Monetary Tools, Financial Reforms,
and the Next Financial Crisis
Robert J. Gordon
Global Economics Conference
Arlington, Virginia
July 20, 2018

The Questions Posted to Mefor this Presentation• How will central banks and governments use
monetary tools in the next financial crisis?
• What are your thoughts on the state ofglobal financial reforms and/or global
responses to US financial reforms?
• What do you see as the future ofinternational monetary policy cooperation?

The First Question Starts Fromthe Wrong Premise• How will central banks and governments use
monetary tools in the next financial crisis?
• There is not going to be a “next financial crisis”• My starting point: to convince you to stopworrying about the next crisis• Change of topic: adequacy of monetary tools forthe next recession• When are we going to have the next recession?

Why We’re Not Going to Have
Another Financial Crisis• There can’t be a global financial crisis without acrisis in the U.S., and there won’t be a crisis in theU. S.
• Previous foreign financial crises that had no impact
on the U. S.
– Mexico 1994
– East Asia 1997-98• Instability in major nations that did not affect U.S.
– Gyrations in Chinese stock market– 2013 Euro crisis, second wave of high unemployment inEurope

U. S. Crisis History:
Only Two U.S. Crises Since 1907

• 1929: Stock market fell by half in one month, but
this isn’t enough to explain Great Depression– Monetary ineptness, money supply declined by 1/3– 25,000 banks failed– Overbuilding in 1920s sapped demand for investment in
1930s, especially for housing• 2008: What were the ingredients?
– Housing price bubble– Sub-prime mortgages bundled into mortgage-backed
securities– Overlevered shadow banks which became insolvent
when MBS were marked to market• 2000-2001? Stock market fell by half but no crisis

S&P Price Earnings Ratio,
1900-1948
220
200
180

S&P/Earnings (Index 1925= 100)

160
140
120
100

80
60
40

20
0
1900

1903

1906

1909

1912

1915

1918

1921

1924
Year

1927

1930

1933

1936

1939

1942

1945

1948

Housing Starts Relative toHouseholds, 1920-41 vs. 2000-2018
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5

0.0
1920/2000

1924/2004

1928/2008
1920

1932/20122000

1936/2016

1940

S&P Price-Earnings Ratio,
1970-2018
200

180160

S&P/Earnings (Index 1995 = 100)

140
120

100
80
60
40200
1970

1973

1976

1979

1982

1985

1988

1991

1994
Year

1997

2000

2003

2006

2009

2012

2015

2018

The 2003-06 Housing Bubble Stands
Out: House Price/Rent Ratio
1970-2018160

Housing Price over Rental Price

140

120

100

80

60
1970

1973

1976

1979

1982

1985

1988

1991

1994 1997
Year2000

2003

2006

2009

2012

2015

2018

When Will the Next Recession Come?
Factors to Consider• Monetary Policy: How Restrictive?
• Tax Cuts and Reform: How Stimulative?
• Added Stimulus from Government Spending• How Long Will Growth Rise to 3% from its
2% average during the expansion?
• Can the Supply Side Support the DemandExpansion?

The Longest Expansions
in U.S. History
140120120109

106

100

9280

7358604540200June 2009-Jul. March 19912018
March 2001

Feb. 1961Dec. 1969

Nov. 1982July 1990

Nov. 2001Dec. 2007

March 1975Jan. 1980

Oct. 1949July 1953

The Current Economy:
A Golden Era• “Golden” with low inflation and GDP growth of 2.9
percent over the year ending in 2018:Q2– Another year of 3 percent growth now to mid-2019• Unemployment rate has fallen from 10 percent inOctober 2009 to 4.0 in June 2018
– Below Most Estimates of Full Employment• But Inflation is not accelerating as in past expansions.
Why? Discussion in second talk today.
• How Low Can Unemployment Go?
– 3.8% April 2000, 3.4% Fall-Winter 1968-69– 19 U.S. states have U rates at 3.5% or below– WI-MN-CO 3.0%

• Conditional on inflation remaining at 2.0% or slightly above

What Has Propelled the Expansion
Over the Past 9 Years?
• “Virtuous Circle” of job growth feeding
income growth feeding consumption growth
feeding more job growth.
• That can go on forever, or until we run out ofworkers• Even as the U rate goes below 4.0 percent,there remain many discouraged workers andthose working part-time who still lack fulltime jobs

