-December to mid-January, but the slide continued with the S&P 500 down more than 10% the previous few weeks. (For basic economic and financial indicators, see Exhibits 1 and 2.) The U.S. economy was in danger of imploding. In the previous year, three of the five big
- 5. investment banks had gone under; the other two converted themselves into bank holding companies. The Fed had essentially taken over the insurance behemoth AIG. Citibank, at one time the largest bank in the world, was teetering close to bankruptcy. And millions of ordinary Americans were in danger of losing their jobs, their homes, or both. The United States was not alone in this crisis. As Figure 1 indicates, global production and trade was plummeting.1 Figure 1. Global production and merchandise trade (annualized three-month percentage change). -15 -10 -5 0 5 10 15 1997M1 1999M1 2001M1 2003M1 2005M1 2007M1 -50
- 6. -40 -30 -20 -10 0 10 20 30 40 50 IP (left scale) Trade (right scale) Data sources: Haver Analytics and IMF staff estimates. 1 Figure 1 is an adaptation of Figure 2 from the January 2009 International Monetary Fund World Economic Outlook update, available at http://www.imf.org/external/pubs/ft/weo/2009/update/01/index. htm (accessed October
- 7. 25, 2009). D o N ot C op y or P os t UV3957 -3- The virulence of the global downturn was alarming. World economic output grew at 5.2% in 2007 and 3.4% in 2008. As late as November 2008, the International Monetary Fund (IMF) was predicting 2009 global growth to be 2.2%. Soon after, in the January 2009 update of its World Economic Outlook (WEO), the IMF marked that forecast down to 0.5%. The global extent of the downturn, as well as the severity with which growth projections were being marked down, was fully evident in the WEO update. No area escaped
- 8. the downward ratcheting of growth expectations. Advanced economies, expected to shrink in 2009 by 0.3% as of November, were now predicted to shrink by 2%. Emerging markets, thought to be able to “decouple” from advanced economies and grow at 5.1% in 2009, were now expected to grow at only 3.3%. It was as if the world’s countries could be viewed on a continuum: On one end were those who were overextended, having borrowed excessively from others; on the other end were those who saved and then lent and exported to the profligate ones. Few were immune from this global downturn. Beyond the numbers, the headlines had been brutal. Iceland essentially declared bankruptcy in October. The currencies of many emerging market countries plummeted against the dollar in late 2008, as investors everywhere rushed back to the “safe” haven of U.S. bonds. Europe was teetering; the euro area was falling into its first- ever recession and its worst slump in 50 years. Worries persisted that Austrian and Scandinavian banks had exposure to wobbly Eastern European markets that might lead to insurmountable losses. There were rumors that the United Kingdom, which had bailed out a number of its banks, would have a currency crisis of its own. Japan was in recession yet again, with growth falling an “unimaginable” 14% in 2008Q4 and its finance minister resigning under pressure. Chinese exports recorded their biggest decline in more than a decade in January, falling 17.5% compared to a year earlier. The International
- 9. Labor Organization (ILO) estimated that 23 million people in Asia would be unemployed in 2009, three times higher than its estimate just one month earlier. The list could go on and on, and the bad news within the United States and from the rest of the world just kept coming. On this brisk mid-February day in Washington, Geithner and Bernanke rolled up their sleeves and re-evaluated their plans to address the nearly impossible task of righting the ship. In terms of monetary and fiscal policy, were they doing all they could to halt this epic slide? Were they doing too much? How Did We Get Here?2 How did the biggest economy in the world come to the brink of a depression? Geithner and Bernanke knew that would be debated for a long time to come, but one could argue that the predicament stemmed from the interaction of financial market innovation, lax internal governance and external oversight, and easy global monetary conditions. 2 The discussion in this section is based on the BIS 2008 annual report, http://www.bis.org/publ/arpdf/ar2008e.htm (accessed October 25, 2009). D
- 10. o N ot C op y or P os t UV3957 -4- Financial market innovations Geithner and Bernanke knew that most financial market innovations are welfare- enhancing. As a reminder that financial market innovation is, in general, a good thing, one need only to picture how life would be different were there no access to credit. That said, financial market innovation often comes with substantial opacity, as innovators, to keep competition at bay, have incentives to mask the true nature of a new product. They also tend to stay at least one
