This article is a contribution to 'Is There Anything That Can Be Done? A TNR Symposium On The Economy.' Click here to read other contributions to the series.
As the Great Recession drags on and on, it’s natural to wonder if we will ever get back to normal. Why is the recovery from this recession taking so long? Why was the recovery from other severe recessions, for example the 1982 recession where unemployment reached 10.8 percent, so much faster? Part of the answer is that we are experiencing a “balance sheet recession,” and this type of downturn is much harder to recover from than the other types we have had in recent decades. But poor policy is also to blame. Unfocused stimulus packages don’t get to the root of the problem, and short-term spending cuts are counter-productive. Instead, we need policies that do a better job of targeting the specific problems associated with balance sheet recessions. There are several things policymakers could do to address this, and each would help to improve the economic outlook.
The length of time it takes to recover from a recession is determined, in large part, by the type of shock that caused it. Productivity shocks, monetary policy shocks, oil price shocks, and bursting stock and asset bubbles can all cause recessions, and the effects of some of these shocks can be reversed much easier than others. For example, in 1982 when Federal Reserve chairman Paul Volcker raised interest rates to fight inflation, investment and consumption plans were put on hold and the economy slowed considerably. But once interest rates returned to normal, consumption and investment plans were taken off the shelf and put into action and the effects of the shock passed quickly.
Historically, the recessions that are the hardest to recover from are those caused by collapsing stock and housing bubbles. When a fall in stock and housing prices wipes out retirement, education, equity, and other savings, the balance sheet losses can’t be recouped overnight. It can take years to recover what is lost. Examples of balance sheet recessions such as Japan’s “lost decade” in the 1990s and the Great Depression of the 1930s show how hard it can be to recover from this type of recession. More generally, recent work by economists Carmen Reinhart and Kenneth Rogoff shows that balance sheet recessions are “followed by a lengthy period of retrenchment that most often … lasts almost as long as the credit surge.”
But these examples also show something else: how costly poor policy can be. A slow, “lost decade” recovery like we are currently on our way to experiencing is not inevitable. The speed of the recovery from a recession depends critically upon how monetary and fiscal policymakers react, and a policy tailored toward the specific type of recession hitting the economy can shorten the recovery time considerably. One of the main reasons the outlook for our economy is so poor is that policymakers have done a poor job of matching the policies they put into place to the type of recession we are experiencing.
The first way to improve policy, then, is to directly target the root of the problem: household balance sheets. When banks were having trouble due to the toxic assets on their books, the Fed took them off their hands at very favorable rates, and then took additional steps to ensure the banks would be able to survive. Unfortunately, however, that help didn’t “trickle down” from banks to households.
But what if we had taken the hundreds of billions of dollars that went to banks and instead used those funds to help households pay their bills, particularly their mortgages? If the money had been used, for example, to fund a modern version of the mortgage relief program that worked so well in the Great Depression—a program that, unlike recent half-hearted efforts such as the Home Affordable Modification Program, allowed households to avoid foreclosure in large numbers—then the assets the banks hold would no longer be as toxic. Helping these households also helps the banks as the money “trickles up,” so it’s possible to address both balance sheet problems at once. If households have the ability to pay their mortgages and other bills, then the bank’s problems will take care of themselves.
Second, in addition to mortgage and foreclosure relief, a job creation program would do a lot to stop the deterioration of household balance sheets. The biggest problem that households on the edge face—and we see this in the foreclosure numbers—is job loss. Unfortunately, job creation programs that are so important to household balance sheet rebuilding have not received anywhere near the attention they deserve. Infrastructure investment with an eye toward projects that are labor intensive would help to create the needed jobs in the short-run and more growth in the long-run, and we ought to be pursuing this vigorously.
Finally, while mortgage relief and job creation programs are likely to have the largest impact on household balance sheets, any policy that gives households extra funds that can be used to rebuild savings (e.g. a payroll tax cut), or that promotes more employment (e.g. more aggressive monetary policy), would be helpful.
To be sure, recovering from a balance sheet recession is never easy, but our failure to put the right policies in place is a big reason why the outlook remains so bleak. Politicians do not appear to understand the nature and urgency of the problem we face. Instead of focusing on helping households, all of the attention is on short-run deficit reduction. While we need to bring the deficit under control in the long-run, short-run spending cuts simply make things even worse at a time when millions of households are still struggling with the aftermath of a financial crisis they had no hand in creating. Helping those households through mortgage relief, job creation, and other means ought to be our top priority. The fact that it isn’t—that we are focused, once again, on deficits and other financial issues rather than households and jobs—says a lot about whose interests have the most sway in Washington.
Mark Thoma is a macroeconomist at the University of Oregon. His research focuses on how monetary policy affects the economy, and he has also worked on political business cycle models. Thoma blogs daily at Economist’s View.