As of Friday, the S&P 500 was below its level of early November 2010, when the Federal Reserve initiated its second round of quantitative easing. Aside from a brief bump in demand that kicked the recession can down the road a bit, the U.S. economy is not measurably better off. Meanwhile, countless individuals in developing countries have been injured by predictable commodity hoarding and global price instability. The Federal Reserve has leveraged its balance sheet by over 55-to-1. As policy makers look to address the abrupt deterioration in U.S. and global economic prospects, we should ask ourselves: Do we really long for more of the Fed's recklessness?
I began drafting this update in a fairly measured way, but on further reflection, I think it is time to be blunt. The economic evidence now suggests that the U.S. and the global economy are again entering recession. Technically, this is not a "double dip." The National Bureau of Economic Research, which officially dates the beginning and end of U.S. recessions, was very clear about this last year - noting that it would view any future economic downturn as a new recession, not as a continuation of the one that ended in June 2009.
If there is one crucial point that should not be missed, it is this: the fundamental source of our economic challenges, from joblessness, to unresolved housing strains, to sovereign debt crises, is that our policy makers have repeatedly opted for fiscal band-aids and monetary distortions instead of addressing the core problem head-on. That core problem is simple: the careless encouragement of asset bubbles, and the refusal to restructure bad debt.
Encouraged by inappropriately easy monetary policy and lax regulatory oversight, the U.S. went on a debt-financed binge of consumption and unproductive investment that lasted nearly a decade. When that binge collapsed, policy makers ignored the fundamental need to restructure bad debt, and instead fought tooth and nail to defend bondholders and lenders who had extended credit carelessly. We are now left with a global financial system where the debtors are incapable of making good on those debts, and governments around the world are frantically trying to prop up bad debt with public funds and monetary policies aimed at distorting the financial markets even further.
The economy is an equilibrium - consumer spending is stagnant not only because unemployment is high but also because debt burdens remain daunting. Businesses are reluctant to hire because they don't see the likelihood of sustained demand. This isn't a problem of tax uncertainty, regulations, or budget worries - it's a low-level equilibrium produced by consumers trying to deleverage and businesses reluctant to hire without the promise of demand. Many workers can't even move elsewhere to accept job openings because they are locked into their current homes. Very simply, barring the emergence of some new economic sector that produces a tremendous supply of desirable new goods and simultaneously produces enough employment to generate the income to buy those goods, we're unlikely to get around the employment problem until we address the debt issue directly.
Restructuring debt does not necessarily mean debt "forgiveness" and it does not always mean "default." It means that the payment structure is changed in a way that makes it possible for the debt to be serviced over time. In the housing market, we don't need government bailouts nearly as much as we need government to act as a coordinating mechanism. Since the housing crisis began, I've proposed the creation of "property appreciation rights" to restructure mortgage debt (see the second portion of Handicapping QE3 for detailed mechanics). These would essentially break mortgages into two pieces, one representing the prevailing market value of the home, with the remaining amount of the mortgage being a marketable claim that the lender would have on future home price appreciation, which could be pooled and administered by the Treasury without the need for subsidies. While lenders would likely earn less on the mortgages than if those mortgages were actually good, and borrowers would pay more on those mortgages than if they walked away from their homes, the credit strains and uncertainty in the housing market could be addressed, foreclosures could be averted, the markets could clear, and the economy could move forward.
Of course, part of the reason that policy makers have protected bondholders at every turn is the constant fear-mongering that the financial system will implode if bondholders suffer any loss. Look - the stock market has just lost about $1.5 trillion in market capitalization, and we might just be getting warmed up. The idea that bondholders are sacred is ludicrous - it's just that the financial companies are very powerful, vested interests. As Sheila Bair, the outgoing head of the FDIC recently noted about the 2008-2009 crisis (see Sheila Bair's Exit Interview ): "'We were rarely consulted. They would bring me in after they'd made their decision on what needed to be done, and without giving me any information they would say, ‘You have to do this or the system will go down.' If I heard that once, I heard it a thousand times. ‘Citi is systemic, you have to do this.' No analysis, no meaningful discussion. It was very frustrating.' ... As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management's risk-taking."
As for sovereign debt, Greek spreads presently reflect a 100% expectation of default within the next two years, with Ireland and Portugal not far behind. Italy (whose debt/GDP ratio is well over 100%) has less extreme credit spreads, but is actually the most troubling because of its relative size. So long as the crisis is contained largely to Greece, European leaders are likely to continue what they perceive as heroic attempts to stem the crisis. The real problem is that each new attempt to impose austerity on the fiscal side, in order to protect bondholders, imposes real economic costs on ordinary people in these countries. Normally, overly indebted countries have the ability to print money and devalue their currencies in order to reduce the real burden of excessive debt. But countries in the European monetary union do not have the ability to issue their own currencies, so in order to make the debt whole, ordinary citizens are being forced to endure austerity that in some countries is increasingly looking like depression.
For Europe, the struggle of citizens in peripheral nations, and the burden on Germany and France in particular, will continue until the debt is restructured. There is no graceful way to do this, but one option is what might be called "redenomination by fiat." Essentially, these governments would break the existing covenant to pay their debts in Euros, and would instead redenominate the obligations in their own national currencies, which they would then predictably devalue to the point where they were capable of servicing the debt. This is what peripheral economies do, and have always done, in response to excessive debt burdens. Moreover, remember that the value of the Euro itself is not determined by Greece per se, but by price levels and interest rates among countries who are members to that currency. A departure of Greece and possibly other peripheral European nations would not necessarily make the Euro weaker, but might instead help to ensure its status as a durable currency. So to the extent that the key member countries of the Euro pursue fiscal and monetary stability, exit of peripheral countries from the Euro area does not imply a "collapse" of the Euro itself. Meanwhile, restructuring would be far kinder to the citizens who continue to suffer economic austerity in order to make bondholders - who knowingly took risk and lent at a spread - whole.
The way that our policy makers address the recent weakness in the markets will tell a great deal about the prospects for a durable recovery. If the policy initiatives focus on subsidizing bad debt on the fiscal side, and distorting the financial markets on the monetary side, it would be best to use whatever short-term enthusiasm those proposals provoke as an opportunity to further reduce risk. The best policy responses are those that relieve some constraint on the economy that is binding. Another round of policies geared to creating an even larger sea of zero-interest liquidity, re-igniting asset bubbles, or further lowering already depressed Treasury yields, would be a signal of panic and incompetence from the Fed. If policy makers instead push to facilitate debt restructuring, coupled with pro-growth fiscal responses (e.g. R&D investment incentives, full funding of the National Institutes of Health, productive infrastructure investment, etc), yet another drawn-out cycle of distortion and crash might be avoided.
