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SUNDAY, OCTOBER 17, 2010 No fast fix will heal bruised economy overnight economy from G1 “It’s endemic in our type of
society that we always think there’s a person who holds the magic wand,” says Sen. Judd Gregg (R-N.H.), a fiscal conserva- tive who isn’t running for reelec- tion, so he can, well, be blunt. “But this society and this econo- my are far too complex to be susceptible to magic wands.” Heaven knows we could use
such a wondrous fix.Even though the Great Recession ended 16 months ago, according to the business-cycle arbiters at the Na- tional Bureau of Economic Re- search, that only means that the economy started to grow in June 2009. It doesn’t mean that the economy has healed. It certainly doesn’t mean that the recession’s victims have healed. Tens of mil- lions of people are still economi- cally wounded from declines in their home values and invest- ment accounts. Worse, despite some modest employment growth we’re down almost 8 mil- lion jobs from the end of 2007, when the Great Recession offi- cially began. Now, on to the real problems in
theeconomy:why they’ve been so resistant to the traditional cures of lower interest rates and higher government spending. And we’ll show you that, when you talk to them in private (albeit on-the-re- cord) forums, people from across the political and economic spec- trum agree that there’s no magic cure for what ails the economy. The fact is that our nation has
suffered a huge financial trauma, and it’s going to take years to get well again. This isn’t exactly un- knowninWashington, but it’s not something people inpowergoout of their way to emphasize. For President Obama, who campaigned on the promise of transformational change, it’s been especially tough medicine to deliver. Take his performance in a September town hall session on CNBC. People in the audience were looking for immediate solu- tions to their problems, and Obama seemed to struggle with how to answer them. You can see why. Look what happened to the last president who ran for reelec- tion during bad economic times: George H.W. Bush, in 1992. Bush came under fire for not doing more to help people who lost their jobs in the recession that had started in 1990, and for not showing more empathy in public. After losing to Bill “It’s the
economy, stupid” Clinton, Bush blamed Fed Chairman Alan Greenspan for his defeat. (If Greenspan had cut interest rates, the thinking goes, it would have looked as though Bush were do- ing something.) Seven weeks af- ter Election Day, the recession arbiters announced that the downturn had actually ended in March 1991 — some 20 months before the election. Bush was right, as it turned out, not to push for extraordinary measures. But tell that to the voters.
Not the normal recession If you think Bush had troubles,
imagine whatObamais wrestling with. Today’s economic problems have proved enormously resis- tant to the traditional rate-cut- ting cure Bush wanted “Maestro” Greenspan to order up. That’s because the Great Recession, whose aftermath we’re living through, was different from the 10 previous post-World War II recessions. Those slowdowns were caused by the Fed’s increase of short-term interest rates to combat inflation. Recessions caused by the Fed’s rate-raising could be cured by the Fed’s rate- lowering. If things looked espe- cially dicey, the federal govern- ment would send people checks to generate economic activity and spur confidence. But the Great Recession was
different. It was triggered by a financial meltdown brought on by excessive lending, reckless risk-taking, the implosion of an unregulated shadow banking sys- temthatassumedthat short-term money would always be available —and ignorant and careless bor- rowing by people and institu- tions. The recession’s genesis is why things are still sluggish even though the Fed has cut short- term rates, which it controls, to virtually zero and has forced down long-term rates, which it doesn’t control, by buying more than $1 trillion of securities in the open market and letting it be known that it and other central banks will buy more. Yet although such “quantita-
tive easing” — econo-speak for “printing money” — helped allay financial panic in 2009 by provid- ing cash to institutions that need- ed it badly, it’s less effective and more risky to use it to stimulate the economy. Hence the knife fight at the Fed Board of Gover-
JOSHUA ROBERTS/BLOOMBERG NEWS
The Federal Reserve is one institution that can act quickly without making a political show. Still, Chairman Ben Bernanke has said, “Central bankers alone cannot solve the world’s economic problems.”
nors between the fans of quanti- tative easing and those opposing it.
