What The 2008 Crisis Can Teach Us About COVID-19’s Economic Cure
Sound monetary policy is as important as political bipartisanship
Mar 31, 2020 | Medium post
Ben Bernanke (Previous Chairman of the Federal Reserve); Credit: CNBC
Recently on March 27th, 2020, the United States overtook China, Italy, and Spain as the country with most COVID-19 cases. Some of us, as Americans, are agonized and fearful of what is next to come. Without doubt, COVID-19 has evolved into an epochal event that will surely stain the memories of billions.
To cushion the economic impact of the pandemic, the Fed has cut short-term policy rate to near zero and is preparing to purchase $700B in Treasury debt and mortgage-backed securities. Though a pandemic is not entirely analogous to the 2008 financial crisis, monetary policy tactics run similar. In a time of uncertainty, it is increasingly important to stabilize financial markets, which affects investor confidence and ultimately households and businesses. Shelter-in-place is enforced throughout the country, and the hope is that the economic pause will be short-lived — once the pandemic passes, normal activity will resume. However, if quarantine measures extend past summer, this could lead to disruptions in production chains and increased bankruptcies for businesses. Read more on whether quarantines can go too far.
“The challenge we face is how to act with sufficient strength and speed to prevent the recession from morphing into a prolonged depression…[and] it is the proper role of the state to deploy its balance sheet to protect citizens and the economy against shocks that the private sector is not responsible for and cannot absorb.” — Mario Draghi, Italian Economist and former President of the European Central Bank
Let’s expand that view into the global sector. America is not the only country susceptible to a recession — many other countries are either already deep in a recession before the onslaught of COVID-19, or most likely entering one now. 2008 has taught us not only how interconnected U.S. financial institutions are, but also how interwoven our economy is with the global world. Because international banks purchase U.S. government and asset-backed securities, subprime mortgages (which led to the crisis) also affected global markets.
Contagion swept through the markets as banks in other countries defaulted on their debts. In 2011, when the U.S. was still trying to emerge from the recession, Greece’s budget deficit reached an all-time high, causing widespread panic of a default. The European Central Bank (ECB) and the International Monetary Fund (IMF) bailed out Greece, in fear that Greece’s default will lead creditors to pull their money from Italy, Spain, and a few other Eurozone countries which had large deficits.
Imagine the impending global recession leading to a panic where financial institutions start pulling their money out of government bonds in countries with a large budget deficit. Rather than a regionalized issue, such as the Eurozone having to decide on whether to bail out one country, it will become a global problem, where many countries will need to work with the IMF to stabilize those that are hit hardest.
In other words, if a parent has 10 kids, and one of them fell into a pool, she could probably save the one child easily. But, if 6 of them fell into the pool, she may need to think about who to save first and how quickly to act before one of them drowns.
“Over 80 countries, mostly of low incomes, have already have requested emergency aid from the International Monetary Fund. — Kristalina Georgieva, IMF Chief.
To avoid a worldwide economic catastrophe, the Fed, as well as other Central Banks, will need to ensure that strong monetary policy is in place to stabilize domestic economies. I went back through Ben Bernanke’s memoir, The Courage to Act: A Memoir of a Crisis and Its Aftermath, and concluded some key lessons from how the 2008 financial crisis was tackled. Bernanke’s autobiographical account of the 2007–2009 financial crisis and the Great Recession adeptly portrays the scene by scene play of our economy as well as the complex decisions the Fed has made to soften the negative impact on Americans. It is a memoir as much as it is a commentary on America’s regulatory structures and shortcomings. In 2009, America emerged wounded from the crisis and recession, though massively cushioned by a number of policies led by the Fed. The Fed’s main job was to use monetary policy to control inflation and interest rates, and consequently decrease unemployment and increase momentum in the economy.
It is currently 2020, and with near certainty if the lockdown were to continue for the foreseeable months, we will be submerged in growing pains of relieving unemployment, fixing a crippling healthcare industry, and revitalizing small businesses. To stabilize our economy and prepare for the impending recession, the government needs to 1) take lessons from history and apply it to our monetary and fiscal policy, 2) uphold financial stability and liquidity within the markets, and 3) look past political party differences and cooperate with the Fed while fully respecting its autonomy.
