How to Feed a Recovery

Friday, July 2, 2010

It’s been a long row to hoe since the economy entered the Great Recession. Even though the recovery seems to be under way, there’s still a way to go until the economy returns to normal. Take a peek at some recent economic activity: on the plus side, for example, retail sales rose by a better-than-expected 0.3 percent in February, despite the major snowstorms that blanketed parts of the nation and kept people off the roads. Companies are also starting to put their cash to work in the economy, through acquisitions such as BP’s recent $7 billion purchase of Devon Energy’s Brazilian assets.

Yet some economic drags still remain. Americans are struggling to stay in their houses, as evidenced by Bank of America’s addition of eight thousand borrowers to its mortgage modification program. Unemployment seems stuck—May witnessed 9.7 percent, little changed from the previous three months—with companies slow to hire.

To get a sense of the current economic climate, I spoke with John Taylor, Stanford economics professor and George P. Shultz Senior Fellow in Economics at the Hoover Institution. He is well known in economic-policy circles for coining the Taylor rule, a monetary-policy principle that offers guidance on how to tinker with interest rates to control inflation and maintain economic growth. During our discussion, we spoke about the state of the U.S. recovery and discussed the impact of the government’s monetary and fiscal policies on the economy.

“When the Fed stops the mortgage-backed purchases you’ll see the private sector coming in, and the allocation will be as it should be—based on profit considerations and long-term efficiency.”

Taylor served as undersecretary of the treasury for international affairs during the George W. Bush administration, and he was also a part of the President’s Council of Economic Advisers, first as a senior economist during the Ford administration and then as a member during the George H. W. Bush years. He is also the author or editor of numerous books, including, most recently, Ending Government Bailouts as We Know Them.

Here are the highlights of our conversation:

Jennifer Schonberger: What’s your sense of the strength of the recovery in the United States? Does the recovery have momentum?

John Taylor: Yes, I think it has momentum. We had a little offset because of the snowstorms in the first quarter, so when numbers come in, they won’t be as strong as you might have expected. But I still think around 3 percent [GDP growth] is reasonable when the first-quarter number comes out. [Note: first-quarter GDP growth was 3.0 percent.] We still have a little inventory boosting things. Consumption looks as if it’s solidifying. However, we still have a drag from business construction on residential construction . . . but equipment spending looks as if it’s solidifying. It’s more of a U-shaped recovery rather than V-shaped at this point. But it looks as if it is solidifying as I see it.

Schonberger: What concerns you most about the economy now?

Taylor: The policy is the most concerning. We have had a large government stimulus, and we have the debt problem, which is huge and growing. We had a debt-to-GDP ratio of 40 percent at the end of the Reagan administration, and 40 percent at the end of Bush 43—at least at the end of the fiscal year. CBO projections are now taking our debt-to-GDP ratio to 90 percent and growing in the next decade. It’s a real concern, and we need to address it.

I think the experience we’ve seen in Greece shows you the difficulties you can get into. You can say that that’s a somewhat longer-term concern, because these things have a way of building up, but it’s a concern nonetheless.

Schonberger: Building on that, an editorial in the Wall Street Journal by Andy Kessler argues that capital misallocation is usually a fallout of bad government policy. He says the life support supplied by the Fed right now is misallocating capital and that when that ends, real wealth creation begins. Is the government getting in the way of wealth creation?

Taylor: Yes, I think it is. These interventions have created uncertainty, and they’ve allocated capital in directions the government wanted to favor. In particular, the Fed’s purchases of mortgage-backed securities, more than other things, were an allocation of funds to particular sectors. I do believe that when the Fed stops the mortgage-backed purchases you’ll see the private sector coming in, and the allocation will be as it should be—based on profit considerations and long-term efficiency.

Schonberger: How did this crisis change your thinking? Did it ever cause you to rethink what you thought you knew?

Taylor: What is most striking to me is the rapid transmission globally of shock coming largely from the United States in the fall of 2008. Of course, you saw the S&P 500 dropping nearly 30 percent in that period, but all the other major stock indices around the world moved in the same pattern. Plus you saw exports and imports plummet, which affected the whole world very rapidly. It’s an indication of how connected things are at this point, and that means that we need to be concerned about the transmission of such shocks.

It’s also gratifying—not so much surprising—that the bounce back from this shock was so strong, and I think that reflected better policies in many emerging-market countries.

Schonberger: The International Monetary Fund’s chief economist, Olivier Blanchard, recently offered the idea for central banks to target a higher inflation rate [4 percent versus 2 percent] to allow for greater room to lower rates in economic downturns to soften the blow. What do you make of that, especially in light of your rule? Would it lessen the chances of repeating a severe recession, as Blanchard argues?

Taylor: I think it’s a mistake to do that. I think we have shown through a longer period of time that the focus on price stability by central banks usually measured by inflation rates—2 percent or so—has been very successful. To go back on that, and to argue for higher inflation again, seems to me to lead you to the bad old days of the 1970s, when inflation crept up and we had booms and busts.

I think the argument that he is giving is not a good rationale for doing that. His argument is that, as you mentioned, if you had a higher inflation rate on average, then you’d have higher nominal interest rates on average, and therefore you could cut them more in a recession. But even in this Great Recession, as I see it, the interest rate that the Fed should have been following as we went into the downturn is not much different than it did [set]. I don’t see negative interest rates. I still think this formula, the Taylor rule, is useful, and that really did not call for interest rates certainly at much below zero. And so even in this very significant shock, I don’t think Blanchard’s point is correct.