- 11. step ahead of regulators. As financial products develop, those that survive the test of time become more standardized and more transparent, but during periods of rapid financial innovation, new products tend to be quite opaque. The recent financial innovation that had caused much grief was the originate-to-distribute model. Loans of questionable quality had been made and then sold, as the Bank for International Settlements (BIS, the central banks’ bank) put it, to “the gullible and the greedy.” The underlying dynamics of this source of financial stress were not new: Time and time again throughout history, financial institutions and investors would get sloppy in assessing risk. In the end, as part of the learning process, some “tuition” was paid: those who made egregiously wrong decisions tended to suffer losses. While financial turmoil often leads to collateral damage—people and firms depend on financial institutions—learning will only take place if the tuition is steep enough. Tuition had indeed been extracted during this crisis, with Lehman Brothers (founded in 1850) and others being allowed to go bankrupt. But how does a government decide whom to bail out and whom to cut loose? Geithner and Bernanke knew they would never know the true answer. The debris from the crisis was so widely scattered that Geithner and Bernanke could not possibly know with certainty who was “too interconnected to fail” (i.e., whose failure would put the entire country at risk).
- 12. And the desire to save important firms from bankruptcy was always tempered by the knowledge that the basic dynamics of a financial crisis—innovation, greed, gullibility, and the need for tuition payments—had not changed in hundreds of years. Lax internal governance and external oversight One needed only to look at the huge losses, write-downs, and bankruptcies in the financial sector to recognize that there had to have been colossal lapses in firms’ internal governance mechanisms. It was reasonable to expect that these deficiencies would be addressed and that surviving firms and industries would learn important lessons, but that within another decade or two, decision-makers would again get sloppy and cause the next round of financial crises. Human behavior is extremely persistent. Regulators also had to shoulder some of the blame. In particular, it was difficult to fathom how an entire shadow banking sector—the off-balance- sheet special vehicles that were set up by traditional banks and investment banks, the enormous markets in selling “credit protection” that ostensibly insured against your counterparties’ default, but only until the insurer itself went bankrupt—could blossom without prompting substantial regulatory activity. Crises D o
- 13. N ot C op y or P os t UV3957 -5- inevitably beget regulatory change, and this one would be no different: the regulatory environment would likely take a turn toward stricter regulations and oversight. Easy global monetary conditions Global interest rates had been at a historic low, partly attributable to an improved credibility of central banks and a focus on inflation targeting, both of which lowered the premia demanded for inflation risk, and partly to beneficial supply shocks (technological progress,
- 14. globalization), which helped to shift out long-run aggregate supply curves and made the jobs of central bankers seem deceptively easy. Global imbalances also kept rates low. When, for example, U.S. monetary policy was finally tightened—recall that the Fed continually raised the policy rate from mid-2004 through 2006 (Exhibit 2)—emerging markets’ policy of managing their exchange rates by purchasing long-term U.S. bonds kept long-term borrowing costs low (and stoked inflation locally and globally). Whatever the cause, global real interest rates had been abnormally low, and history shows that periods of low real interest rates often end in speculative frenzies. 2008: An Ugly Year Geithner and Bernanke could see that the situation was desperate. As reported in the New York Times, November sales (compared with a year earlier) fell 47% at Chrysler, 42% at Nissan, and 41% at General Motors (GM). Even the big foreign car companies suffered, with sales dropping 32% at Honda, 27% at BMW, and 34% at Toyota, which would book its first annual operating loss since its launch year in 1937–38. “It feels like we’re back in 1982 right now,” Bob Carter, general manager of the Toyota Division of Toyota Motor
