Recession and Public Policy: A Tutorial

The current recession, which is causing great anxiety in the US and abroad, has led to a major shift in public attitudes toward the intervention of government in private economic activities. Because major banks have failed and important industries have experienced dramatic downturns, comparisons to the depression of the 1930s have been offered in the press and may be motivating some of the government’s response. Economists are not in agreement about what special measures should be taken, if any, to counter the recession. It seems that the recession originally threatened mainly the prospect of more bank failures arising from a downturn in the market for mortgage finance but it quickly expanded to include both home construction and the automobile industry. By now, the downturn has hit most other industries as well. This note explains how the problems in banking, housing, and automobiles are related and discusses policy actions that are the subject of current public debate.

The Housing Part of the Housing–Finance Problem

The housing-finance story is well-known: in the last 7 or 8 years, housing prices had been rising steadily, and mortgage lenders and borrowers were speculating they would continue. They made many mortgages based on too-high evaluations of house values and too-high estimates of borrower’s ability to pay. Borrowers and lenders were betting that if borrowers found themselves unable to meet their monthly payments, they could sell their houses at prices above what they had paid and everyone would come out ahead. In fact, the profits to be made in the housing market led a number of people to buy houses that they didn’t plan to live in, simply as an investment, and home builders found a ready market for new houses in such a speculative market. The number of new houses built in the last few years exceeded the increase in the population by a significant amount.
Mortgage brokers make their money by finding borrowers and making loans; they sell the mortgages to banks or to the semi-government organizations Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), who then resell many of the mortgages to banks and other financial institutions. Fannie Mae and Freddie Mac buy only mortgages that meet minimum standards of security: the income of the borrower must be enough to give assurance that the borrower will have a good chance of meeting the payments, and the value of the property must be high enough to make the mortgage secure. But mortgage brokers have a strong incentive to make things easy for borrowers in order to make a deal attractive, and they apparently didn’t always ensure that when the loan was made, borrowers had the necessary income or that the house was adequate collateral for the amount of the loan. To make more mortgages affordable, lenders offered an array of terms including “adjustable rate mortgages”—low rates for a time that would “adjust” to higher rates after a few years. Given the prospect of continually increasing housing prices, this kind of loan did not appear to be a serious problem, and Fannie Mae and Freddie Mac encouraged them as a way of providing home ownership to buyers who might otherwise have been unable to afford it.

All was well until the market turned down.

First, housing prices stopped going up, and many people, particularly those who had recently had their rates adjusted, found themselves unable to meet their payments. And they also found out that they couldn't easily sell their houses at the current prices. To get their money back, lenders had to foreclose on homes—i.e., evict the borrowers and sell the houses in an attempt to recover the remaining debt.

Then, starting about a year ago, the number of foreclosures increased dramatically, and housing prices actually started falling. That was the first sign of a serious problem in the housing market. As prices fell, more and more borrowers who had been planning to sell their houses, either to cash in on past price increases or who had to move, found themselves unable to sell their houses. Potential buyers decided to sit on the sidelines in the hope that the price would fall further. In addition, some people who didn’t have to sell found that they were “upside down,” or “under water”: their payments were high enough and the value of their house had fallen far enough below what they owed that they chose to simply walk away, and leave the house to the lender. That was common in places like Florida and California where there had been extensive speculation in the housing market . The price decline accelerated and housing sales declined. It has not yet stopped declining.

The Finance Part of the Housing–Finance Problem

Any mortgage is a gamble; the lender hopes that the money he invests will generate a positive return. No one will normally lend with an expectation that the borrower will fail to meet his payment schedule but there is always some risk. While in some cases, brokers actually misrepresented loan conditions and borrower qualifications in order to make mortgages feasible, that was probably not a major contributor to the meltdown in the housing market, and it would be a mistake to blame the entire breakdown in the financial system on the mortgage brokers and borrowers, Fannie Mae and Freddie Mac, and the banks that bought the mortgages. They made mistakes in evaluating houses and mortgages but they were all doing what actors in the market are supposed to do: search for the highest level of return on investments. The problems arose, at least in part, from the development of new methods of marketing mortgages in the home finance market.

