The U.S. economy is stuck in a painfully slow recovery. Neither accommodative monetary policy nor fiscal stimulus has done the trick in generating robust growth, and no one seems to really have a grasp on why. We propose an explanation for why they have not been working, and on that basis we will explicate a feasible path to renewed robust growth.
We begin by assessing the normal impact of monetary policy on the course of an economic cycle. We then consider several factors, mostly having to do with housing, that distinguish the Great Recession from the typical economic cycle. We do this with a general view toward identifying important but underappreciated causes of the recession, but more specifically in order to determine the factors that have limited the impact of monetary policy in recovering from it. Finally, by examining comparable financial crises and balance sheet recessions in other countries, we argue that fiscal consolidation and the resulting exchange rate depreciation are more likely than government stimulus initiatives to generate a robust recovery.
he 1980/1981–82 “double-dip” recession demonstrates the sharp impact that monetary policy has on mortgage lending, new home sales and residential construction. These were “natural experiments” in which monetary policy was tightened and relaxed twice in quick succession. With each shift in monetary policy, expenditures on new housing units responded more quickly and with larger magnitude than output in any other major sector of the U.S. economy. These recessions also demonstrated how robust housing sales and construction are as leading indicators of a coming downturn.
As shown in Figure 1, from the peak of housing construction in the third quarter of 1978 until the peak of the economic cycle six quarters later, expenditures on new single-family and multi-family housing units (which we refer to hereafter as “housing construction” or “housing”) fell 21.7 percent. When housing construction reached its first trough in the third quarter of 1980 it had fallen 40.6 percent from its peak. The decline in sales of new homes was even more precipitous, from a peak in the second quarter of 1978 until the peak of the economic cycle seven quarters later, new home sales were down 37.1 percent, and this figure had dipped 45.6 percent to its first trough in the middle of the 1980 recession. When monetary policy was relaxed (that is, when the Effective Federal Funds rate was reduced from 19.4 percent in early April 1980 to 9.0 percent in mid-June 1980), new home sales shot up 35.9 percent in the next quarter. One quarter after that, housing construction increased. When monetary policy was tightened again toward the end of 1980, new home sales dropped sharply, and two quarters later housing construction began another decline. In that second decline, which lasted from the second quarter of 1981 to the second quarter of 1982, housing construction fell 36.0 percent. Over an almost four-year period, from the third quarter of 1978 to the second quarter of 1982, housing construction fell 55.2 percent. The policy point, however, is this: Each shift in monetary policy quickly had an impact, first on new home sales and then on residential construction, and each foreshadowed what followed in the overall economy. These shifts are depicted in Figure 1.
In addition to the large changes in sales of new housing units and in expenditure on new housing units, declines in housing and consumer durables came before investment declines and exceeded the size of investment declines over the same period.1 In the 1980 recession, real (that is, inflation-adjusted) expenditures on housing fell $88.3 billion, whereas real non-residential fixed investment fell only $29.6 billion.2 Over the course of the two combined recessions, housing fell $120.9 billion, the sum of housing and consumer durables fell $201.7 billion, and investment fell $131.5 billion. Households’ interest-rate-sensitive components of consumption therefore had a stronger impact on the development of this downturn than non-residential fixed investment: Housing plus durables peaked 12 quarters before investment, and the dollar amount of their decline exceeded the investment decline by 53.4 percent. The timing and magnitude of these events reveal that housing and households’ durable goods consumption play a crucial role in economic cycles.
A key observation from this episode is that, under normal circumstances, monetary policy has its sharpest impact on mortgage finance and consumer lending. When the Federal Reserve increases its purchases of short-term Treasury securities, prices go up and short-term interest rates go down. This has two effects on depository institutions. First, it brings down their cost of funds: Since Treasury bills, a close substitute for demand and time deposits, have a low yield, banks can pay a low interest rate and still attract deposits. Second, at the same time, mortgage and other interest rates fall much more slowly, so open market purchases by the Federal Reserve widen the gap between the lending and the borrowing rates of depository institutions. Consequently, open market purchases by the Federal Reserve encourage lending, primarily to households and to small businesses that rely on financial intermediaries for access to credit.3
When mortgage lending increases, it immediately leads to more sales of new homes, which in turn leads to construction of new homes to replenish the depleted inventory. When lending to consumers increases, consumer durable goods sales increase. These effects are clearly demonstrated in Figure 1, which shows that each shift to short-term interest rates led to a corresponding shift in new home sales and also to a change in residential construction and consumer durable goods purchases. But, as the graph also shows, monetary policy shifts had a much more limited effect on non-residential fixed investment.
