International Affairs Forum:
Would you compare and critique the response of the major Central Banks to the economic crisis to date?
Dr. Joseph E. Gagnon:
The Federal Reserve and the Bank of England were much more aggressive than the Bank of Japan and ECB. The Bank of England actually was a little hesitant at first but then, a few months into the crisis, it really changed gears. Now of course you might say the crisis was more centered in the United States and Englandthe United Kingdom but there were huge problems in Europe:, Spain, Ireland, and Germany especially early on. Japan was less affected in many ways financially, although they did suffer a huge loss of exports and a big drop in GDP. All four economies were hit with a very big macro shock to their economies but the financial sectors were hurt more in the United States and the United Kingdom and than in Europe, and not as much in Japan.
On the macro side, the Federal Reserve and the Bank of England reacted more and faster than the other two banks. In fact, the European Central Bank never cut its rates in the first stages of the crisis. Even in the summer of 2008, because oil prices were high, they raised rates and people here (in the U.S.) were surprised at and wondered what they were thinking. But finally the ECB did also ease and the Bank of Japan even eased a little bit, although not much. The Bank of Japan is clearly the most timid of these and has never really given Japan the monetary policy that the economy needs.
I think aggressive action by the Fed and Bank of England was good. Moreover, once they got to a zero interest rate, the Bank of England and the Fed did more, and started buying long term bonds and trying to push down the longer term interest rates, which the ECB never did. It's amazing that the effect on output in this crisis was less in the United States than in Europe or Japan, despite the fact that it was more centered in the United States than it was in Europe or Japan. I attribute that to a more aggressive, better policy.
What about their efforts in the financial bailout and dealing with troubled banks?
There again, Japan was not really affected but the United States, Europe and the United Kingdom were affected a lot. Banks in all those regions, and other financial institutions in all those regions, had major institutions in serious trouble and some failed. In all three cases, the central banks behaved roughly similarly. Here you have to combine the central banks with the governments. It’s not just about the central banks, it's about the whole government and-- central banks working with government's finance ministries together. In each region, I think they did what they needed to do to keep the system from collapsing.
Do you think the U.S. should have stepped in to save Lehman?
What Chairman Bernanke has said is that because of the framework that we had in the United States at the time, it was not strictly legally possible for them to save Lehman Brothers. The Federal Reserve can only lend in emergencies only if the lenders put up collateral realistically valued at more than the loan. In the case of Bear Sterns and AIG, that was just barely possible. To this day, the collateral that Bear Stearns and AIG put up is actually more than the value of the loans. In fact, the Fed' has made money on those loans.
Lehman just didn't have any collateral. If you look at the Lehman bankruptcy proceedings as they've gone forward, the bond holders of Lehman Brothers are only getting pennies on the dollar. Lehman didn't have underlying assets that it could put up for the Fed. They thought they could basically fool someone into buying them. Lehman thought that they had some people lined up in the UK to buy them, and the UK regulators said no. People in Korea looked at them and the Korean regulators said no. They couldn't get anyone to buy them because anyone who looked at their books ran away scared. They knew this company had a huge hole in its balance sheet.
If the Fed had bailed out Lehman, maybe things would have gone better, but the Fed would have lost money and it really would have been violating athe law because they wouldn't have had collateral. The Perhaps the Treasury could have done it somehow.; pPerhaps the Fed could have pretended there was collateral-- and that's what many people think they did with Bear Stearns and AIG, --but they didn’t. They took those rules seriously and Bernanke was not about to do this without strong support from Treasury. At this point, I think Paulson was angry with Lehman and didn't want to. So between Paulson's anger and Bernanke's law abiding caution, there was no bailout for Lehman. You can argue whether that was the right thing or the wrong thing to do. Lehman Brothers was not a commercial bank, it was not in a framework with examiners the way commercial banks are. But yet it turned out to be every bit as important. Who knew?