The rate of return on an individual mortgage is higher than the return on government bonds for two reasons: the risk that an individual mortgage holder may occasionally find himself unable to meet his payment schedule, and the paperwork burden of accounting (which is a major cost in banking). Banks have always tried to reduce the risk of failure in a single mortgage by diversifying—holding a large number of mortgages on the principle that while a few borrowers might run into trouble, it was unlikely that many would have the same problem at the same time. But a new way to diversify arose that promised to reduce the risk even further, and also cut down on the paperwork burden. And this changed the whole nature of the mortgage market. Instead of just selling individual mortgages to banks, Fannie Mae and Freddie Mac “securitized” them. That is, they grouped many mortgages and issued bonds based on the expected payments from the mortgages in that bundle. These “Mortgage Backed Securities,” or MBSs, promised higher rates of return than many other investments available on the market.

People who buy bonds cannot usually do the research (called due diligence) to determine how risky the bonds are, so they rely on bond rating organizations for the research. Largely based on the fact that Fannie Mae and Freddie Mac had approved the underlying mortgages as having proper security, the rating organizations gave these “Mortgage Backed Securities” high ratings, and investors all around the world bought them. Banks who bought them counted them as assets and offered them as collateral for borrowing from other banks and other lenders.

Banks make money by lending or by investing in securities like MBSs. Since cash provides no return, they like to keep only enough cash to serve the needs of their depositors. If a bank has excess cash, it will lend it even for a small return, and even for as short a period as overnight. Typically, such overnight loans are to other banks which may have come too close to the margin and need to adjust quickly. When a bank gets into trouble because it has made bad loans that have to be revalued downward on its balance sheet, other banks are afraid that the borrowing bank may fail and be unable to repay loans—so they refuse to lend to a bank in trouble, even for a short term.

Bank failures are not unprecedented; there are standard procedures under which regulatory authorities either take over the bank or force it into a merger with a healthier bank, or force it to close altogether. But such failures are not common among the very largest banks. Moreover, if a large bank gets into trouble, the Federal banking authorities may treat it as “too large to fail,” because the largest banks are often so closely involved with other banks as borrowers and lenders that such a failure could adversely affect the balance sheets of all, and cause problems for banks that would otherwise be deemed “healthy.”

The Housing–Finance Interaction

As an indicator of the “health” of banks, they are required by law to maintain a minimum ratio of assets to liabilities on their balance sheets. Accounting rules require that banks value what assets they own at “current market value” (referred to in the press as the “mark-to-market” rule), and when the housing market went into decline and borrowers stopped paying or fell short in their payments and other homes houses went into foreclosure, the returns on MBSs declined also. It turned out that the MBS holders didn’t know the quality of the mortgages underlying the bonds but were required to estimate their value at levels that put a number of the largest banks into insolvency. The result was that many banks, including some of the largest in the world, found themselves with greater liabilities than assets: they were designated by the regulatory authorities as “insolvent” and required to increase their assets or go into bankruptcy.

There had been a couple of large failures in England in 2007, and the first to fail in the US, in September, 2008, was Bear Stearns, the fifth largest investment bank in this country. Many people were shocked that the government let Bear Stearns fail, thinking that it had qualified as “too large to fail,” and stock markets all over the world fell in reaction. When Fannie Mae and Freddie Mac next turned up in trouble, the US Treasury decided to intervene and took them over. Shortly later, Lehman Brothers investment bank went into bankruptcy, at that time the largest bankruptcy in US history. The Treasury Secretary announced that we were in the midst of a “credit freeze,” and that we faced a catastrophe if the government didn’t do something to inject capital into the banking system. With a lot of doom-saying and arm-twisting, the Bush administration got the Congress to pass a bill promising $700 billion to prevent bank failures by buying the questionable securities: the Troubled Assets Relief Program (TARP). So began the housing-finance crash and the bail-out program whose objectives and methods have, as yet, not been defined.

The Automobile–Housing Interaction

The US automobile industry has been in trouble for years, as more efficient foreign producers have been competing effectively in the US market. Some of the problems are analogous to those of airlines after air travel was deregulated. In the case of airlines, regulation had ensured that American airlines were protected, not only from foreign competition but from domestic competition as well. Regulatory authorities controlled routes airlines could fly, schedules, and ticket prices. In essence, individual airlines were monopolists on the routes they were allocated and they charged monopoly prices. Such circumstances led to the formation of unions of airline employees who demanded a share of the monopoly profits and, as their power grew, they secured agreements from the airlines about work rules that operated to the unions’ advantage. When deregulation took effect, new airlines sprang up that were unencumbered by past agreements with the unions; they were able to hire workers at lower wages, with fewer work rules, and were able to achieve efficiencies that were unavailable to the older “legacy” airlines. Eventually, they drove most of them out of business.