- 15. Sales, said on a conference call. “Consumers are simply not shopping today.” Michael C. DiGiovanni, GM’s executive director for global market analysis, added: “Our industry is in a much more severe situation than the rest of the economy. It’s in an unsustainable position for all manufacturers. We cannot continue to operate at these levels or else the entire industry’s going to go down.”3 In the fall of 2008, the “Big Three” U.S. automakers went to Washington, caps in hand, seeking about $50 billion to see them through a difficult time that, according to them, was not of their own doing. GM received a $13.4 billion emergency bridge loan from the U.S. Treasury in December and was fighting to avoid bankruptcy protection. Chrysler, which received $4 billion in federal funding, was considering an equity carve-up that would help avoid bankruptcy but leave the existing equity owners (Cerberus and Daimler) with less than 10% of the company. Consumption spending, not just on cars, but on just about everything, had been falling sharply. (See Exhibit 3a on growth in economic activity and employment; Exhibit 3b for 3 Nick Bunkley, “Another Month of Miserable Auto Sales,” New York Times, December 2, 2008. D o N ot C
- 16. op y or P os t UV3957 -6- the contribution of quarterly growth by the components C, I, G, and NX; and Exhibit 3c for confidence measures.) first time in decades, home prices were falling sharply. Permits for new home construction—a leading indicator of economic activity, in part because new homes typically generate much additional spending—were always cyclical, but these days, they were plummeting as they had in the mid-1970s. - October, it was announced that the budget deficit for the fiscal year 2008 was a record $455 billion. With all of the bailouts considered by the Treasury in late 2008—and with the
- 17. increased expenses (in terms of unemployment benefits, for example) and decreased tax revenues associated with a slowdown—the FY 2009 budget deficit was expected to be in the $750 billion to $1 trillion range. to summarize the strain in financial markets was the TED spread, calculated as the gap between three-month LIBOR (offshore interest rates for three-month dollar- denominated loans) and the three- month U.S. Treasury bill rate. The size of this gap was thought to reflect a risk or liquidity premium. As Exhibit 5 shows, it had reached extremely high levels. Another measure, the Baa–Aaa spread, represented the difficulty most firms would have in getting loans compared with those firms who had the best credit quality (i.e., who had Aaa credit ratings). It had reached levels not seen since the Great Depression. With credits markets not functioning, investment was falling sharply, as firms could not borrow to fund new projects. –Aaa spreads to high levels also played out internationally, with money from all over the world flowing into short-term U.S. debt instruments, such as money markets and Treasury bills. (For one analyst’s description of these capital flows, see Exhibit 6). ssive increase in money
- 18. demand associated with the flight from risky assets by increasing the size of its balance sheet (Exhibit 7) had been thwarted by a plummeting of the money multiplier. Going Forward: What’s in Store for 2009? Geithner and Bernanke did not know the best way forward. No one did. Each potential path was fraught with pitfalls, moral hazard, and the potential wasting of the public’s money. But neither considered doing nothing to be a viable option, and new policies were almost continuously being proposed and implemented. D o N ot C op y or P os t
- 19. UV3957 -7- Fiscal policy: the American Recovery and Reinvestment Act of 2009 Geithner, and the entire Obama administration, was committed to a fiscal stimulus package but did not know what form it should take, only that it ought to be “substantial.” Much debate over tax cuts versus new spending took place. The Economist reported various estimates of spending multipliers.4 Direct federal spending and federal funding of state and local infrastructure had the highest (estimated) multiplier effects at anywhere from 1.0 to 2.5. Individual tax cuts had lower estimated effects (0.5 to 1.7). The range of estimates for each type of stimulus indicated that, really, no one could predict with any certainty the likely impact of various proposed new spending or tax cuts. Eventually, on February 17, 2009, Obama signed a stimulus package that totaled $787 billion: about one-third tax cuts and one-third aid (for states, the unemployed, and for access to health care). Of the rest, labor, health, and education got 8%, infrastructure about 7%, and some was earmarked for energy and water. For line-by-line details with amounts—including items such as a $3.2 billion tax credit for GM, $1.3 billion to “invest