What you want to do in a crisis is lend freely to banks that have good collateral, that are fundamentally solvent, or that would be solvent in a more healthy economy. The solvency of banks is closely tied to the health of the economy and so, if you have a sick enough economy, almost every bank will be insolvent. If you have a strong enough economy, almost every bank will be solvent. The rule is you lend to solvent banks. The trick of it is though, how do you define what a solvent bank is? I think that Lehman turned out to be insolvent under any definition, although Bear Stearns and AIG may have been, at least under an optimistic good case outcome, solvent. In fact, this can be proven because the Fed is not losing money. So, I think this is what they all did and I think it was good.
How do you view the situation today?
In the US, it seems that we’ve dealt with the problems of the sub -prime process mortgages and the aftermath of that. The Dodd-Frank legislation last year pushed things in the right direction but I'm not convinced it’s nearly enough. Ideally, there should be much more robust systems and triple layers of fail-safe mechanisms so that banks don't get into these kinds of troubles again. So, I think Dodd Frank goes in that direction but I think we could go a lot more.
Dealing with Fannie and Freddie --
Exactly. We haven't decided what we're going to do with Fannie and Freddie and how we're going to deal with the mortgage issue going forward. We have other decisions to make and, even to the extent that we have made them in Dodd Frank, it could be more. There are international negotiations on capitoal standards for banks that are decided at a more international level, which I think are not aggressive enough but they're a step in the right direction and maybe therey'll be more.
That's common around the world and there's not much difference in the US and EUurope, except for the Swiss, who are going a very different route. The EU, and Japan to some extent, are holding back what I think should be even tougher capital standards for banks; to make sure they have enough capital, to buffer, to cushion against a loss. What you want is that banks have their own money and stockholders should have their own money at stake so that bond holders are protected and the first person to lose is the stockholder. Banks didn't have enough of that; it was only 4% before the crisis, that's just not much at all. The fiction was that banks loans are in a safe bar on lending and they have a margin that's good enough. That's just wrong. Banking is a fairly risky business.
The Swiss are going for almost 20% real capital, including and something that's contingent capital, where it’s a bond that if the bank gets in crisis, it turns into stock. That's good because the Swiss can't afford to bail out their banks, they're too big for their country. For anyone to dealing with the Swiss banks, they have to have a substantial amount of capital. The Germans and others don't want to do this because they think it would be hard for their banks to raise that much capital. I think that's a big mistake. We should all be aiming for banks with 20% capital. People say that would raise the costs of doing business for banks but it would only be a little bit. It’s probably a price worth paying for a safer system. 20% is still not a huge amount. In the early days of US banking, that was actually quite normal, and even higher ratios for smaller and riskier banks could have been 30 – 40% capital. But that's a decision that's done internationally and that's where we're going.
Of course, there’s also the European sovereign debt crisis where the macro slow down and the bursting of some housing bubbles, especially in Spain, has exposed their economies to a lot of weakness, and caused their governments to have to bail out some banks at great expense and threatened their physical solvency.
Is the US next?
The US certainly has problems fiscally but there is something fundamentally fragile about the way the Euro area is set up, in which there is no central fiscal authority, and no sense in which the ECB works hand in hand with a central fiscal authority and buys its bonds and regulates its interest rates for everybody. Each country in the Euro area has to sell its bonds on its own terms. There's not a unified bond market because each bond is actually paid off by someone different and there's no centralization.
It’s like state governments in the United States where each state actually pays a different interest rate, and they vary across states depending on the solvency of the state. There can be a state bankruptcy, if you can imagine. In the Euro area, each country is like a state in the US. So the Fed doesn't buy state bonds in the US and it doesn't regulate and maintain their interest rates. Neither does the ECB in Europe, so the European countries have greater fragility in the way that US states have greater fragility. In other words, any one state could get into trouble and people might stop buying its bonds, its bond rating might be lowered, and its interest rates might go up. Then its fiscal situation gets worse because now it can't really afford to pay the interest on its bonds. It gets into this escalating crisis when interest rates go through the roof. That can happen to a US state and it can also happen to a country in the Euro zone. It cannot happen to the United States as a whole because the Fed will always step in and buy treasury bonds to keep interest rates where they want ithem.
