Crossroads (Toward Philippine economic and social progress)
Philippine Star, 1 October 2014


It has been a full year since I commented on the world economy. The US economy is important to all open economies – through the influence it has on trade, investment and productive activity.

The US economy underwent a serious collapse as a consequence of the sub-prime financial bubble in 2007. The impact of this event was global, affecting all countries, including the Philippines.

Today, the US economy has bounced back from the recession and is on its way back to health. Growth per head is at 2.5 percent per year. The unemployment rate, once 12 percent of the labor force, is now inching toward 6.5 percent. Inflation has been below the two percent targeted by the Fed.

How the US managed its recovery. Initially, the economic debacle did major damage to the financial sector. The consequence of this financial collapse was a decrease of demand for goods and services, pushing the economy toward serious recession and unemployment.

It was feared that the recession could turn into something worse, a depression. The emergency required special actions. Great uncertainty prevailed during 2008 to 2011 when the US had to face the worst of those times by taking moves to stay the damage and to stimulate productive work.

The government first decided to bail out the big banks, and allowed one major investment bank to collapse — the most exposed among them (Lehman Brothers). “Too big to fail” was a common argument applied to the rescue operation. It was essential first to save the system so that it continued to operate.

Among the big names rescued in those early operations were Citibank, Bank of America, JP Morgan, Goldman Sachs, Morgan Stanley, Merrill Lynch, AIG. The American financial sector was in near shambles. It was essential to restore it to function as in its most fundamental task, as facilitator of real economic activity.

With a failed financial system, the normal flow of consumption, investment, production and income – the real economy — would suffer permanent damage. A spiral downwards of these flows would happen without the intermediation that the financial system performs.

The recession meant that the economy suffered from lack of aggregate demand. To cure the malaise, both fiscal and monetary policy needed to work and complement each other in support.

On the fiscal side, the US government undertook an initial program to buy and isolate the toxic assets of the system through a Troubled Assets Relief Program (TARP), to rescue the damaged financial institutions and allow them to function. In addition, the program propped up major industries.

Thus, the federal government actively rendered assistance to the American automobile industry. It bought, through direct investments, to save General Motors from complete collapse. It also saved Chrysler from bankruptcy, and assisted to sell it to an Italian carmaker – Fiat. Only Ford, the other automobile giant, escaped the consequences of the fall in demand because it undertook forward-looking company restructuring just before the financial crisis.

Government spending priorities were directed toward the repair, upgrade, and expansion of infrastructure. A resurgence in public investment was made, especially in transportation as well as in the support of new developments in energy exploration and other job-creating innovativeness. But it could not raise the budget to fiscal stimulus levels.

Large, additional fiscal expenditures were hampered by the existence of a public debt limit. A reluctant Congress would not raise the limit without a fight. Thus, fiscal stimulus could not be unleashed, a victim of political gridlock.

Monetary stimulus takes the lead. It was left to monetary policy to undertake the measures needed to raise aggregate demand. By happenstance, the American central bank was ready. Ben Bernanke, the chairman of the Fed, was a serious student of the operational shortcomings of the Great Depression of the 1930s.

As an academic, Bernanke was one of the foremost experts on the US Great Depression. He understood that inadequate policy responses prolonged that depression and extended economic suffering much longer. In many studies of that period, he analysed how the economy could have been better helped by better policy measures.

Quantitative easing — QE. Without sufficient fiscal stimulus, monetary and credit expansion was the cure. This was a combination of traditional and innovative weapons – interest rate policy and something bolder.

As early as December 2008, the Fed had slashed interest rates to their lowest and had kept them there – almost close to zero. This was the traditional weapon: with interest rates so low, the demand for loans induce individuals and businesses to borrow.

To complement this program, the Fed initiated a massive program of buying of bonds held by the public. This was the “quantitative easing” (QE) program. QE included something new – the buying of privately-held corporate bonds. (The buying and selling of government bonds in the open market is a traditional tool of monetary policy.)

The massive purchases of private bonds through a series of phased programs of bond-buying effectively quadrupled the size of the Fed’s balance sheet from 2008 up to the present time. This was unprecedented.

As long as the economy was suffering high unemployment, the Fed announced that the bond-buying program would continue. Much later, it would become known that the target rate of unemployment of 6.5 percent of the labor force would make the Fed “taper”, that is, reduce the QE program.

The twin measures of low interest rate and quantitative easing, or in traditional parlance, easy money policy, the Fed was able to stimulate demand within the private economy.

Thus, economic recovery became possible. That program resuscitated the private economy back to economic health. Had the monetary policy makers allowed bankruptcies through lack of stimulus, another Great Depression would have come into being.

Crime and punishment. The story did not end there, however. Independently and through other mechanisms, the excesses of the financial institutions that fanned the crisis were subjected to an investigation of their accountability.

Although they were restored back to financial health (with them being able to repay the borrowed funds extended to them), the government assessed these institutions hefty, commensurate, and unprecedented fines.

JP Morgan, Citibank, Bank of America, AIG were all made to pay historic fines as compensation for their crime of commission in the mishandling of the sub-prime housing debacle.