In the case of the US auto industry, protection from foreign producers was initially in the form of high transportation costs. It was hard for foreigners to ship cars to this country and still make a profit, despite their lower labor costs. The response of foreign producers was to specialize on a relatively small segment of the market—cars smaller and less costly to operate than the standard American car. The American manufacturers chose not to compete in this market. It would have been costly for them to re-tool, and they were bound by their existing work rules and dealer relationships. When they did make an abortive effort to make smaller cars, the market largely rejected them.

Then, three things happened to change the conditions that had protected American car manufacturers: 1) the costs of transportation fell, making the cost of international shipment of all kinds of products relatively much less important; 2) Japanese car makers, whose products had originally suffered from quality problems, learned how to improve quality; and 3) the Japanese and other foreign manufacturers found that they could open factories in the US and hire labor not subject to union wages and work rules. From the end of World War II, American car companies have been fighting a losing battle with their foreign competitors. In recent years, foreign competition has increased as new foreign companies in Korea, India, and now China have entered the market. It has been estimated that foreign producers operating in the US have a cost advantage of more that $1200 per car. It is hard for a producer to compete when operating at so high a cost disadvantage; the lower costs show up in superior quality and added “extras” that make foreign cars more desirable. Given the entry of new manufacturers abroad and the development of foreign owned plants in the US, it has been estimated that world-wide manufacturing capacity exceeds the market for new cars by about 20 percent. Some manufacturers are soon going to fail.

A fourth factor entered the car market about two years ago: the rising price of gasoline. Partly because we used to be one of the largest suppliers of crude oil from domestic US sources, gas has always been less expensive in this country than in Europe. In addition, because the US is so large and distances people travel are often great, the comfort of large cars has been an important selling point. Large US cars have had little market abroad but a relatively large market at home. But when the price of gasoline suddenly shot up to about $4.00 per gallon, comfort began to take second place to the cost of travel and the demand for large cars began to drop off. The gas price hike no doubt contributed to some easing in the housing market: people reconsidered the advisability of buying homes far into the suburbs, which would have made commutes suddenly more expensive. The result of the gas price increase was to leave American car makers with a lot of unsold cars, a great deal of debt associated with their production, and their old contractual commitments to the union. They are currently losing money at the rate of billions of dollars a year and their stock prices have fallen to practically zero.

Recession

Every now and again, economic activity expands and contracts in what is commonly called the “business cycle.” The cycle varies in the periods between the peaks and troughs, and in the intensity of the fall-offs. In recent experience, the duration of the declines has been shorter and the upturns longer by even more, so that the period between peaks has increased. Causality in business cycles—exactly what causes expansions to stop, businesses to go into contraction, and things to pick up again after a recession is not well understood. Some elements are clear: a recession starts when businesses find that things they had bought, either for use in production or for sale at the retail level, go unused or unsold on the schedule for which they had been bought. As a result, producers and retailers reduce their purchases until inventories fall to the level needed for future sales. As these purchases are reduced, businesses making products for use in later production or for sale at retail reduce their production and economic activity diminishes. In making the cuts in production, employees who are not needed immediately in the production process are laid off and employment declines. As their earnings decline, their demand for products declines as well, amplifying the decline in production. That is recession.

The recession that started in 1929 lasted through the middle 1930s, but when recovery began, government actions reversed the recovery and the recession continued until the start of World War II. That long period of recession was the “Great Depression.” Unemployment reached levels of 25 percent of the labor force and remained above 17 percent until the advent of the war, except when it hit about 14 percent briefly in 1937. There is still considerable controversy about what caused the depression, why it lasted so long, and whether better government policies could have led to a quicker recovery.

