Kevin Warsh: It's Greek to me - economic events of the last three years
Speech by Mr Kevin Warsh, Member of the Board of Governors of the Federal Reserve
System, at the Rotary Club of Atlanta Meeting, Atlanta, Georgia, 28 June 2010.
* * *
The views expressed here are my own and not necessarily those of my colleagues on the Board of Governors or
the Federal Open Market Committee. Nellie Liang, Daniel Covitz, William English, and Brian Madigan of the
Board's staff contributed to these remarks.
It is tempting to view the economic events of the last three years as a series of unrelated,
unpredictable, unfortunate financial shocks. And it is easy - too easy, really - to bemoan the
latest flare-up of crisis conditions, and chalk it up to the global economy's continued string of
bad luck.
If what ails us is nothing more than a case of bad fortune, then the mixed metaphor of the
moment has it about right: the black swans are caught up in the perfect storm. And if what is
needed to induce a durable global economic expansion amounts to more doses of the
nowfamiliar spending packages and weekend shock therapies, then we would know that our luck
was indeed changing. If only it were so.
In my view, a strong, sustainable U.S. economic expansion is not in the hands of the fates. It
rests in our hands - the hands of fiscal, regulatory, trade, and monetary policymakers.
Equally, it rests with business leaders like you here at the Atlanta Rotary Club.
We will soon give notice to the third anniversary since the onset of the global financial crisis.
As we mark this occasion - and continue to witness shocks arising intermittently and
unevenly - it might be worth debunking some popular views that have become part of the
crisis narrative. In their stead, I will begin with what I believe are some truths, perhaps hiding
in plain sight all along.
Subprime mortgages were not at the core of the global crisis; they were only indicative of the
dramatic mispricing of virtually every asset everywhere in the world. The crisis was not made
in the USA, but first manifested itself here. The volatility in financial markets is not the source
of the problem, but a critical signpost. Too-big-to-fail exacerbated the global financial crisis,
and remains its troubling legacy. Excessive growth in government spending is not the
economy's salvation, but a principal foe. Slowing the creep of protectionism is no small
accomplishment, but it is not the equal of meaningful expansion of trade and investment
opportunities to enhance global growth. The European sovereign debt crisis is not upsetting
the stability in financial markets; it is demonstrating how far we remain from a sustainable
equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy
time, but it alone buys neither stability nor prosperity over the horizon.
In the balance of my remarks, I will survey recent economic and financial market
developments. Next, with the benefit and burden of recent U.S. experience, I will offer some
changes for the next edition of policymakers' Crisis Response Guide. Finally, even amid
greater uncertainty about economic prospects, I will seek to further the discussion about a
path for policy.
Economic and Financial Market Developments
Recent economic data support a moderate recovery in economic activity. As the Federal
Open Market Committee (FOMC) noted last week, information received in the past couple of
months suggests that the recovery is proceeding and that the labor market is improving,
albeit gradually. Household spending is increasing, but remains constrained by high
unemployment, modest income growth, lower housing wealth, and tight credit. Business
spending on equipment and software has risen significantly; however, investment in
nonresidential structures continues to be weak.
Owing to a less-than-assured economic outlook and broad uncertainty about public policy,
employers appear quite reluctant to add to payrolls. After sizable increases in March and
April, private nonfarm payroll employment rose by only 41,000 in May. Employers, however,
continue to lengthen workweeks for existing employees. Notably, the workweek for
production and nonsupervisory workers in manufacturing reached its highest level since July
2000, and overtime hours per worker now stand at pre-recession levels.
Meanwhile, most broad measures of inflation remain subdued. And long-term inflation
expectations appear stable.
Financial conditions, notably, have become less supportive of economic growth. In early
May, concerns intensified regarding fiscal difficulties in some European countries. Financial
market volatility resurfaced with a vengeance in U.S. markets. The implied volatility of equity
prices (VIX) jumped to levels not seen in more than a year. In short-term funding markets,
spreads between the Libor (London interbank offered rate) and the OIS (overnight indexed
swap) rate widened and commercial paper rates for many issuers jumped. Investors became
decidedly less willing to provide funds at longer tenors.
