Stress Test – not enough to bolster the real economy

Paul Krugman in the ‘New York Review of Books’ wrote a very informative review of Tim Geithner’s book “Stress Test: Reflections on Financial Crises”. Although I have not read the book Krugman does put across a strong view that the stimulus to end the US economy’s free fall was too small and too short-lived given the depth of the slump.

We can think of the economy as a patient who was rushed to the emergency room with a life-threatening condition. Thanks to the urgent efforts of the doctors present, the patient’s life was saved. But while the doctors kept him alive, they failed to cure his underlying illness, so he emerged from the procedure partly crippled, and never fully recovered.

Something went very wrong with the US economy in 2008. But what?

Quite early on, two somewhat different stories emerged about the economic crisis.

1. A classic bank run of enormous proportions. And there certainly was a very frightening panic in 2008–2009.
2. The large overhang of private debt, in particular household debt.

What’s the difference? A financial panic is above all about confidence, or rather the lack thereof, and the overriding task of policy is to restore confidence. However confidence will not overcome the problem of debt overhang. It needs policies like sustained fiscal stimulus and debt relief for families.

Financial panics arise institutions promise their creditors ready access to their funds but are unable to pay them. This is because they invest in assets that are relatively illiquid, and this works only when a small fraction of a bank’s depositors try to pull their money out on any given day. When this does happen the bank is forced to sell assets – usually at fire sale prices – in order to raise cash – and this can break the bank. And this in turn means that when investors fear that a bank may fail, their actions can produce the very failure they fear: depositors will rush to pull their money out if they believe that other depositors will do the same, and the bank collapses.

The point is that a financial panic is very much a case of self-fulfilling prophecy. And it needs a “lender of last resort,” providing banks facing a run with cash, so that they don’t need to engage in desperate fire sales.

So why was it so hard to organise an effective response to the 2008–2009 panic? One answer is that the Fed was set up to deal with conventional banks, and had neither a clear legal mandate for nor much experience in bailing out shadow banks. Fear of bank losses led to 3 ideas that needed to be debated.

1. Some who warned of “moral hazard”—that bailing out banks would reward bad actors, and encourage future irresponsibility.

2. Some who were in favour of nationalization argued that the banks needed to be bailed out. The idea was that the government, in return for taking on big risks, should temporarily acquire ownership of the most troubled banks, so that taxpayers would profit if things went well.

3. Some thought that the financial crisis should be treated more or less as an ordinary lender-of-last-resort problem—that temporary nationalization would hurt confidence and was unnecessary, that once the panic subsided banks would be OK.

Stress TestWhatever the reasons, however, the stress test pretty much marked the end of the panic. The graph below shows several key measures of financial disruption—the TED spread, an indicator of perceived risks in lending to banks, the commercial paper spread, a similar indicator for businesses, and the Baa spread, indicating perceptions of corporate risk. All fell sharply over the first half of 2009, returning to more or less normal levels. By the end of 2009 one could reasonably declare the financial crisis over.

But a funny thing happened next: banks and markets recovered, but the real economy, and the job market in particular, didn’t. It’s still very hard to find a full-time job—both the number of long-term unemployed workers and the number of people unable to find full-time jobs remain far above pre-crisis levels.

Balance Sheet Recession

The best working hypothesis seems to be that the financial crisis was only one manifestation of a broader problem of excessive debt—that it was a so-called “balance sheet recession.” This is where households have taken on high levels of debt and at some point face pressure from creditors to ‘deleverage’, reducing their spending in an effort to pay down debt. But by doing this they reduce consumer spending in the economy and this can turn into a self-reinforcing spiral, as falling incomes make debt repayment even harder.

However a balance sheet recession cannot be cured by restoring confidence. Fiscal stimulus and debt relief are required by the government to reduce private debts and allow debtors to spend again. The private sector is not in a position to do so.


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