Amidst mixed headlines about tariffs and trade negotiations, the good economic fundamentals behind the stock market rally remain intact. Last week's US economic data showed continuing strong growth while inflation remains in check. The Atlanta Fed's model projects 4.4% for Q318 Real GDP Growth, with Friday's Retail Sales report (thanks to upward revisions to June and July) boosting its estimate of consumption. Besides the low August Core CPI, the Mid-September Michigan Consumer Sentiment Survey showed a pullback in the important 5-year inflation expectations to their recent low of 2.4%. This week's data releases are relatively minor.
The past week also saw a couple of well-known economists, Larry Summers and Paul Krugman, address the causes of the last recession and anemic recovery. Summers highlighted a non-conventional specification of expectations to explain the depth of the recession. Krugman blamed the stubborn insistence of Republicans on preventing large enough fiscal stimulus for the slow recovery. I view Summers' idea as another attempt by him to shift the focus away from policy mistakes, as did his earlier promotion of "secular stagnation" to explain the anemic recovery. I agree with Krugman regarding the Republicans, but it is not the full story. The Democrats deserve part of the blame for the weak recovery, as well.
To better understand the role of policy in the 2008-09 recession and aftermath requires starting in 2003 when China began using its currency to grab market share and eviscerate the US manufacturing sector. From a macro perspective, some sector of the US economy had to spend more than it earned to offset the drag on GDP from the Chinese incursion. Policymakers, particularly the Fed, relied on the household sector to do so by allowing people to borrow through credit cards and mortgages. Democratic Senators and Congressmen exacerbated this effort by pushing FNMA and Freddie Mac to buy subprime mortgages. This allowed banks to issue subprime mortgages without keeping them on their balance sheets, which explains why they were not as careful in approving mortgages as they should have been. But, then, many of the banks bought the packaged mortgages or leveraged versions of them -- perhaps thinking that agency bonds would not be allowed to default, taking on excessive risk -- which the Fed did not stop in its supervisory role. The result was that relying on the household sector to overspend was not a sustainable approach to offsetting the macro effects of the Chinese incursion.
The risk to mortgages and its derivatives materialized after the Fed began hiking rates in 2005. This led to a pickup in mortgage defaults over the next couple of years, which led the markets to downgrade the value of the mortgage-related securities. With potentially large losses on the banks' books, interbank lending began to dry up as no one could trust the credit worthiness of its counterparts.
In this situation, Bernanke and the Fed made several major mistakes in 2008. First, they viewed the market problem as a liquidity problem. So, they cut the funds rate aggressively over the year. However, the problem was not illiquidity but a lack of confidence. The main result of the lower rates was to boost commodity prices, particularly oil -- which rose to $140/bbl in the summer. The latter killed the consumer. Second, the Fed and Treasury exacerbated the confidence problem by allowing Lehman Brothers to fail. Third, Bernanke and Treasury Secretary Paulson went on TV in September saying the US economy was headed to the worst recession ever -- in order to convince Congress to pass TARP. This prediction killed business expectations, and massive layoffs followed right afterwards.
The consensus narrative of the recession blames the supposed greed of banks for overdoing it on allowing people to take on debt. However, this story does not recognize that banks were doing what policymakers wanted in order to keep GDP Growth up while China was depressing the US manufacturing sector. This incomplete analysis led to overly tight restrictions on bank lending in the aftermath of the recession. This was one major reason for the subpar recovery. The restrictions could not be fully offset by low interest rates because of the zero bound on the latter.
Obama made things worse by blaming the bankers (and the one percenters) for the recession. FDR had done the same thing in the 1930s, using his speeches to castigate businesses. Official berating may have been more important than generally thought in preventing the US economy from rebounding more strongly than it did from the 1931-32 recession. (The failure of the economy to rebound strongly in the 1930s is, I believe, a conundrum for economic historians.) The same result could have been in play in the more recent recovery. Moreover, many of Obama's regulatory actions had anti-growth implications (regardless of whether you agree or not with their aims).
This way of analyzing the 2008-09 recession and subsequent subpar recovery puts a different light on policy under the Trump administration than how it is frequently portrayed. The Republican's shift to deficit spending is not as wrongheaded as many think if it is viewed as a belated move to offset the drag from Chinese imports. The recent easing up of Dodd-Frank bank regulations is in the right direction. And, Trump's pro-business tendencies and deregulatory actions may be important stimulants for economic growth.
The analysis also helps explain why both establishment Democrats and Republicans have fared poorly in elections. Voters at least implicitly understand that both are to blame for the poor economic performance of the past 10 years.
Follow me on Twitter at @cjslyce. I may comment on just-released US economic data or other market developments.
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