In recessions, it is clear that when consumers start to cut back on spending, businesses cut back and the economy contracts. Sometimes such fluctuations are of very short duration: weeks and maybe even months of ups and downs are generally ignored in the analysis and even the definition of “recession.” The contribution of consumer behavior to the cycle is well recognized, however, and some government policies have been aimed at stabilizing consumer spending as an antidote to recession. Unemployment insurance, for example, diminishes the amplifying effect of lay-offs by helping to maintain incomes for the unemployed; welfare programs that are often expanded during recessions have the same effect. But recessions happen nonetheless and every time one comes along, economists and politicians worry that maybe this one will be “The Big One.” That is what is worrying politicians and some economists now.

We are in a recession now, largely based on the effects of the fall in housing prices and last year’s increase in gasoline prices. The housing price fall contributed to the recession in two ways: when people stopped buying houses, the construction of new houses dropped to practically zero in many markets and led to increased unemployment in the construction industry. Industries that supply new houses with kitchen equipment, heating and cooling, housewares, etc., also found that their sales were falling drastically. Beyond that, however, the rising home prices in the past had made home owners feel wealthier, and when people feel wealthier, they consume more. Some of the wealth due to higher home prices led people to refinance their mortgages at higher levels and spend part of the increase. The fall in the housing market, leaving them with higher mortgages and lower house prices, made people feel less wealthy and led them to cut back on their consumption. One of the things that people spend on when they feel wealthy is expensive items, like cars; when they cut back spending, expensive items are among the first to be scaled back. Car sales, including foreign cars as well as American models, have fallen dramatically. The experience of the American big three manufacturers has not been much worse than that of foreign manufacturers, but their financial weakness after years of decline had them on the edge of bankruptcy before this recession began; and they are now insolvent, begging for government support.

Now, in addition to the fall in home prices. consumers have suddenly found their wealth diminished by the falling value of savings that are invested in stocks and bonds. If they are most concerned about providing for their future security, they will try to save from their current incomes rather than going out and spending much on anything but necessities. That is what appears to be happening now, and government attempts to induce consumers to increase spending have not increased consumer confidence. It may not be possible to get consumers spending again until they feel more secure. When that happens, they will spend more because they want to buy goods and services, and businesses will then respond with investment and production decisions that lead to increased hiring and growing demand. If businesses foresee that current government spending will increase their tax burden and reduce the profitability of their operations in the future, they will not invest and hire. Some people seem to believe that government deficits in a recession don’t imply future taxes. Many more seem to believe that higher spending will result in higher taxes. In general, no one seems to have much confidence that what is being done now will make this recession go away very soon.

What Can Be Done?

Every intervention in markets—bailing out failing banks and individual industries like automobiles, and spending on things just for the sake of getting money into the hands of consumers—distorts those markets and makes it more difficult for individual actors in the market to estimate what will happen in response to their current and future actions.

What made the depression in the 1930s “Great” is that it lasted for almost 13 years; it is clearly too early to compare this current recession to that one. Unemployment in the 1970s was nearly as high as it is now, and many economists argued that there was no way to reduce it below about 6 percent without generating inflation. Clearly, they were wrong then, just as they are wrong now to view current unemployment as disastrous. But what will turn this one around is the big question. Inventories of houses and cars will take some time to be sold off, and employment in home building may not come back to its earlier level for years to come; in the domestic auto industry, earlier levels may never come back. The economy will not return to growing employment until the demand for other goods and services returns. To make that happen—assuming that it can be made to happen—government looks for actions it hopes will lead to increased spending and increased activity in general.

Here are the ways that may be done:

1) Government can spend directly on goods and services.
2) Government can encourage individuals to spend.
3) Government can encourage businesses to spend.
4) Government can rely on monetary policy alone.

1. Direct government spending
In discussions of this topic, economists tend implicitly to assume that the only issue of concern is the effect of government on the level of economic activity. That is a misapprehension. When government spends, as is being envisioned as a result of the stimulus bill, the spending helps those who are directly affected but in the process, it makes those individuals proponents of more of the same. Few government spending programs end when their original sponsors imagine they will end. Moreover, once a spending program starts, it tends to grow, causing budget problems later on. For example, in 1972, railroads were losing passenger traffic to cars, buses, and airplanes, and they were losing money on the services they were providing. The government offered to contribute $400 million and let them stop providing passenger service, if they would also contribute $400 million to set up a semi-public rail passenger business that would become self-supporting by the time the $800 million ran out. Since then, that railroad passenger “business” (Amtrak) has asked for and been granted over $25 billion from the government, and is now in line to receive extra funding through the stimulus program. So while government spending can indeed lead to increased employment on the particular things it spends on, such spending becomes the object of political interests other than purely “the economy,” and may be diverted to unproductive ends such as building a bridge to nowhere.