- 20. in air transportation,” and $2.3 billion to improve Department of Defense facilities related to the quality of life—see Exhibit 8. As renowned conservative economist Robert Barro of Harvard argued, the Obama administration hoped that the multiplier associated with this package would be greater than one, perhaps as high as 1.5; he noted that a multiplier of one would imply that when increasing spending, the government was not crowding out private investment but was only using slack resources—unemployed labor and capital. Barro instead anticipated that the multiplier was more likely to be far less than one and that any increase in government spending would be at least partially offset by some reduction in private spending.5 The U.S. public could only hope the administration was correct on this one, but people worried that Barro might be right. Whichever side was correct, the stimulus would do nothing to lessen the U.S. debt burden (Figure 2). 4 “Can the Centrists Hold?” Economist, February 5, 2009 (print edition). 5 In 1974, Barro popularized the term Ricardian equivalence, named for the British economist David Ricardo. See any intermediate macroeconomics textbook for details. Briefly, according to the Ricardian view, consumers are forward-looking and spend based on current and expected future income. If, for example, consumers expect the new stimulus plan to increase their future
- 21. tax liability, they might save now in anticipation of a higher future tax bill. See also Barro’s “Voodoo Multipliers,” Economists’ Voice 6, no. 2 (February 2009), http://www.bepress.com/ev/vol6/iss2/art5. D o N ot C op y or P os t UV3957 -8- Figure 2. U.S. debt by type of borrower (as a percentage of GDP). 0 50 100
- 25. Households Business Govt Financial Data source: Author calculations based on data from Federal Reserve’s Flow of Funds Accounts. Of course, the current crisis was global, and sizable fiscal deficits were emerging all over the world, as Figure 3 from the IMF’s January 2009 update of the WEO indicates.6 Figure 3. General government fiscal balances (as a percentage of GDP). -8 -6 -4 -2 0 2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Emerging and developing economies World Advanced economies
- 26. Data source: IMF staff estimates. 6 Figure 3 is adapted from Figure 6 in http://www.imf.org/external/pubs/ft/weo/2009/update/01/index. htm. D o N ot C op y or P os t UV3957 -9- Treasury policy: TARP The first incarnation of the Treasury’s Troubled Asset Relief Program (TARP), signed by
- 27. Congress in early October 2008, was a $700 billion “bazooka” to bail out the U.S. financial sector. The original idea behind TARP—to free banks and other financial firms of the most toxic loans and securities on their books by purchasing them in auctions—never got off the ground. The hope was that a big buyer (the government) would end up paying more than the prevailing fire-sale prices but less than the intrinsic value if held to maturity (so that these would actually be good investments for the U.S. taxpayer). Instead, with the crisis deepening, on November 12, the Treasury buried the original idea and moved toward deploying TARP funds to recapitalize banks and nonbank financial institutions (such as the financing arms of the big car companies). By the end of 2008, the government had committed $244 billion of public money not to troubled assets, but to troubled financial institutions. This included $40 billion to buy shares in AIG, the single largest injection of capital ever by a government, and $125 billion to banks such as Citigroup, Wells Fargo, and JPMorgan Chase. On February 10, 2009, Geithner announced the revamped TARP. As the Economist reported, the response was less than positive:7 Most disappointment was directed at the sketchy plan to tackle banks’ toxic assets, such as mortgage-backed securities and leveraged loans. At a late stage Mr. Geithner rejected the idea of a government-run bad bank (as well as blanket
- 28. guarantees for noxious assets), put off by the high upfront cost and the problems it would have valuing the debt. He now hopes to amass $1 trillion of buying power by drawing in investors, such as private-equity groups, whose inclusion would stretch the government’s money further and bring more discipline to pricing. [B]ut Mr. Geithner still has a yawning gap to bridge between banks, which do not want to sell at depressed prices because of losses they would have to recognize, and potential buyers, who need to be sure of healthy returns. It was this that put paid to both the original TARP and Mr. Paulson’s efforts to rescue structured- investment vehicles. Distressed-debt investors, such as Blackstone and BlackRock, are interested but want more information. To be sure of attracting them, the government might need to provide a combination of cheap loans and a guaranteed floor on losses. But even then, the mooted public- private partnership may not be big enough. Barclays Capital counts $2 trillion–3 trillion of troubled assets in America, excluding prime mortgages, which are souring fast. Goldman Sachs appeared to agree with Barclays on this. Goldman reportedly estimated that the United States had troubled assets that amounted to about 40% of GDP. In the depth of Japan’s lost decade, troubled assets (in the form of