The Virtuous Circle – Employment
Feeds Consumption Feeds
Employment

54

C4 Real PCE

3
2
10-1
-2-3-4
C4 Payroll Employment

-5-6
2007

2008

2009

2010

2011

2012

2013
Year

2014

2015

2016

2017

2018

Why Is GDP Growth Speeding Upfrom its 2% Path to 3%?
• Normal expansion deficit shrinks asrising incomes pull up Federal revenues• Now the corporate and individual tax
cuts provide 0.3% growth stimulus in2018• Bipartisan two-year $300 billion
increase in government spending 201819 provides 0.8% growth stimulus eachyear

Government Deficit Should Decline inExpansions, But Not Now
420-2-4-6-8-10

1970

1975

1980

1985

1990

1995

2000
Year

2005

2010

2015

2020

2025

Stock Market Wealth Effect• S&P 500 has increased 30% since Oct 31, 2016
• This represents about +$6 trillion in wealth• How much of this wealth would have to raise
consumption to boost GDP by half a percent?
• Answer: 1.5 cents spending per dollar ofextra wealth• Together with tax cuts and govt spending, ,that’s more than enough to boost GDP growthfrom 2.0 to 3.0

What Will Bring the Expansion
Finally to an End?
• End of bipartisan government spending
increase? It could be extended in 2020, anelection year
• Trump’s trade war? Even a 10% tariff on$400 billion of Chinese imports only impacts
3% of personal consumption expenditures.
Raises inflation by 0.3% for a year.
• Traditional answer? Monetary tightness,measured by the inverted yield curve

The Yield Curve Inverted Before
Recessions: 1970-2018543210-1-2
1970

1975

1980

1985

1990

1995
Year

2000

2005

2010

2015

When Will the Yield Curve Invert?
• Fed is on track to raise Fed Funds rate to 3% byend of 2019
• But by then 10-year rate, now 3%, likely to be 3.5
to 4%, so no inverted yield curve• What could change the forecast FF path?
– Rise of inflation faster than Fed’s overly optimistic
forecast– Impact of Trump’s tariffs on inflation rate
– Overheating of economy in response to tax cuts andextra government spendingAdequacy of Monetary Tools
to Deal with the Next Recession• Widespread concern that Fed “doesn’t haveenough room to drop rates.”– Fed Funds rate has typically declined 5% in
response to a recession– Now barely 2% and can’t fall below zero

• Potency of rate declines greatly exaggerated,legacy of old Regulation Q era pre-1980– Then S&Ls had a monopoly of mortgage lending– Fed rate policy controlled flow of S&L lendingMonetary Weakness: Housing Starts
Were Much More Sensitive in 1970s
4540
3530252015
10501960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Verdict on Monetary Potency
to Fight the Next Recession• Residential housing is the most sensitive spending
component to interest rates– Business investment depends on confidence, tax policy,
and capacity utilization, not interest rates• Rate cuts have little impact on residential housing• What about Quantitative Easing (QE)?
• Huge increase in Fed’s balance sheet from $0.8
trillion to $4.5 trillion decreased the 10-year rate at
most 50 basis points• Conclusion – Fed has little power to blunt the nextrecession

Is Government Helpless toFight the Next Recession?
• If monetary ease has little impact, what about fiscal?
• 2009-2010 Obama stimulus was $800 billion (5% of GDP)
spread over two years• Stopped the collapse but didn’t stimulate a brisk recovery– GDP grew at only 2% per year 2010-2017• Impact of Obama stimulus followed by sequester-driven
fiscal austerity from 2012 to 2015
• Big obstacles to another stimulus– Rising debt-GDP ratio under current policy– 2018-19 Tax cuts and spending increases just when we don’t
need it• Current fiscal stimulus should have been saved for nextrecession

Public Debt % GDP
10090807060
504030201001990

1995

2000

2005

2010
Year

2015

20202025

Second Topic• What are your thoughts on the state ofglobal financial reforms and/or global
responses to US financial reforms?
• U.S. Dodd-Frank and stress tests leave us
with a well-capitalized banking system• Sub-prime mortgages and over-levered
shadow banks could become a problem
again but not now nor in sightGlobal Reform?
Look at Euro-zone• Not prepared for next recession– Interest rates still near zero, negative some countries– Quantitative easing still happening, unlike Fed’s
normalization of balance sheet• Slow recovery caused by– Lack of bank bailouts, slow start on monetary stimulus,fiscal austerity• Fiscal coordination impossible because of divide
between Germany and S. Europe• GDP still hasn’t recovered to 2007 in Greece, Italy• Lack of serious structural reforms except in FranceConclusion• No financial crisis in U.S.
• Next recession not in sight• Fed has little power to stabilize economy• Fiscal stimulus in next recession hampered byhigh debt-GDP ratio• 2018-19 fiscal stimulus exactly the wrong timing,should have been saved for next recession• Wild card? More inflation than Fed forecasts,
stay tuned for my second presentation