his discussion of the double-dip recessions indicates how monetary policy usually works, but that’s not how it has worked in the Great Recession. The recent recession is widely attributed to a housing bubble that began with a recovery of house prices in 1998 but then turned into an unprecedented mortgage-financed bubble between 2002 and 2005.4 During the period of most rapid price increases, between July 2003 and July 2005, the Case-Shiller composite index of housing prices in twenty U.S. cities increased 35 percent.5 Notably, as shown in Figure 2, this was also a period of historically high flows of mortgage finance (measured as a percentage of GDP).
This large increase in mortgage lending provided the financial impetus to the rapid rise in home prices. Between the first quarter of 2002 and the first quarter of 2006, the real mortgage debt of U.S. households rose from $5.97 trillion to $8.97 trillion, an increase of more than 50 percent in only four years.6 This ratio surged to an historic high in the five and a half years after the 2001 recession. In every quarter between the fourth quarter of 2002 and the first quarter of 2007, the net flow of mortgage credit was more than twice as high as its average level of 3.2 percent of GDP in the preceding half century.
Excessive lending, combined with lax underwriting standards and low down payments, pushed house prices well above sustainable levels. When the bubble burst, many mortgages became delinquent and a large part of the loan principal of defaulting borrowers was lost by lenders and investors because of the low down payments and the large price declines. New investment in mortgage credit dropped precipitously from a historical high of 8.8 percent of GDP in the second quarter of 2006 to -2.0 percent of GDP four years later.
Where did the money come from that fueled the large price increases and the large accumulation of mortgage debt between 2002 and 2005? In part it came from the extreme monetary ease from 2001 to 2004,7 but a considerable portion of it came from overseas. In 1997, the current account deficit (the amount of money flowing into the country minus what was flowing out) stood at $152.8 billion, or 1.55 percent of GDP; by 2006 it had ballooned to $772.9 billion, or 5.97 percent of GDP.8
When rapidly escalating mortgage delinquencies revealed the fragility of the housing market in 2006, the flow of mortgage funds abruptly began a sharp decline, and the price collapse accelerated. The impact of these developments on housing is apparent in Figure 3: Sales of new homes began a sharp collapse in the first quarter of 2006 and residential construction expenditures began to collapse the next quarter. When investment peaked in the first quarter of 2008, housing plus durables had already fallen $230.9 billion over the previous seven quarters.
The grey area in Figure 3 shows the recession. It was not until the third quarter of 2011 that GDP recovered to its peak level from the first quarter of 2008, making it the longest downturn in GDP since the end of World War II. The recoveries in investment and consumer durables have been weak, and there has been no recovery in housing, as Figure 3 shows. This lack of response to historically low short-term interest rates has no precedent in the postwar era: Indeed, residential construction increased more than any other area of the economy after every recession between the 1948–49 case and that of 2001.
Figure 4 shows the collapse of home equity. The figure shows that the value of homes moved up in step with mortgage debt from 1997 through the first quarter of 2006.9 Afterward, home values began to decline, mortgage debt held steady, home equity plunged and is now below its 1997 level. Since the banks hold the mortgage debt of households, bank balance sheets have suffered a decline in asset value. This has sharply reduced their willingness to lend.
An unusually large inventory of homes from foreclosure now limits demand for housing construction. Damage to household balance sheets is limiting the recovery of durable goods consumption. And suppressed aggregate demand is limiting the need for non-residential fixed investment. Evidence of all three problems is visible in Figure 3. Resolution of the first problem takes time: A decrease in the surplus of homes is difficult when slow job creation reduces the rate of household formation. The second problem also takes time to resolve, as households slowly reduce their mortgage debt through years of principal payments.