- 29. nonperforming loans) totaled 35% of GDP. Moreover, the Japanese experience was a lesson in the cost of delaying dealing with troubled banks; the fiscal cost of Japan’s bailout of its financial sector totaled almost one-quarter of GDP. 7 See “Dashed Expectations,” Economist (February 12, 2009), D o N ot C op y or P os t UV3957 -10- In contrast, the U.S. savings and loans bailout of the late 1980s—in which a government entity (Resolution Trust Corporation) forced the closure of troubled banks, took on their bad assets, and
- 30. in bankruptcy proceedings recouped much money on behalf of depositors—cost 3.7% of GDP (Table 1). Table 1. Fiscal cost of financial sector bailouts. Country Start of Crisis Fiscal Cost (% of GDP) United States 1988 3.7 Finland 1991 12.8 Sweden 1991 3.6 Mexico 1994 19.3 Japan 1997 24.0 South Korea 1997 31.2 United States 2007 5.8* * As of September 2008. Data sources: Luc Laeven and the Economist. Federal Reserve policy Fed policy during this crisis had been nonstandard, uncommon, aggressive, scary—pick your favorite descriptor. In the old days, prior to the onset of this crisis, there were three tools available for monetary policy:
- 31. implementing monetary policy was the use of open market operations (OMOs)—purchases and sales of U.S. Treasury and federal agency securities. With OMOs, the FOMC specifies the short-term objective, which can be a desired quantity of reserves (as was common prior to the 1980s) or a desired price (the federal funds rate, the interest rate at which depository institutions lend balances at the Fed to other depository institutions overnight). In the early 1980s, Paul Volcker’s Fed moved the focus from a quantity objective (reserves) toward a price objective (attaining a specified level of the federal funds rate).8 8 Another change is increased transparency. Market participants had to divine Fed policy until 1994, when the FOMC began announcing changes in its policy stance; in 1995, the FOMC began to explicitly state its target level for the federal funds rate. Transparency increased even more in February 2000, when the statement issued by the FOMC shortly after each of its meetings began to include the committee’s assessment of the risks to the attainment of its long-run goals of price stability and sustainable economic growth. D o N ot C op
- 32. y or P os t UV3957 -11- o adjust the discount rate, the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve bank’s lending facility (the discount window).9 itional policy tool was the level of reserve requirements, the amount of funds that a depository institution must hold in reserve (in the form of vault cash or deposits with Federal Reserve banks) against specified deposit liabilities.10 On these traditional tools of monetary policy, the Fed had gone about as far as it could go. In December, the Fed set a range of 0 to 25 basis points for the target federal funds rate
- 33. (Exhibit 2). On that dimension, monetary policy was as loose as it could be. But Bernanke— derisively called Helicopter Ben for suggesting during the deflation scare of 2002–03 that to stay clear of deflation he could just drop money from a helicopter— had known full well that there were other, nonstandard tools that were permissible by the Federal Reserve Act’s Section 13(3).11 In addition to the traditional tools, the Fed had employed three other types of tools to improve the functioning of credit markets. The first of these three new tools was in the spirit of the Fed’s traditional role of providing short-term liquidity to financial institutions: -term liquidity facilities for U.S. banks and currency swap facilities for foreign central banks. During the course of the crisis, the Fed had created a number of new facilities for auctioning short-term credit. Ensuring that financial institutions had adequate access to liquidity was thought likely to increase their willingness to extend credit and to help ease conditions in interbank lending markets, thereby reducing the overall cost of capital to banks. To ease conditions in dollar- funding global interbank markets, the Fed also approved bilateral currency liquidity agreements with 14 foreign 9 The Federal Reserve banks offered to depository institutions three discount window credit programs—the primary, …