Let us explain.Eventhoughthe
Fed is very powerful, it’s not all-powerful, just as the United States is not all-powerful when it comes to its own financial affairs. The Fed has to worry not only about theU.S. economy and mon- ey supply but also about debasing the dollar too much too quickly, lest it spook the foreigners who finance our trade and federal budget deficits. If foreigners lose faith in the dollar’s value, it could run our interest rates up sharply and abort any recovery. To its credit, the Fed—the one
institution that because of its independence can actually act quickly without making a politi- cal show—sort of admits that its power is limited. “Central bankers alone cannot
solve the world’s economic prob- lems,” Chairman Ben S. Bernanke said in a speech at the Fed’s conclave in Jackson Hole, Wyo., in August. The Fed wouldn’t let us inter-
viewBernanke about the limits of the Fed’s power. It’s easy to see why: He’d risk diminishing what remains of the Fed mystique by talking on the record about its limitations and problems. However, former Fed vice chairman Donald Kohn, a 40- year Fed veteran, agreed to dis- cuss those limits, provided we made it clear he was speaking for himself as an outsider, not for the Fed. “TheFederal Reserve canmake
a difference, but it doesn’t have a magic bullet,” Kohn said. “It can’t take a weak economy facing a lot of major challenges and rapidly turn it into a strong economy.” Kohn isn’t alone in that view. “The public has been sold this notion that somehow we can con-
trol the economy — that we can fine-tune it so we don’t get infla- tion on the upside, we don’t get recessions on the downside, [that] when something happens, they can step in and offset it,” says another longtimeWashington in- sider, Douglas Holtz-Eakin. “The economics profession is painfully aware that this is just not true, and [that it] has a terrible impact on politicians, presidents in par- ticular.” Holtz-Eakin, president of the American Action Forum, a con- servative think tank, was Sen. John McCain’s economic adviser in the 2008 campaign.He and his Democratic counterparts know the dirty little secret: that the huge financial traumasuffered by the economy won’t disappear overnight. “No one has found a way to
have an incredibly severe finan- cial crisis and snap back a year or two later,” says Jason Furman, deputy director of the White House’s National Economic Council.
Losses: Plenty of them Look at the numbers on the
economy and you’ll see why. The biggest single source of wealth for many people—their home equity — has fallen almost 50 percent from its peak in 2006, according to Federal Reserve statistics. Loss: $6.5 trillion. U.S. stocks are still down 25 percent from their peakin2007, their 75 percent gain in the past 19 months notwith- standing. Cost: $4.8 trillion.Then there are the 7.7 million lost jobs with their associated lost income, lost wealth and lost consumer spending.Loss: untold trillions of dollars. This wealth-reducing trauma, combined with consumers be- coming afraid to spend and lend- ers changing from being ultra-lax
to ultra-strict, has sucked huge amounts ofmoney from the econ- omy. Don’t let occasional upticks in consumer spending, the stock market or home equity fool you into thinking that things are okay, because they aren’t. “The economy suffered a really
deep wound — it’s healing, and it’s a little bit uneven,” says Alan Krueger, assistantTreasury secre- tary for economic policy. “But that is what you’d expect given the loss of wealth from the finan- cial crisis.” People used to collectively
spend more than they took home — hence, our negative national savings rate, which was covered by borrowing. Now we’re spend- ing 6 percent or so less than we’re taking home. That’s a big head wind to fight. The switch from borrowers to savers augurs well for the long run, if the trend lasts. But in the short run, it hurts the economy by diminishing activity. Compared with all the losses we’ve talked about, the $814 bil- lion in stimulus spending — the effectiveness of which we won’t get into today—is small beer. So what do you do? One pro-
posed solution is to jump-start the economy with deep and per- manent tax cuts. That’s more than a little problematic, given that the Great Recession began in 2007, when tax rates, especially on investment income, were about the lowest in modern times and there were no “Obama tax increases” on the horizon. President GeorgeW. Bush had
pushed through two big tax cuts — one in 2001 because the gov- ernment was supposedly taking in too much money, the second in 2003 to stimulate investment. But the economy tanked anyway. The latest tax-cut screed, the Re- publican Party’s Pledge to Ameri- ca, has no meaningful numbers, proposes no changes in programs like Social Security,Medicare and defense, and asks no sacrifices of anyone, yet it says it can balance the budget. Good luck with that. What about having the Trea-
sury engage in a massive stimulus programto put money in people’s pockets and have them spend it, ginning up economic activity and restoring confidence? But stimu- lus money has to come from somewhere—and it doesn’t seem possible for theTreasury to raise a few trillion more stimulus bucks without dire consequences to in- terest rates and the dollar’s value. It doesn’t help that the admin-
istration wrongly predicted that its stimulus package would hold unemployment to 8 percent; the rate soared to 10 percent and still hangs stubbornly in the mid- nines.