1. Lessons of history should be continuously applied to today’s economic issues
Bernanke’s deep understanding of historical panics, especially the Great Depression, and macroeconomic situations led him to promote the less popular New Keynesian ideas of government spending and borrowing during the recession, as well as austerity measures during growth stages. This contrasted with Robert Lucas’s New Classical economics approach in the 1970s, which postulated that monetary policy had no effect on the economy and instead increased inflation. The approach rapidly gained popularity within the macroeconomics community and guided many economic decisions that followed.
Though Bernanke’s ideas were unconventional in macroeconomic standards, he nonetheless decisively chose to rely on his own research and understanding of history to instigate three rounds of quantitative easing (QE), where the Fed purchased large quantities of government securities and assets to inject liquidity into the economy. Contrary to Lucas’s model, the results did not overextend inflation, debunking widespread assumptions on QE’s inflationary tendencies.
Whether an economic policy is effective requires application as well as sound theories. One productive way to learn is by analyzing past programs and policies implemented during historical panics, recessions, and inflationary periods. Some policies may need to be reinstated, some may not. But regardless, the Fed should exercise its independent right to launch and evaluate large unconventional ideas based on historical extraction, rather than implement policies based on conventional wisdom.
2. Financial stability is absolutely critical to preserve the stability of the economy
Bernanke’s decision to bail out big banks is to this day quite controversial. However, given the economic downturn proceeding Lehman’s bankruptcy, it is difficult to refute that the interconnectedness of our financial system could very well generate a domino effect on all lending institutions, leading to an abysmal outcome (e.g., bankruptcies of large banks, rise in unemployment, panic runs) accelerated by the housing market crash. The most important element is to maintain liquidity in the markets, facilitating lending to businesses and individuals in need.
Small businesses are hit especially hard with the current economic shutdown, and the Fed should work with the government to ensure businesses are able to compensate borrowers for their expenses or provide necessary support for avoiding defaults. To do so, the Fed should closely monitor creditor actions and the health of financial institutions to avoid panic runs and fire sale of assets. This requires an increase in transparency on its actions, where any bailouts / security purchases are frequently and clearly communicated to the public. Furthermore, the Fed should maintain low interest rates until the economy gains momentum and stabilizes at a reasonable unemployment rate.
3. Solidarity and political bipartisanship can propel rapid progress
Lack of political bipartisanship fuels stagnation (e.g., Peter Diamond’s nomination, government shutdown in 2013) and threatens the Central Bank’s autonomy. As the Chair of the Federal Reserve, you already face a great deal of scrutiny. Not only was Bernanke dealing with the public’s lack of understanding of quantitative easing, the media’s numerous unsubstantiated criticism, and the misrepresented call to “audit the fed” in a case where the Fed is already heavily audited, he was also the brunt of attacks by politicians who lacked expertise on inflationary and asset-purchase consequences. Politicians such as Ron Paul (R) and Bernie Sanders (D) opposed his monetary approach and disrupted the Fed’s ability to promote the aggressive fiscal stimulus it needed ease unemployment growth.
As we fight the pandemic, it is important the nation sees more solidarity among the diverging political parties, the Central Bank, and our government branches in order to quickly pass legislation and continue critical progress to avoid economic chaos. Without solidarity, we will greatly impede our progress to rescue our economy in a timely manner.
The Fed, as well the central banks of numerous countries, have the responsibility of ensuring and easing the flow of credit to banks and businesses. Many of the programs that were developed in 2008 are reemerging. For example, the Commercial Paper Funding Facility (CPFF), which lets the Fed buy commercial paper directly from banks and large corporations to help facilitate lending to small businesses, has been reintroduced in light of the pandemic.
All around the world, the economic reality of the pandemic is settling in, and the need for stabilization mechanisms appears inevitable. The recent $2T stimulus package in the U.S. is a positive boost, but likely we will need more than that. I wouldn’t be surprised if the U.S. passed several fiscal stimulus packages throughout the next year. For many other countries, it is unclear whether their own reserves and domestic resources will be sufficient, and hence, it is important that the U.S. keeps its own economy afloat as to not further drag down the economies of other countries.
Bernanke made clear through his time as Chair of the Federal Reserve that the Fed’s job is not solely to control inflation, but also to stabilize the economy through a range of policies and governance. It is critical that our administration evaluates historical recessions and policies, stabilize our financial institutions, and unite to act with decisiveness rather than ambiguity. Let’s hope we’re much more prepared to combat the impending economic recession than we were to curb the spread of the virus.