Now, at some point there could be a fight between the Fed and the Federal government because, even in our system, if the Fed wants to control inflation it may have to let interest rates go up at some point and the federal government may not like that. The Fed has ultimately ruled authority on what the interest rate's going to be to get inflation down, but Congress could always change that law. I think a lot of investors think that if Congress really ran away with spending and couldn't raise the taxes to pay off the debt, they might take over the Fed and have us print money. That would be inflationary, and that would not be good. But it would not be a default the way Greece would default. It would not be a sudden notn- payment, it would be a gradual inflating away of it. We could have a fiscal crisis in the US but it wouldn't be as urgent, it wouldn't be as dramatic, it wouldn't be as sudden as it was for the Europeans.
It’s really much less about their monetary policy than it is about fiscal policy. The governments in Europe are negotiating, they're setting up a mechanism, and they’re setting up rules. I think it’s long overdue and they're always coming in the last moment. It's understandable that this kind of thing is difficult to do; it takes a crisis to make people do it. So far, they have managed to keep it together, but just barely. It's sort of a close run thing, it’s like you would like to see it flattenplanned out andin advance better but it is hard to do that.
I think they euro area needs a much more centralized fiscal system where taxes are raised across the whole area and spending is set more centrally. But that would require giving up sovereignty. They're not there yet, but they’re taking steps. Their approach has been to set up rules, set up a mechanism that lends in emergencies, but under strict conditions. It still tries to keep each country sovereign but it tries to force it to behave in a way that the group wants it to behave.
What about on the macro side?
It is amazing to me that the US unemployment rate rose so high so quickly compared to these other countries. It’s still a puzzle, people are still studying it. We know in Germany and a couple other countries in Europe, the government actually subsidized employers to keep employees on short time so they wouldn't be unemployed. I think that was a good thing and we probably could have had a bit more of it here. But that doesn’t explain the difference between the two countries. Employers are quicker to fire and hire in the US than they are in Europe but that difference has just been magnified in the past few years, and that is surprising. US employers were too quick to lay people off and have been too slow to hire them back in an unusual way. Compared to Europe the difference has been wider this time than it has before.
Now if you then look at just inflation and GDP or output, the US has had better outcomes and I think it reflects a better policy. We've been more aggressive at fighting this recession than the other countries. The Bank of England may be up there with us but the ECB has been more reluctant, and the Bank of Japan, very reluctant. If you can imagine, a sort of a spectrum with the US Bank of the Federal Reserve and the Bank of England at the top and mostly aggressive and having the best results. Europe is having a slower recovery than the US, and had a deeper recession, a slower recovery. I don't think inflation is really an issue for bothany of these economies.
What effect has the crisis had on major countries outside of the areas you’ve discussed?
Advanced economies countries like Canada and Australia weren't hurt as much, and the developing economies such as China, India, and Brazil weren't hurt at all, or very little. They're growing strongly again and, outside the big three, --US, Europe and Japan, --the world is growing strongly, and that's a little over half the world economically. They are putting upward pressure on commodity prices and production of commodities is just not keeping up. I think a lot of it is that these rapidly growing countries have a particularly strong demand for commodities. They are in a stage of their development where people really do want more cars, houses, other things with commodities in them, and of course, they need more energy. Contrast that to the US and Europe where, when we grow, we don't need more cars. We might have a better car but it doesn't have more commodities in it. However, China actually wants cars which it never had. That's very demanding on the world's commodity resources. Their growth is very commodity intensive at this stage of development. They're growing rapidly and they're putting upward pressure on commodity prices.
As we saw three years ago in 2008, the Europeans are very worried about the effect this has on inflation because it does. These commodity price increases are very large, 20-50%. Big numbers. Theiry are a small share of inflation, say 10%, but if that raises the inflation rate by 1% percent or a half a percent%, but that's enough to get the Europeans concerned, and they've been responding by raising rates.
