Eighty years ago today, President Herbert Hoover announced in his first State of the Union address that the worst effects of the stock market crash were behind us. But in December 1929, the worst was yet to come. Within a couple of years, unemployment would hit 25 percent and half the nation’s banks would fail. Economic policy under President Hoover was a case of much too little … far too late. The Federal Reserve alternated between doing nothing and doing the wrong thing.
On the other hand, the “Great Recession” that started in December 2007 ended last August or September as evidenced by the 2.8 percent rise in real Gross Domestic Product during the third quarter. It is the longest since World War II and one of the worst in terms of GDP decline and unemployment rise. But it has been nothing like the 1930s.
Bold actions from Washington, and especially the Fed, kept recession from becoming depression in the wake of a global financial crisis.
However, we’re not out of the woods yet. Saying the recession is over simply means the decline in the overall economy has ended. It will take years to return to normal. For instance, the unemployment rate won’t fall to 5 percent until 2014 or later.
The consensus forecast is for 3 percent GDP growth next year — just above the 2.5 percent threshold needed to keep unemployment from rising due to productivity and population growth. There’s also the risk of relapse: the dreaded “double dip.”, If in response to fears over inflation, the Fed were to drain the huge amount of money it has pumped into the economy too quickly, we could have a replay of 1937 when the Fed sent the economy into decline well before the nation had recovered from the huge collapse of 1929-32.
And such a fear is neither borne out in the consensus forecast, nor is it apparent in financial markets, where we get the same estimates of 2 percent inflation by comparing yields on conventional U.S. Treasury bonds with those of inflation-protected securities.
Inflation fears have been fanned in part by misunderstandings — intentional or otherwise — of how monetary and budget policies work. Fed actions over the past year have created billions of dollars of reserves that now sit idle at banks. These can’t possibly cause inflation unless they are lent out. If excessive lending develops, the Fed can respond by draining funds though Open Market Operations and by using its new authority to pay interest on bank reserves.
Budget deficits do not automatically create inflation; the Fed would have to opt to “print money” to buy the debt first. If the Fed does not “monetize” the debt, federal borrowing will crowd out private borrowers, probably causing interest rates to rise. And as long as the Fed remains politically independent, it is not likely to print money to cover the deficit.
Looking back, there’s plenty of blame to go around. Alan Greenspan kept interest rates too low for too long, helping to trigger the housing boom. The Congress allowed Fannie Mae and Freddie Mac to grow too large with far too little capital. Regulators were overly lax and there were huge supervisory gaps. Private sector financial executives took leave of their senses — and perhaps their morals — in an orgy of sub-prime lending and credit default swaps.
Under Chairman Bernanke, the central bank made some mistakes, but mostly got it right — in sharp contrast to the 1930s. Those who seek to eviscerate the Fed by giving Congress the authority to audit monetary policy and stripping the Fed of its regulatory powers, are making a terrible mistake; the foreign exchange value of the dollar would plummet as investors throughout the world began to doubt the credibility of the Fed. If anything, we should add to the powers of the Fed, by making it the sole regulator of financial institutions and the proposed “systemic regulator.”
The Fed is renowned for its independence from political pressures. Unlike the typical cabinet level department, members of the Board of Governors are appointed to staggered 14-year terms and they are subject to senate confirmation. This arrangement would provide the independence necessary for a “systemic” regulator who would have to make “life or death” decisions about financial institutions at the brink. Downgrading or eliminating the Fed will only make the next financial crisis much worse.
Nicholas Perna is a lecturer in the Economics Department and a former economist at the Federal Reserve Bank of New York.