Schonberger: In terms of addressing the “too big to fail” problem, you believe in a clear operational definition and measure of systemic risk for financial institutions. How should we define that?

Taylor: We should define it using data on how firms are connected and interconnected to each other. So that interconnection—one bank could be lending to another bank—is part of the concern people have when they say things are “systemic.” When we look at those data—and there aren’t much available, unfortunately—you don’t see as much of an interconnection as people think. But until we get better measures of that connection, it seems to me that we really can’t define it very well.

What I’m arguing for is really a systematic study of the definition so that it can be applied in practice, but we’re not there yet. When people cry out that there’s systemic risk, you don’t know how to define that, and that causes all sorts of distortions.

Schonberger: Will any of the financial reform legislation under consideration in Congress be effective in addressing the underlying problems of the financial crisis?

Taylor: I think that expanding the resolution authority that the FDIC has for banks is a mistake. The experience during the crisis shows that if you give so much discretion to a government agency to define or decide when a firm needs intervention, it causes a lot of uncertainty. Much better would be a rules-based, or law-based, process.

“When people cry out that there’s systemic risk, you don’t know how to define that, and that causes all sorts of distortions.”

Rather than what is being proposed, with an expanded resolution authority, I think the bankruptcy code is a better way to proceed. There are some proposals to have what is sometimes called a Chapter 11-F—a Chapter 11 for financial institutions—that deals with some of the systemic issues people are worried about. It’s a much better approach than giving discretion to a government agency to decide when to intervene with a firm.

Schonberger: Incidentally, where do you come down on the Volcker rule?

Taylor: The Volcker rule, unfortunately, has been defined in many different ways, and that needs to be resolved. There is definitely a reason to restrict the amount of risk-taking for an institution that has access to the Federal Reserve’s discount window or access to guaranteed deposits. You need to reduce that. Of course, we do have ways to reduce that. I think increasing the capital requirements generally for those institutions, to the extent that works, is worthwhile. If you can find a way to specify the proprietary trading, and whether that’s risky or not, then that should be part of it as well.

Schonberger: Do you think we also need a hard size-cap on banks?

Taylor: No. We already have the 10-percent-of-deposits rule. People are thinking about modifying that. But I don’t think a hard cap is really practical, and they’ll always find ways to get around that. So something close to what we already have should be sufficient.

Schonberger: We recently interviewed Simon Johnson, former chief economist of the International Monetary Fund, and he said the financial industry had captured the government. How much of what has happened comes down to big finance embedded in the halls of government? And if that power structure is not amended, if that’s even possible, will we continue to be prone to the same issues?

Taylor: I think you need to look at the specific cases. Let me give an example, which I think is worrisome. Certain regulators, in particular the presidents of some of the Federal Reserve district banks, are appointed with a lot of influence from the entities that are being regulated—the commercial banks and financial institutions. I’ll focus on New York for the time being. So there’s obviously a setup here in which the regulated institutions influence the regulator.

The Federal Reserve structure, where you have the district banks creating a degree of independence outside of the Washington–New York nexus, is good. It gives a good structure of independence and decentralization. But when you have that system, in particular in New York, that is appointed that way, it raises questions.

There are various ways to deal with this. One example is, in the Federal Open Market Committee, don’t grant the New York Fed’s presidents a more significant role compared with other presidents. That might offset some of these pressures.

Schonberger: In your new book, Ending Government Bailouts as We Know Them, Paul Volcker says he thinks there is a correlation between financial engineers and the number of damaging failures in the market. Do you agree?

Taylor: No. I have great respect for the financial engineering and the sense in which that has benefited people for many years. I do think that you need the regulations that are out there and to have them enforced properly. That has to do with risk taking and, largely, transparency. And if you deal with that—hardball with the government and this “too big to fail” problem—then I think you should allow people to make the trades and engage in bilateral contracts that reduce risk. Then you have people absorbing the risk that others don’t want to hold. That’s all very beneficial.

Schonberger: Would you apply your approach, then, to the possible regulation of credit default swaps (CDSs), which obviously played a large role in Greece and here domestically with AIG, Goldman Sachs, et al., in the financial crisis?

Taylor: I think the proposals to deal with CDSs on trading on exchanges or through clearinghouses make sense and deal with many of people’s concerns. You can’t do that for the very specialized CDSs. I do think CDSs have proved a useful function. . . . As I go to the heart of the financial crisis, it seems to me that it wasn’t due to credit default swaps.

Schonberger: Right. You argue it was more the lack of transparency, of a road map for the ad hoc bailouts. You argue that the government created greater uncertainty.

Taylor: Yes. Absolutely. And in some cases, where people thought there was regulation . . . for example, the commercial banks, the most heavily regulated institutions, weren’t being regulated in a way people thought. They allowed the off-balance-sheet [structured investment vehicles] to exist, and that creates more uncertainty. . . . In some sense, what’s most important is you set the rules, such as regulation; enforce those in a transparent, consistent way; and then the market knows what’s going on and people can make choices. You’ll have a much more stable system.