2. Encouraging individual spending
There are several ways in which government can encourage individuals to spend. One way is to increase individual incomes by a long-term reduction in income taxes. Empirical research on consumer behavior has shown that unless people expect an increase in their incomes to be “permanent,” they tend to save, not spend it. This implies that a temporary tax reduction will not be very effective in fighting recession. Another way to increase consumer spending is to take actions that increase their wealth. Reducing taxes on business profits should lead to increased prices in the stock market, thereby making individual investors wealthier. Since so many Americans now own stocks in their retirement accounts, such an increase would help to offset the wealth decrease associated with falling housing prices and the fall in the stock market.

3. Encouraging businesses to spend
Decreasing taxes on profits would not only lead to increasing stock prices, it would also encourage businesses to invest more, and investment spending would have an expansionary effect just as would consumer spending. Another encouragement to businesses would be to allow more rapid depreciation of capital investments. The latter is a familiar approach, but it would tend to distort investment decisions by treating capital differently than other inputs to production, and would be less efficient than simply allowing businesses to realize higher profits on investments.

4. Relying on monetary policy
As noted above, we are all flying blind when it comes to ending the recession and beginning the recovery. There has always been a lot of argument about the role of monetary policy (control of the money supply) versus fiscal policy (taxing and spending) and no one can claim to know all the answers. Those who would rely on monetary policy argue that markets work best when participants can be confident about the rules of the game. The effects of monetary policy are more general, and they distort private incentives less than changes in spending and taxing; while monetary authorities make mistakes, sometimes with disastrous effects, advocates of a monetarist approach tend to rely on the general effects of monetary policy more than fiscal policy to counter recession. When government starts to adjust fiscal policy, either with spending or tax changes or with new rules about business behavior, participants draw back waiting to see how they will be affected. Doing something is therefore almost bound to slow down market clearing behavior, and thus slow down recovery. Beyond that, since a sense of urgency often leads to adoption of poorly thought-out policies that are difficult to retract, whatever policy is adopted is likely to have long-lasting perverse effects. It is worth noting that before the stimulus bill was introduced in Congress, the Congressional Budget Office estimated that the downturn in the economy would end in about eighteen months, presumably without government action. I don’t know if that estimate has been revised since passage of the stimulus.

Where Do We Stand Now?

Society has an interest in seeing the economy recover from the recession with employment returning to its pre-recession levels. The question is what, if anything, can be done to help that happen. The current administration seems to prefer direct spending rather than concentrating on encouraging expansion of individual spending as a way to revive economic activity. When it comes to business spending, the administration appears to believe that urging banks to lend will result in more investment. That ignores the fact that the recession involves working off inventories, and this takes time. Reductions in business borrowing reflect a lack of profitable opportunities rather than bank unwillingness to lend. Lending doesn’t make profitable investments appear; it is the appearance of profitable opportunities that make lending occur. So far, it appears that most government actions are leading to growth of government, not private spending. As government spending grows, and taxes are raised to pay for it, the prospect is for a very slow recovery from the current recession.

Politicians are generally not satisfied with inaction, and policies are currently being made on the basis of political attitudes about the desirability of government versus private spending and guesswork about consumer behavior in response to government actions. Both the Bush and the Obama administrations have threatened catastrophe. The initial bank bailout, and the much broader wider stimulus bill that was just enacted promise massive amounts of spending. If that spending were to immediately result in employment of idle resources, it would increase hiring and might have some expansionary effects beyond increasing the incomes of those immediately hired. As it turns out, much of that spending will take several years to occur. And now, the administration has announced a budget proposing to raise taxes, including the tax on capital gains, and to cut spending. Since the stimulus was justified on grounds that spending should be increased, it seems odd that the administration now proposes decreases in spending; given the makeup of Congress and all the arguments they have offered in favor of more spending, spending decreases are much less likely to appear than tax increases. And tax increases will extend the slide in the stock market and prolong the recession. It looks like we are in for a bad time.