The collapse of the mortgage security market meant that trillions of dollars’ worth of financial assets had become worthless. This economic recession was a deadly combination of a financial crisis compounded with a wider economic crisis. In the face of economic recession, the Keynesian prescription is for expansionary monetary and fiscal policy to stimulate the economy. The problem was that the tools of policy that are normally effective were both severely hampered.
The usual prescription for a recession is for the Fed to buy Treasury bills from primary security dealers and then allow the money creation process to work its magic. When banks are unwilling to lend, this prescription does not work. Instead of money being created, the financial system was destroying money. Because many of the failures in the financial system had occurred outside of traditional banking, the Fed was hard-pressed to get money where it needed to be.
The Fed is set up by law to work with the banks. The tools it has at its disposal are aimed at banks, but this financial crisis was different. The shadow banking system that had been created by deregulation was out of the scope of the Fed. In order for the Fed to get things working again, the shadow system had to be transformed into the more regulated traditional banks. That is what they did. Goldman Sachs and Morgan Stanley, the last of the great investment banks, changed their status under SEC regulations and submitted to the Fed.
A visit to the Federal Reserve Board of Governors website throughout the financial crisis indicated that something interesting was happening. Almost on a monthly basis, the Fed was inventing new tools of monetary policy. The first was the Term Auction Facility (TAF), which allowed banks to bid on loans from the Fed without the perceived downside risk to borrowing from the discount window. Soon the Fed was creating other lending facilities to inject money into the system. The Fed started buying up mortgage-backed securities and agency debt. Ultimately what the Fed was doing was creating markets for assets in exchange for cash, a process called quantitative easing.
In the end, most of the facilities created during 2008 to halt the financial collapse expired in February of 2010. The Federal Reserve did not forgo traditional policy measures during the recession. The FOMC reduced its target for the fed funds rate to 0%. This is as expansionary as the Fed can get with open market operations.
While the Fed was busy trying to simultaneously repair a frozen banking system and return the broader economy to normalcy, the government responded by taking extraordinary measures. The Treasury under Henry Paulson attempted to fix the immediate financial crisis in banking and the mortgage security market. Congress and the president, first Bush and then Obama, planned a massive policy response. The problem for government was that when the crisis hit, government was already engaged in heavy-duty fiscal expansion. Taxes were extremely low and spending was extremely high. Economists questioned how much more stimulus government could deliver.
Congress passed the Troubled Asset Relief Program (TARP) in 2008, giving the Treasury the ability to recapitalize the banks that had been hit hard by the collapse of the housing market and CDOs. This was only the beginning of the government’s efforts to stabilize the economy. The government also purchased control of failing automaker General Motors for $50 billion to keep it from going out of business.
Another program aimed at encouraging durable goods consumption was the Car Allowance Rebate System (CARS), also known as “cash for clunkers.” Under the program, buyers would receive a rebate from car dealers when trading in a used, less fuel-efficient vehicle for a new, more fuel-efficient vehicle. The dealer would then be reimbursed by the government. According to the government, 680,000 cars were sold under the program, which helped spur domestic spending in the economy.
To stimulate investment in housing, the government awarded a substantial tax credit of $8,000 for homebuyers. Furthermore, unemployment benefits were extended for millions of out-of-work Americans. The largest of all the government’s programs was the Recovery Act of 2009, which planned to spend almost $790 billion in order to expand the economy. Combined with tax cuts, two wars, and 0% interest rates, the stimulus is quite aggressive by historical standards. Most economists believe that the government and central bank’s response to the crisis averted a second Great Depression.
Theories affect the way economists and policymakers tell the story of what is actually happening. These narratives of reality have the power to affect reality if enough people believe them. The story of expected inflation creating inflation is a powerful story, and if policymakers do not address it, the story could become the reality.
When an economy falls into recession, businesses cut production and quickly lay off workers. During economic recovery, the logical conclusion is that this process should run in reverse, but that is not necessarily the case. As production begins to pick back up, firms often discover that their remaining workforce has become much more productive. As a result, firms are able to steadily increase output without hiring more workers. As output continues to increase, firms increase the number of hours their labor force works before hiring more. Finally, after accounting for increased productivity and increased working hours, if demand is present then firms begin to hire. Unfortunately for the unemployed, this process can take a very long time. Jobless recovery is the bane of the politician’s existence. The GDP may increase, but unemployment can still remain high for a while. The unemployed vote and do not really care for the neat explanation just given.
The Federal Reserve is walking a precarious tightrope when it comes to inflation. It does not help that so many pundits are warning of coming inflation. Expecting inflation is often enough to spark inflation. The Fed has introduced hundreds of billions in reserves to the financial system in order to unfreeze the flow of credit. The danger to the economy comes in two forms. First, if the Fed begins contracting the money supply too soon, the economy may fall back into deeper recession. Second, if the Fed waits too long to contract the money supply, then inflation may take hold, and that would require the Fed to respond by sending the economy back into recession.