Monetary and Fiscal Policy Conundrum


Monetary and Fiscal Policy in the United States:

Part of the Problem and Not a Solution

Uwe Bott

March 7, 2008


For a long time, I have held the view that the Bush-recovery of post-2001 was shallow and unsustainable (see Letter to the Financial Times, October 6, 2005 The recovery was based on private and public sector consumption, both of which were reckless. This was in sharp contrast to the investment-driven growth period of much of the 1990s.

Irresponsible tax cuts and huge spending increases under President Bush as well as unparalleled consumer profligacy led to huge accruals of public and private sector debt. This addiction was further fueled by the Federal Reserve Bank which maintained record low and - for a long period of time - negative real interest rates. Mr. Greenspan's central bank was nothing but a "bubble bank". It had failed to prick the stock market bubble of the 1990s and it actively promoted the creation of the real estate bubble through maintaining vigorously pro-cyclical monetary policy.

With cheap money and asset price inflation, homeowners were assured that the sky was the limit for the value of their homes. They devoured one refinancing after another to feed their sheer infinite hunger for consumption. Meanwhile, financial institutions felt encouraged by laissez-faire overseers and sleepy rating agencies to underwrite loans with growing risks and to develop multiple layers of leverage. This looked appealing to investors and borrowers alike and was celebrated as the ultimate triumph of financial engineering.  

Of course, the rest is history. The economy has stalled, credit and liquidity are scarce, the dollar is plummeting, inflation is skyrocketing, unemployment is rising, consumer confidence is shrinking, and Sovereign Wealth Funds are growing tired of bailing out the U.S. economy while being pummeled by protectionists. The quagmire of stagflation is looming on the horizon. The economy is on life-support, while policy-makers seem to carry on with business-as-usual. 

And as business-as-usual is concerned, President Bush and the Chairman of the Federal Reserve, Ben Bernanke, are reaching for the same old playbook they have used before. Congress approved and the President signed a $170 billion fiscal give-away in January of this year and the Federal Reserve Bank entered into panic-stricken, serial interest rate cuts. As credit markets froze, the Federal Reserve and other central banks also injected hundreds of billions of dollars of liquidity into the financial system.

All of this to no avail. In fact, most of it is counterproductive, because our policy-makers are applying cyclical remedies to a structural malaise. The huge debt buildup in the private and the public sectors will need restructuring and this will take a considerable period of time. More consumption might feel like a great fix, but it would only aggravate an already dismal situation. This structural crisis has also caused a tremendous drop in market confidence. Consumers are afraid - and with good reason - that they might lose their jobs. Meanwhile, the most "creditworthy" participants in the financial system do not trust each other. In fact, they do not even trust themselves. The accumulation of unregulated bad habits has left them doubtful of their own balance sheet strength. They will not lend to anybody else until they understand their own book.

None of these issues will be effectively addressed with lower interest rates or fiscal stimulus. It is fair then to ask: What should be done? The answer is quite simple and quite complicated. Structural crises and crises of confidence take much longer to be resolved and require coordinated, often qualitative solutions rather than simplistic pump-priming.

Banks will need to do all in their power to understand their total exposure to impaired on- and off-balance sheet assets. Transparency is indispensable in that regard. National regulators in the United States and elsewhere have to develop holistic approaches to the regulation and supervision of the entire financial system. Non-bank banks, including hedge funds, need supervision. Insurance companies need closer oversight. Banks need to be inspected more thoroughly and regulators should seriously rethink the internal-rating based approach of Basel II, because it may only lead to even looser standards of risk assessment. Already several banks that are using this approach are reporting stronger capital adequacy ratios than under the standardized approach. This should at least make us wonder about the impetus of this new approach. For all players, regulators must tighten prudential lending standards.

But national supervisors cannot do the job alone. Globalization also requires a global approach to supervision and regulation. Collegial meetings among regulators will not suffice. Instead they must develop a coherent and institutionalized process of supervising financial institutions with a global reach.

The rating agencies too must reform themselves or be reformed. They really got themselves into trouble when they increasingly moved away from their original core business of rating plain bond issues of the private and public sector. These ratings were based on quantitative and qualitative assessments representing strong elements of judgment. The proliferation of structured instruments, such as asset-backed securities, mortgage-backed securities and collateralized debt obligations during this Millennium led to a corresponding need for ratings of these securities. Rather than using their time-tested (albeit imperfect) judging these instruments as an independent third-party, the rating agencies used primarily quantitative models and became more of an intermediary between issuers and investors. Wrong assumptions in these models led to immeasurable miscalculations and rating agencies were hesitant to downgrade the affected instruments as this would be associated with a failure of their modeling capacity (as well it should).

Therefore, rating agencies must step back from this role and apply quantitative as well as qualitative factors to future ratings of structured instruments or withdraw such ratings altogether.  Moreover, the Securities and Exchange Commission of the United States (SEC) should break up the oligopoly of rating agencies and forego a process by which the SEC has currently only recognized seven such agencies.

Finally, on the fiscal front we have to move away from short-term fixes. Instead, a national infrastructure revitalization plan should be approved with commitments stretching over the next ten years. Our bridges crumbling and our tunnels are collapsing and a revitalization plan should be designed as a Public/Private Partnership, but it will require annual investments on part to the federal and state governments of at least $200 billion over the next ten years. Yet, such plan would raise our long-term competitiveness, increase employment and it may even have some tangential environmental benefits.

But our perspective has to be long-term and not short-sighted. Rebuilding confidence and rebuilding our infrastructure while restructuring the nation's balance sheet will take time, but ultimately it will be beneficial and it will avoid throwing good money after bad.   

The Courage of Our Convictions Carries the Day