It is the unprecedented severity of the slump in housing, and the failure to recognize the key role of housing in rebalancing economies, that explains why monetary policy has not achieved what policymakers expected it to achieve. The accommodative Federal Reserve monetary policy in 2008, combined with the bank bailouts, probably prevented a collapse of the financial system like the one that occurred in the Great Depression. To that extent, the monetary stimulus effort has been a success. But since monetary policy typically has its most pronounced effect on mortgage lending and consumer finance, and since these are both unresponsive now due to households’ excessive debt burdens and concerns about the prospect of further house price declines, monetary accommodation has failed to generate a recovery despite its magnitude and duration.
Other direct evidence reinforces this assessment. Lending and economic performance changed little when the Federal Reserve embarked on its second quantitative easing program (QE2). Between November 17, 2010, and July 6, 2011, the Federal Reserve increased its holdings of U.S. Treasury securities by $750.9 billion.10 We’ve shown that in past recessions, when the Federal Reserve drives down short-term interest rates, banks have an incentive to lend. But during the seven and a half months of QE2, total lending of commercial banks in the United States declined from $6.92 trillion to $6.56 trillion.11 If, as we have argued, it is the gap between lending rates and funding costs that creates the incentive to lend, then the lack of response to QE2 is completely understandable: Whatever problems restrained lending before QE2 remained during the program, because easing only drove the yield on short-term Treasury debt down from 0.2 percent to 0.1 percent. Although it’s possible that bank lending would have fallen more without the QE2 program, its ineffectiveness strongly suggests that monetary policy alone cannot rekindle investment and growth in the current environment. It obviously hasn’t in this case, after all.
The inability of either fiscal stimulus or exceptionally easy monetary policy to generate a robust recovery is directly attributable to the severe household and bank balance sheet damage caused by the housing boom and bust. Until that damage is repaired, we are unlikely to see robust economic growth. The challenge, then, is to determine what can repair it quickly—but without plaguing us with distortions in the future. Our examination of past financial crises indicates that fiscal consolidation has triggered exchange rate depreciation in other countries, and depreciation has led to strong recoveries based on export growth.
Financial Inflows and Depreciation: Three Cases
n all the cases we’ve examined of economies that experience a boom and collapse, with a financial crisis precipitated by the latter, a rapid increase in fixed investment has been a significant element of the boom.12 In most cases, substantial support for the boom has come from foreign investment. During a boom, most financial inflows find their way into private investments by either households or firms. After a boom in fixed investment collapses, the demand for private investment instruments (such as mortgage-backed securities) diminishes sharply. If the supply of public investment instruments (that is, sovereign debt) also declines, there are few instruments that foreign investors can obtain from a country that has been running a current account deficit. And if foreign investors can’t find appealing investment instruments, then financial inflows will cease or even switch direction.
With a floating exchange rate, foreign demand for investment instruments props up the value of a currency: The foreign investors first convert their own currency into the that of the country where they invest and then purchase the investment instruments. In the absence of those investments, that source of upward pressure on the currency disappears. If the investments are large enough, removing them will lead to depreciation. Currency depreciation immediately reduces the price of exports and raises the price of imports; exporters expand output in response to the surge in profit margins. Hence, the reversal of financial and capital account flows translates into a reversal of the current account deficit, and the shift toward exports also adds to total output and generates an added income stream for export-oriented firms, their suppliers, and the labor market associated with them.
We know this from several cases outside the United States. The course of the Finnish (1990–93), Thai (1996–98) and Icelandic (2007–10) collapses and the financial crises all three countries experienced were similar in many ways to our own case, despite the fact that the downturns in GDP and in fixed investment were considerably larger in all three than they were in the United States. GDP fell 12.6 percent in Finland, 16.0 percent in Thailand and 14.3 percent in Iceland. From the peak of fixed capital investment just before the start of the crises, Finnish fixed investment fell 52.5 percent, in Thailand 58.9 percent and in Iceland 77.7 percent. In Finland, fixed investment peaked in the last quarter of 1989; it was 17 and a half years before fixed investment reached that level again. In Thailand, fixed investment peaked 15 years ago (in the fourth quarter of 1996); real fixed investment was still 9.9 percent below that peak level in the third quarter of 2011. In the third quarter of 2011, real fixed investment in Iceland was 67.7 percent below the peak it attained in the fourth quarter of 2006. In the United States, by comparison, non-residential fixed investment plus investment in residential structures fell 32.5 percent between its peak in the first quarter of 2006 and its trough in the fourth quarter of 2009; it now stands 23.4 percent below its peak level. In all of these economies, something needed (or needs) to pick up the slack from the steep declines in fixed investment before recovery could (can) occur.