Other institutions, such as the ASSOCIATED PRESS
DonaldKohn, a 40-year Fed veteran, agreed to discuss the central bank’s limitations if it was clear he wasn’t speaking for the Fed. The central bank wouldn’t allow questions to Bernanke on the topic.
“The Federal Reserve can make a difference, but it doesn’t have a magic bullet. It can’t take a weak economy facing a lot of major challenges and rapidly turn it into a strong economy.” —Donald Kohn, former Federal Reserve vice chairman
Fed and the Social Security Ad- ministration, both nonpartisan, also underestimated our econom- ic problems. But the administra- tion’s mistake, which seems to have been an honest one, has undermined its credibility. The fact that stimulus pro-
grams seemed designed to favor unionized workers, a core Demo- cratic constituency, didn’t help. Nor did the fact that Cash for Clunkers and the $8,000 credit for first-timehomebuyers caused one-time spikes in new-car and house sales that fell off sharply after the programs expired.
‘Quantitative’ what? Our final little secret is that the
United States is now being forced to live within its means,andthat’s
Long haul Te recession officially ended in June 2009, but jobs have been slow to materialize, home prices are still down and companies are reluctant to spend despite sitting on piles of cash.
U.S. unemployed 7.5 Recession 5.0 2005 2006
U.S. homeowners’ equity in real estate
$12 trillion
3 6 9
2005 ’06 ’07’08 ’09 ’10
0.2 0.4 0.6
2005 ’06 ’07’08 ’09 ’10
SOURCES: National Bureau of Economic Research; Bureau of Labor Statistics; Federal Reserve; Standard & Poor's THE WASHINGTON POST
20072008 2009 2010
Cash and equivalents held by S&P 500 industrials
$0.8 trillion 15.0 million 12.5 10.0
not fun. For years our country could spend and spend because two bubbles showered compa- nies, consumers and govern- ments with free money. Who needed to save when stocks were producing returns of almost 20 percent a year, which they did from August 1982 through the spring of 2000? Or when house prices rose at double-digit rates and you could get cash easily and quickly through refinancing, a second mortgage or a home equi- ty loan?Homeowners raising and spending cash propped the econ- omy for years. The closestwe’re likely to come
to free money is the Fed’s pro- posed quantitative-easing moves to buy Treasury securities. Let us show you how it works—and the problems with it. Let’s say the Fed buys $1 tril-
sloan-g.ai PROOF1
FPO
lion of Treasury securities in the secondary market. Out of thin air, it creates $1 trillion in credit balances in the sellers’ accounts. The sellers have $1 trillion more cash than they did, increasing the money supply. There is now $1 trillion less in publicly traded Treasurys, which props up their price. By contrast, if Goldman Sachs
Topic: Business
Run Date: 10 / 14 / 2010 Size: 23p2 x 5.5” Artist: Chris Canipe
wanted to buy $1 trillion of Trea- sury securities, it would have to find $1 trillion of cash to pay for them. Sellers would have $1 tril- lion more cash than before.Gold- man would have $1 trillion less. There would be no increase in the money supply or decrease in the Treasury supply. If the Fed could buy endless amounts of Treasury securities without any side effects, it would be almost like free money. The securities would cost the Trea- sury little or nothing in theway of interest, because the Fed turns over its profits — $53 billion last year, $40 billion in the first half of 2010—to the Treasury. So if the Fed buys $1 trillion of
2.5 percent, 10-year Treasury notes, Treasury’s $25 billion an- nual interest expense is offset by the $25 billion of extra profit the Fed would make, all (or almost all) of which would be turned over to the Treasury. See? Isn’t that grand? There is, however, a problem.
