With the 10-year anniversary of a terribly damaging financial crisis, many are reflecting on the lead-up to that crisis, which preceded the Great Recession and painfully slow recovery.
While we learn from past policy mistakes, each recession has its own triggers and characteristics. For example, because financial sector problems were central to the Great Recession, policy makers focused their response on increasing the safety and resilience of some of our large financial institutions. While it is important that the banking system remains well capitalized, fighting the last war is not always sufficient. When the next economic slowdown arrives, the trigger could come from any number of directions, including the financial sector. A major concern is how prepared policy makers will be to offset the next downturn, whatever its cause.
In a recent paper titled, “Some Unpleasant Stabilization Arithmetic,” written with Joe Peek and Geoff Tootell and recently presented at the Boston Fed annual economic conference, we discuss some of these likely challenges. Perhaps foremost is that the primary tool to offset recessions, monetary policy, may be limited in its ability to respond. In most recessions, the Fed reduces interest rates by 5 to 6 percent. Short-term interest rates are currently around 2 percent, and it is unlikely they will be near 5 percent when the next recession occurs, particularly since the current estimate of the long-run level of short-term rates is less than 3 percent.
While the Fed has other monetary policy tools, such as buying large quantities of government securities, these tools have proved to be politically sensitive, making their deployment in future recessions complicated. Hence, the ability to counter economic downturns with monetary policy alone may be impaired, shifting more of the stabilization burden to fiscal and regulatory policy tools.
Traditionally, one would consider increasing federal, state, and local spending when the next downturn occurs. However, the willingness and ability to use these tools depends, in part, on whether they, too, have sufficient room to operate. With the recent federal tax reductions and expenditure increases, the debt-to-GDP ratio has been rising and is expected to continue rising even without a recession. With a higher, and rising, debt burden, there might not be a willingness to increase federal spending or reduce taxes in response to the next recession.
Alternatively, state and local spending, which actually exceeds federal spending, could be increased. Unfortunately, many states have not replenished their rainy-day funds, which have generally been small relative to the size of state budgets anyway. Balanced budget amendments in many states only make it more difficult to use these tools. In the previous recession, many state and local governments cut government employment; they probably won’t be better situated in the next recession.
On the bank regulatory front, although the largest banks are well capitalized, many smaller banks have increased their risky lending to commercial real estate. While the previous recession was exacerbated by leverage by many households, currently there has been an increase in highly leveraged firms. Furthermore, unlike many other countries, the United States has no entity responsible for financial stability able to take actions if households or firms take on too much risky debt.
Times are good right now. But the 10-year anniversary of the crisis should galvanize all of us. It’s a reminder to ensure we are doing all we can to prepare for the possibility of future problems or downturns — taking steps during the good times, so that we are better prepared to withstand the next recession.Eric Rosengren is president and CEO of the Federal Reserve Bank of Boston and submitted this piece before the start of the Fed’s customary blackout period, from Sept. 15-27, which precedes policy meetings.