We’ve seen common patterns in Finland, Thailand and Iceland. In each country, economic output contracted sharply when fixed investment collapsed. But in all three cases capital inflows and large current account deficits continued until government expenditures were curtailed. Once government expenditures fell, neither the private sector nor the public sector could absorb capital inflows from abroad because there is little demand for new private investment in a country that has just experienced an asset market collapse and a collapse of fixed investment. International capital inflows reversed direction, their currencies depreciated sharply, and net exports grew rapidly.
Following depreciation, when exports rapidly increase (and typically overtake imports as they did in Finland, Thailand and Iceland), that addresses several problems at once. First, a current account surplus replaces the net capital inflows that existed when the country was running a current account deficit. That is, the income stream generated when exports exceed imports is a form of capital formation that can replace financial inflows from abroad. Second, the capital formation that results from a reversal of the current account can be used to repay the foreign debts accumulated during the period of current account deficits; far from “beggaring thy neighbors”, they are paying them back. Third, export production becomes a source of growth in place of the growth of fixed investments that is so common during a boom. Finally, depreciation creates the inflationary pressure that domestic monetary policy could not create, and typically overcomes the deflationary pressure that so commonly follows the collapse of an investment boom. These forces begin mending damaged balance sheets by reducing debt load relative to asset value, and by rebuilding equity.
The declines in investment in Finland, Thailand and Iceland were extremely deep, yet growth rates during the recovery periods in those countries have been considerably higher than in the United States since the second quarter of 2009. The annualized U.S. growth rate in the ten quarters since the bottom of the recession has been 2.4 percent. In Finland the annual growth rate over the first ten quarters after the recession was 3.4 percent, and in Thailand it was 5.0 percent. Iceland is only five quarters into its recovery, but its growth rate over that period has been 5.5 percent per year. Our argument is that export-driven growth is the most effective course when the collapse of a fixed investment boom leads to losses on assets, a financial crisis, a severe downturn and damaged balance sheets. Thus, fiscal consolidation can restore growth after a balance sheet recession.13
hen households and banks suffer from widespread continuing balance sheet damage, the economy’s response to both monetary and fiscal stimulus is severely muted compared with what would normally be expected if household and bank equity positions were strong. The experience of other countries strongly suggests that in these circumstances fiscal consolidation triggers a mechanism—currency depreciation—that supports recovery of aggregate output.
The fiscal consolidation/currency depreciation mechanism is remarkable as a policy instrument because it offers a subtle end-run around the failure of monetary easing to stimulate households’ demand for housing and durable goods via the normal route of lowering financing costs. The effect of depreciation is to immediately increase the solvency and improve the balance sheets in export-related industries. It will also tend to be at least mildly inflationary, and this serves to initiate a mechanism for reducing the burden of debt and improving balance sheets generally in the economy. Note that we witnessed the opposite occur in the aftermath of the 2008–09 U.S. stimulus program, which ushered in an increase in the U.S. current account deficit and worked against an increase in domestic demand and employment.
Although the export increases in Finland, Thailand and Iceland were very large, comparable increases are not required in the United States for at least two reasons. In Finland, fixed investment fell from 30.4 percent of GDP just before the peak of their economic cycle to only 16.0 percent four years later. In the United States, fixed investment (including residential construction) fell from a peak of 15.0 percent of GDP to 10.1 percent of GDP. The fixed investment decline in Finland was more than two and three-quarters times as large relative to GDP as it was in the United States. In the third quarter of 2011, investment in the United States is $380 billion below its peak level. In Finland most of the adjustment took the form of a shift from fixed investment to a greater emphasis on exports. For the U.S. economy to replace that investment gap with exports, we would need only to see an increase in exports from 13.9 percent of GDP to 16.4 percent of GDP. An increase in exports of this magnitude is feasible. Indeed, it seems to be happening, although it is not clear that Administration economists appreciate the full value of the effort. Even were the effect to be less than that, it would still foster growth.