The Fed can’t do that indefinitely without touching off inflation, debasing the dollar, or both.Mar- kets are bigger and more power- ful than the Fed. Consider the reaction of people
like veteran Wall Street value investorHughLamle ofM.D. Sass to quantitative easing. “It’s one thing to do $800 bil-
lion once,” he says. “But if the federal government is going to print $1 trillion a year for five years,maybe I don’t want to be in dollars.” A second factor is that long-
term rates are already so low that it’s not clear how much stimulus you get from cutting them more. It’s a big deal to cut interest rates to 5 percentfrom8percent. But at lower levels, the result is less dramatic. Do you think the difference
between 3 percent and 2.5 per- cent is going to matter? Mean- while, these ultra-low rates are penalizing American savers—es- pecially retirees relying on CD income to supplement Social Se- curity. They tend to spend all their income,andit’sdownsharp- ly. That’s one reason the economy is weak. Don’t get us wrong, there are plenty of winners in this game —
just not the ones who need help. Cash-rich corporations are issu- ing billions of dollars of cheap debt for purposes such as buying back stock rather than expanding and creating new jobs. Corpora- tions have record cash on hand but aren’t using it to expand in theUnited States. Banks, too, are profiting might-
ily from quantitative easing.They can borrow short-term money for essentially nothing, then buy Treasury securities, knowing that the Fed will support the securi- ties’ prices by buying them in the market. Playing the yield curve is easier, less risky and more lucra- tive than what the government wants the banks to do, which is to make loans.
It comes down to housing Perhaps the biggest problem
we have standing in the way of having good times return is hous- ing—which is an example of how deep-rooted our problems are and how resistant they are to government programs. Housing was a major source of
national wealth for decades, and home equity, however sadly di- minished, is still the biggest sin- gle piece of wealth many Ameri- cans have. That’s especially true of lower-income people. No one shouts this from the
rooftops, but the federal govern- ment and the Fed are doing all they can to prop up house prices. Thanks to the Fed’s forcing down of long-term rates, fixed-rate mortgages are at record lows. Most of thosemortgagescomevia Uncle Sam. For the first half of the year, 89
percent of mortgages came from the government-run FannieMae, Freddie Mac, Federal Housing Administration and Department of Veterans Affairs, according to Inside Mortgage Finance. That’s almost triple the levels of hous- ing’s peak years: 31 percent in 2005 and 30 percent in 2006. Even with all that effort,
though, housing prices may be stabilizing at levels far below their peak four years ago rather than recovering broadly. When will house prices get
back to where they were? John Burns of John Burns Real Estate Consulting, one of the nation’s savviest real estate analysts, in- vokes the seven-and-seven rule. In previous local-market bubbles, Burns says, “the rule of thumb is seven yearsdownand seven years up” after the bubble pops. Apply that rule to the national market, where the bubble popped in 2006, and we’re talking about a sustained recovery starting in 2013, and taking until 2020. That’s pretty grim, but probably realistic. So when are we going to know
when things are getting better? They may, in fact, be getting better now, but it’s going to take a long time for the wound to heal completely. We need to take care of people who have lost their jobs and lost their hope. But after the midterm elec-
tions, when there’s going to be immensepressure to adopt every- one’s programs, we can’t just throw money at everything, searching for magic cures and magic sound bites. Ifwedo, it will take us that much longer to climb out of the hole.
Allan Sloan is senior editor at large at Fortune magazine. Tory Newmyer is a writer at Fortune. Doris Burke is a senior reporter at Fortune.
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