A verity of economic analysis that emerged in the 2008-09 downturn is that what hit was a “financial crisis.” The indication was that the origin and central location of the downturn was in the banking system, as opposed to say industry. Furthermore, because the episode was a financial crisis, the economic damage had to be greater, and the recovery smaller and slower, than if it had been principally a non-financial crisis. The 2009 bestseller This Time Is Different encapsulated this view.
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Timothy Geithner, U.S. treasury secretary, testifies at a Senate Banking Committee hearing in Washington, D.C., U.S., on Wednesday, May 20, 2009. Geithner said he expects a pair of government programs to help banks remove their distressed assets will start by early July, policy makers’ next step in ending the worst credit crisis in decades. Photographer: Joshua Roberts/Bloomberg News photocredit: BLOOMBERG NEWS
Another verity came during the small and slow recovery (which did in fact come to pass) afterwards. This is that the Federal Reserve’s quantitative easing program undertaken for several years after ’08 fit the times. The big problem in the crisis was mortgage debt, this debt was housed in the financial sector, and QE was designed to buy up this “distressed” or “toxic” asset massively. QE’s proponents held that the smothering attention paid to the financial crisis’ main problem, care of QE, prevented the Great Recession from turning into a Great Depression.
The two verities contradict each other. If the economic recovery from a financial crisis has to be small and slow, then the Fed’s big action to get at the heart of that crisis cannot have worked. On the other hand, if QE was appropriate, then a financial crisis can be addressed and its effects shortened and dulled. To break the contradiction, one perhaps could say that a financial crisis can be so bad that the best that immense remedial action against it (QE) can do is prevent another Great Depression.
Another option is to pursue the implications of the contradiction. The central element of QE was the Fed’s purchase of $1.75 trillion in mortgage-backed securities (MBS). The reasoning went something like this. The big increases in house prices prior to 2008 produced mega millions in mortgage debt that became nonperforming assets once prices tanked with the Great Recession. Given the immense amount of this debt, and given that it functioned as an asset against liabilities within the financial system, the system became horribly capitalized. Financial firms therefore could not lend out, and this blocked access to credit within the economy. The stalling and shrinkage in the economy, in turn, prevented the MBS from recovering value. The only prospects, if things were left alone, were small/slow recovery or Great Depression.
It would appear, given these assumptions, that QE should have resulted in a large and quick recovery. If the problem was the ruination of the financial system’s balance sheet by MBS, then the Fed’s swapping of that for good cash—U.S. dollars—via QE should have solved the problem abruptly. How can the Fed relieve the financial system of its toxic asset, replace it with cash, and have the financial crisis in its chief effect (the small, slow recovery) persist?
This question takes on a further hue in consideration of the typical monetary theory adhered to by the Fed. In its accommodative or loose mode, the Fed seeks to buy U.S. government bonds for cash. U.S. bonds are, of course, excellent collateral and reserves. Their replacement with cash on the balance sheets of financial firms can have only a minimal impact on the conduct of business. This is confined to financial firms’ making slightly more varied decisions about what to do with capital than beforehand. Normal Fed accommodating operations have, per the theory, a limited ability to change what the economy was going to do anyway. In the Keynesian language, the liquidity preference between systems with different U.S. bonds/cash ratios is negligible.
QE, in contrast, proposed, at least implicitly, that its effects would be transformative. Here the point was to cash out at par not U.S. bonds but toxic assets. The effect should have been spectacular. Whereas before QE, the banking system had to cover $1.75 trillion in non-performing and unmarketable assets, with QE it had cash where those assets once were. Lending should have ensued to a far greater degree than previously.
Yet this did not happen. Economic growth was minimal in the Ben Bernanke/Barack Obama years, out of a deep recession no less.