Fiscal stimulus serves only to extend a current account deficit from the pre-crash period into the post-crash period, pushing up the value of the dollar and thus making our exports less competitive on world markets. We have shown three countries that all cut their government expenditures and quickly experienced a sharp depreciation, rapid export growth and then a robust recovery. Proponents of fiscal stimulus suggest that government expenditures should fill the gap created by declining private investment, but this is an enormous gap to fill, and past experience suggests that it would need to be filled for a long time. No government could persist in such a program and remain solvent, nor is there any need to do so. The growth and recovery in Finland, as in Thailand and Iceland, came in net exports. Fortunately, the United States experienced a much smaller decline in fixed investment, so we need a much smaller increase in exports to compensate for it.
There is good reason to believe that we will need the growth in exports to compensate for the decline in fixed investment: In the year and a half since fixed investment bottomed out at 10.1 percent of GDP, it has only risen to 11.1 percent. We’ve only recovered a fifth of the way to the peak of fixed investment five and a half years ago. Based on our own slow recovery, and on the decade and a half that it has taken other countries to regain declines in fixed investment after boom’s end, it is clear that something else needs to fill the gap, lest we spin our gears in a very low-growth economy for many years. Export-led growth has filled that role in all of the other comparable crashes we have examined. There is no reason to think it cannot do so in the U.S. case as well.
1For brevity we refer to households’ durable goods expenditures (National Income and Product Accounts Table 1.1.5 line 4) as “durables” (D), non-residential fixed investment (NIPA Table 1.1.5 line 9) as “investment” (I), and expenditure on new single-family and multi-family housing units (NIPA Table 5.3.5 line 19) as “housing” (H). (Many researchers take NIPA Table 1.1.5 line 12 as their measure of residential construction, but that category includes brokers’ commissions on real estate sales and other miscellaneous items.) All series are converted from nominal to real figures by dividing by GDP deflators. GDP deflators are calculated by dividing NIPA Table 1.1.5 line 1 by Table 1.1.6 line 1. In addition to GDP and some of its components from the NIPA, we also graph new home sales, which are compiled by the Census Bureau.
2Unless otherwise noted, dollar amounts in this article are inflation-adjusted to 2005 dollars.
3While households and small businesses rely on financial intermediaries, large corporations typically have access to corporate bond markets, especially for their long-term financing requirements. Consequently they are less affected by shifts in monetary policy that primarily affect the incentive of financial intermediaries to lend.
4Between 1996 and 2006, annual rates of real house price appreciation were -1.1 percent (in 1996), 2.5 percent (1997), 5.4 percent (1998), 5.4 percent (1999), 6.1 percent (2000), 5.7 percent (2001), 8.2 percent (2002), 8.6 percent (2003), 10.9 percent (2004), 10.5 percent (2005), -2.2 percent (2006) and -11.9 percent (2007). The early years of price rises were associated with increasing net flow of mortgage credit, while the years of double digit price increases were associated with historically high levels of mortgage credit, as Figure 2 shows.
5Nominal Case-Shiller house price indices increased 72 percent in Las Vegas during this two-year period, 62 percent in Phoenix, 56 percent in Los Angeles, 47 percent in San Diego and 43 percent in San Francisco.
6The net flow of mortgage funds is the change in total mortgage credit outstanding. It is approximately equal to new mortgage originations (including home equity loans) minus mortgage pre-payments and mortgage principal payments. These data are taken from the Federal Reserve Flow of Funds, Table F.218, line 2.
7Note the turnaround and surge in the flow of mortgage credit in Figure 2. The Federal Funds rate was not tightened until the end of 2004 (Figure 3).
8The current account deficit figures are from the Federal Reserve Flow of Funds, Table F.107, line 63. 9Households’ residential assets are from the Flow of Funds, Table B.100, line 4. Residential mortgage debt is from the Flow of Funds, Table L.218, line 2. Housing equity is the value of residential real estate minus mortgage debt.
10We calculate Treasury security acquisition by the Federal Reserve from the difference between line 3 in Table 1 of the July 7, 2011 and the November 18, 2010 H.4.1 releases from the Federal Reserve.
11The figures on bank lending come from line 9 on page 2 of the H.8 release from the Federal Reserve.
12Fixed investments are primarily residential and commercial structures and firms’ investments in plants and equipment.
13Detailed analysis of the Finnish, Thai and Icelandic crises and recoveries, complete with graphic illustrations, are available from the editors upon request.