Treasury yields fell to near historic lows, in part as investors sought refuge in
dollardenominated, highly liquid, safe-haven assets. Equity prices, reacting to increased risk and
prospects for weaker global growth, also fell. Broad equity price indexes touched lows as
much as 14 percent below their recent peak in April. And retail investors may have
experienced one scare too many; outflows from equity mutual funds appear to rival the
retreat in late 2008. Risk spreads on U.S. investment-grade and high-yield bond prices rose,
and corporate bond issuance fell to about half the run-rate of earlier this year. Broad
measures of industrial commodity prices decreased substantially from their peaks - mostly
on account of weaker expected global demand. There has been, however, some modest
improvement across some markets in the most recent weeks.
As I noted, a moderate cyclical recovery characterizes the last several quarters in the United
States. But while the recovery is proceeding, investors remain uncertain about its trajectory.
Financial market participants are still searching - perhaps better characterized as lurching -
for a new equilibrium.
The economy's path depends in part on whether a new market and public policy equilibrium
is established to keep the financial repair process on track. If volatility in financial markets
persists at elevated levels, the expected pickup of business fixed investment may disappoint.
Business leaders in the United States may react to the latest in a long series of shocks by
postponing investments in capital and labor alike. In that way, massive excess cash balances
might not be a source of strength, but a reminder of caution.
If, however, volatility levels across asset markets abate - indicating that the financial repair
process is continuing - the economic recovery should continue apace. Businesses and
consumers would then be better positioned to convert the recovery into a more durable
expansion.
An Updated Crisis Response Manual
Given recent U.S. experience in responding to the financial crisis, allow me to offer for
consideration some ideas to inform the policy response going forward. You can judge for
yourselves whether policymakers - at home or abroad - will be receptive to these ideas.
First, don't blame the mirror.
In times of economic weakness or financial distress,
policymakers are often troubled by the messages embedded in financial market prices or
bank lending statistics. Some supervisors might disagree - even strongly - with the prices
markets assign to a banking system's financial wherewithal. Some elected officials may
blame commercial banks for the low levels of lending. Some out-of-favor fiscal authorities
may take great umbrage at the prices assigned to their funding costs. Still, outlawing a class
of securities or upbraiding an industry tends to be counterproductive.
Second, don't fall in love with the mirror. In benign economic times, market prices can lull
investors and policymakers into a false sense of security. Financial market prices may
appear more sanguine about prospects than fundamentals suggest. The cost of issuing a
10year Treasury bond or German bund might be exceptionally low by historical standards.
Inflation expectations may appear well anchored. But this is no guarantee of future
performance. Market prices adjust slowly and steadily...until they don't. Then, market prices
can act in a nonlinear fashion. That's when policymakers end up with fewer, less desirable
options. And economies are done harm. So, in each of these messages, we might think of
the financial markets as a mirror, a very imperfect but still telling reflection of reality.
Third, facts, not force, should be the predominant policy response. Prevailing wisdom has it
that policymakers must overreact when markets do. In my view, this is an uncertain
proposition. If a problem were unique or isolated, game theory suggests that overwhelming
force might serve policymakers' interests. But, these problems are not isolated. And it is no
game. Markets will continue to clamor for more explicit government commitments. Better to
feed the proverbial beast with more facts than force. The Federal Reserve-led stress tests
are but one example where the balance was reasonably struck.
Fourth, there are no free lunches, but there is an early-bird special for dinner. Economic
trends - fiscal, monetary, trade, or regulatory - tend not to improve when the immediate is
continually given preference over the important. The economy's long-term growth prospects
must be given top billing. As economist Charles Schultze reminded us, it is not the wolf at the
door but the termites in the walls that require attention.1 The sooner the house's structure is
strengthened, the better.
A Way Forward
The job for policymakers, like business leaders, is not getting any easier. There is an
understandable tendency - amid an uncertain environment - to defer the tough decisions.
But, we might find framing the policy choices - and confronting tough judgments - a prudent
way forward.
The most recent round of turmoil in financial markets caused many fiscal authorities around
the world to reconsider whether they can spend their way to prosperity. Some are concluding
that fiscal consolidation may be the better path to economic expansion. That spending cuts
are key to establishing a credible path of fiscal sustainability. That channeling government
funds from higher-yielding private-sector activities to lower-yielding public-sector activities
undermines economic potential. That fine-tuning aggregate demand requires a precision that
is difficult for governments to execute effectively. And, that market forces are often more
certain than promised fiscal spending multipliers.