This is a very different philosophy than what the Federal Reserve has, and to date, what the Bank of England has. The Federal Reserve cares more about the underlying inflation rate,. We are which is dominated by wage pressures in the US because wages are the vast bulk of costs. They're 70% of costs or more, where commodities are 5 or 10% of costs. The Fed tends to ignore commodity prices unless they're expected to continue significantly over 7several years. But if you look at a futures curve for oil prices recently, they are actually perfectly flat, all the way out for the next 9 years. We had a big run up, but the futures market does not expect any further increases from where they are now. The Federal Reserve looks at that and says, we had the inflation already and the market's not expecting any more. If we were to raise rates now, it would not make sense because there's nothing we can do about the price increase we already had. The way monetary policy works is not through commodity prices, but really through wages. We basically have to throw people out of work and get them to accept lower wages and then that part of inflation would go down, to offset the higher oil prices, and the Fed does not want to do that.
But in Europe, they seem willing to do that. It's a different philosophy. I don't understand why they do it but I think the Fed is right not to think that they need to slow the recovery down and keep people unemployed longer when the cause of the blip in inflation is something that is outside their control and is not expected to continue. This is the big issue now, how to respond to commodity price increases. There are very different strategies on both sides of the ocean. I've talked to Europeans about this and what I’ve heard as a defense of this approach is, well, we have a history in Europe that when overall inflation increases, which includes commodities, workers demand bigger pay increases, and we have to fight that. There’s been some work, even before the Euro was created, showing that in a lot of European countries in the past, the overall inflation rate, which includes commodities, was actually a better predictor of future inflation than the so -called underlying rate that strips them out. I've never fully understood why that is, but people claim it’s true and I've seen some evidence that supports it.
In the US, that was not true. So there's a difference in how our economies behave to some extent. I suspect the euro area has changed and has become more like the US. If you look at the last five years, where it’ has definitely not been the case -that the overall inflation (as it's called in the euro area) has been a better predictor of future inflation. In fact, underlying inflation has been a better predictor because there was this big run up in overall inflation in 2008 in the euro area, which was followed by a collapse in 2009. In other words, it didn't predict rising underlying inflation did not respond to the runup in overall inflation caused by commodity prices. The underlying inflation rate actually cut through that swing. ThereIt was a better measure of future inflation. Even if the euro area behaved differently in the past, it is not behaving like that now, and therefore I would urge them to not worry so much about thatcommodity prices.
Any other thoughts on how the Fed and ECB are positioned towards addressing the economic recovery in the future?
I would say is that the Fed explicitly cares about unemployment in thea way that the ECB does not, and that's written into the charters of both institutions. The Fed is actually told that its objectives are to maximize employment and have stable prices. Stable prices and maximum employment are its objectives. The ECB is told that stable prices are its objective, end of story. Consequently, that can be pointed to as a big difference. A lot of people say in practice the ECB does seems as if it does care somewhat about unemployment, but not as much as the Fed. In many periods, you'd say they behaved similarly. They respond to movements in the economy and try to stabilize inflation.
We're now in a period where they seem to differ a lot on commodity price. Commodity prices were rising back in 2008, and to me that explains some of their slowness to react to the gathering crisis, because they were looking at it as a gathering crisis on one hand, but on the other hand commodity prices were very high, so they were sort of torn, and the Fed was less torn and basically responded to the crisis. That was why they behaved differently then, and once again now it's coming up again, the commodity prices are important. Again, that difference is showing up.
Dr. Joseph E. Gagnon is a senior fellow at the Peterson Institute for International Economics. He was also visiting associate director, Division of Monetary Affairs at the US Federal Reserve Board. Previously he served at the US Federal Reserve Board as associate director, Division of International Finance and senior economist. He has also served at the US Treasury Department and has taught at the University of California’s Haas School of Business (1990–91). He has published numerous articles in economics journals, including the Journal of International Economics, the Journal of Monetary Economics, the Review of International Economics, and the Journal of International Money and Finance, and has contributed to several edited volumes.
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