Fiscal policymakers must wrestle with difficult questions of timing, external conditions,
economic potential, and policy credibility. Ultimately, in my view, fiscal consolidation happens
either when policymakers choose the path, or it gets chosen for them. The former is
preferred. The events in Europe remind us that the latter is likely if policymakers do not act in
a timely way.
What About the Conduct of Monetary Policy?
The challenges for monetary policy are not dissimilar from those confronting the fiscal
authorities. The allure of short-term gains must be balanced dispassionately against
longerterm and potentially larger consequences.
Last week, the FOMC announced that it would maintain the target range for the federal funds
rate at 0 to 1/4 percent, and it continues to anticipate that economic conditions are likely to
warrant exceptionally low levels of the federal funds rate for an extended period. The Fed
announced no changes in the size or composition of its balance sheet. However, the
published minutes of recent FOMC meetings make clear that the Committee has been
carefully considering critical aspects of its balance sheet policy.
In my view, the Fed should pursue a deliberate, well-communicated strategy that clearly
differentiates the path of the Fed's policy rate from the size and composition of its balance
sheet. The Fed's policy tools should not be conflated or confused. One of the surviving
features of the Fed's extraordinary actions is the breadth of tools at our disposal. They
comprise a handy set, and should remind us that every problem is not a nail. And that we
have more than the hammer in our toolkit. By considering, communicating, and, potentially,
deploying our policy tools independent of one another, we have the best chance to achieve
the Federal Reserve's dual objectives of price stability and maximum employment.
I consider the Fed's policy rate - the federal funds rate - to be the dominant tool in the
conduct of operations going forward. It is far and away the most powerful, its effects on the
economy and financial markets most clearly understood, and it is the most effective in
communicating our intentions.
The Fed's balance sheet of $2.3 trillion - of which $1.6 trillion represents long-term Treasury
securities, agency mortgage-backed securities, and agency debt acquired since late 2008 -
should be considered, sized, and comprised independently of the policy rate. In my view, the
macroeconomic effects of these extraordinary holdings are less significant, their effects on
financial market conditions less clear, and the markets' understanding of our objectives less
understood than our dominant tool.
Still, if federal fiscal policy is approaching its political or economic limits, some believe that
the Federal Reserve should do more, including expansion of its balance sheet.
In my view, any judgment to expand the balance sheet further should be subject to strict
scrutiny. I would want to be convinced that the incremental macroeconomic benefits
outweighed any costs owing to erosion of market functioning, perceptions of monetizing
indebtedness, crowding-out of private buyers, or loss of central bank credibility. The Fed's
institutional credibility is its most valuable asset, far more consequential to macroeconomic
performance than its holdings of long-term Treasury securities or agency securities. That
credibility could be meaningfully undermined if we were to take actions that were unlikely to
yield clear and significant benefits.
Indeed, the Federal Reserve should continue to give careful consideration to the appropriate
size and composition of its existing holdings. Actual sales will not take place in the near term.
But, depending on the evolution of the economy and financial markets, we should consider a
gradual, prospective exit - communicated well-in-advance - from our portfolio of
mortgagebacked securities. In making this judgment, we should continue to assess investor demand
for these assets. Ultimately, in my view, gradual, predictable asset sales by the Fed should
facilitate improvements in mortgage finance and financial markets.
Any sale of assets need not signal that policy rates are soon moving higher. Our policy tools
can indeed be used independently. I would note that the Fed successfully communicated and
demonstrated its ability to exit from most of its extraordinary liquidity facilities over late 2009
and early 2010, even as it continued its policy of extraordinary accommodation.
Conclusion
The United States is not Greece. We have the largest, most robust economy in the world.
We have the deepest, most liquid financial markets. And the dollar is the world's reserve
currency, bestowing key advantages upon us. But, none of this is our birthright. It must be
earned, and re-earned.
The events of the past several years underscore that unanticipated, nonlinear events can
happen, even to the most well-intentioned policymakers in the strongest economies in the
world. We ought not to be dismissive of the threats to our privileged position in the world.
And we should take the necessary measures to ensure that our economy is strong over the
long term.