Fotios Siokis
May 30, 2019

On December 10, 2018, the Graduate Center hosted an attention-grabbing discussion on the causes of the Great Recession and the possibility of a future downturn due to high levels of corporate indebtedness. Janet Yellen, the former Federal Reserve Chair, was interviewed by the Nobel Laureate Professor Paul Krugman.

Professor Krugman initiated the discussion by asking if Chair Yellen had any indication in advance that this particular crisis would become the worst economic crisis since the Great Depression. Yellen responded with an anecdote. When she became the President of the Federal Reserve in San Francisco back in 2004, the first issue raised by the bank supervision unit was the high commercial lending for development and construction, especially in the areas of California and Arizona, due to the booming real estate market. Despite all efforts made by the Federal Bank of San Francisco, banks were leveraging most of their capital in real estate, emboldened by house price increases, and it was almost impossible to convince people, let alone members of the Congress and industry, of the dangers. The authorities found themselves unable to put a stop to this lending and issued mild warnings, while house prices continued to rise. By 2005, Chair Yellen was convinced of the existence of a housing bubble, as large lending institutions, such as Wells Fargo and Countrywide, offered mortgage loans with very lax lending standards. NINJA loans (meaning there was No Income, No Job or Assets) or combined loans provided to one borrower, with a loan value of 125% of the value of the property, were typical examples of bank practice. On this issue, Krugman concurred, adding that Countrywide’s case was indeed a scandal.

Yellen recognized the fragmented financial regulation system that existed in the USA with many different regulators. Countrywide was an example, where the mother company – a gigantic entity exposed heavily to risky mortgages – was converted into a federally chartered thrift company in 2005 in an attempt to avoid the stringent supervision by the Federal Reserve Bank. Thus, it would be regulated by another entity (Office of Thrift Supervision), whereas a subsidiary – a small bank – was supervised by the Federal Reserve Bank.

When Countrywide failed, Yellen became more concerned with the environment of vast financial excess, and overleveraged households, while banks were competing eagerly to finance all possible projects, even the most egregious ones. Yellen gave another example of this idiocy, where a private equity firm tried to take a company private and surprisingly could obtain a loan to buy out the main shareholders without even being evaluated. In addition, the terms of the contract were so favorable that if the economy faltered, the borrowers had the option of not paying interest on the debt until they were able to do so. The process, common in those days, called payment-in-kind (PIK) where the borrower assumes more debt (this is the payment in kind) in times when borrowers could not pay interest.

Easy Loans, Shadow Banking, and Highly Leveraged Large Investment Banks

She mentioned that ample liquidity in the market and the housing bubble were the main issues of discussion in monetary policy meetings. She admitted that, at the time, she had a poor perspective on the impact of the shadow banking system (referring to non-bank financial institutions that were not subject to regulation and engaged in maturity transformation by raising – largely by way of borrowing – short term funds and using them to purchase assets with longer-term maturities).

It was shocking how leveraged investment banks became and how reliant they were on overnight, short-term, wholesale credit, on financing gigantic portfolios of illiquid assets. And how that system could impact the core banking system like the kinds of runs we saw with Lehman and with Bear Stearns. Nor she did ever imagine that there was a company like AIG out there selling enormous amounts of insurance that made investors so comfortable that they weren’t taking on undue risk.

Fed Failure to Understand Magnitude

On this point, Krugman stepped in and said that it was surprising that the Fed’s alarm did not ring enough bells? In response Yellen affirmed that at the Fed hadn’t put all the pieces together at the beginning, despite the series of meetings in 2006 and the extensive debates in the Federal Open Market Committee of a potential housing bust. Nobody expected that this seismic magnitude would create a severe financial crisis and a fall of the housing prices in excess far beyond 20%. They were contemplating that house prices could fall and could have an adverse impact on the economy leading up to a recession, like in 2002, which was caused by a decline in stock prices. The ripple effects through the economy looked manageable, with the Fed probably able to contain it by cutting interest rates.

State of Mind of Policymakers at Fed/Aftermath and Stress Tests/Turning Point

Following Krugman’s question regarding the state of Central Bankers’ minds during the extreme crisis and if they felt confident that they could get through it, Yellen replied that this was indeed a horrifying experience, with this crisis having the potential to make the Great Depression look like a mild downturn. The Fed recognized the need to do everything possible to stabilize the financial system after the collapse of numerous banks. While the financial crisis was transmitted to the real economy, with wide-ranging potential repercussions and the unemployment rate increasing to 10%, the Fed acted quickly with response measures, and by December 2008 short-term interest rates were effectively at zero.

Also, intense pressures on capital markets forced the Fed to move relatively quickly and to conduct stress tests for the major banking organizations in assessing their viability and potential capital shortfall. That act, according to Yellen, was the turning point for the financial system and for curbing people’s panic regarding banks’ undercapitalization. The Fed’s strong commitment to stabilizing the system forced the banks, back in April of 2009, to recapitalize either through the use of private funds or through the injection of government equity. On this issue, Krugman stated that, injecting capital basically meant the government bought stocks, which diluted the existing stock, while banks had more money that could be lost ahead of hitting the debt holders.

Subdued Inflation

Regarding inflation, Krugman initially pointed out that Yellen, in contrast to some other colleagues throughout that period, correctly predicted that 1) inflation would stay low and 2) that the recovery would be sluggish despite enormous monetary expansion.

Regarding her prediction of low inflation, Yellen responded that at the time there was insufficient demand to ignite inflation. In contrast, an immense shortfall in demand and the vast capacity of the economy to supply goods and services resulted in the unemployment rate peaking at 10%.  Despite some beliefs – including those of people in the financial markets and Congress – that printing money or creating reserves was bound to create inflation or to verge on hyperinflation, there wasn’t an inflationary environment, and this was indicated by survey measures of inflation expectations.

In regard to a sluggish recovery, Yellen’s pessimism was based on previous historical events where crises such as this one were followed by vastly prolonged downturns with substantial debt overhang, while a long period of time is needed before any revival in consumer spending occurs. Therefore, since short-term interest rates were nearly zero and fiscal policy was not able to help further, the Fed explored alternative policy tools to stimulate the economy. She also pointed out that, in small economies after such a crisis, growth comes from the exchange rate’s depreciation as demand for the country’s exports increases, but she believed that it would not apply in this situation.

Krugman expanded on the issue of lower-bound, short-term interest rates and recalled that some countries essentially achieved even negative rates, although not by a lot. He went further, saying that the Fed was able to decrease short-term interest rates to zero levels, but this constrained the Fed’s ability to do more.

Liquidity Trap and Quantitative Easing

Yellen pointed out that the economy was in a liquidity trap where, at zero-bound, short-term interest rates, conventional conduct of monetary policy – buying short-term debt and paying by printing money – wouldn’t have any effect on the economy. It wouldn’t create inflation, and it might not even increase the money supply.

In Krugman’s remark that this situation brings back memories of the Japanese experience, Yellen argued that, with the benefit of hindsight, in Japan’s case the Central Bank, as a standard monetary policy tool, engaged in purchasing very short-term government treasuries by printing money. But the yields on those treasuries were already close to zero, and therefore the act of creating money by deciding to increase the number of nickels in circulation, buying up dimes and paying for them by issuing two nickels per dime had no impact at all. All in the Fed, however, believed that long-term interest rates are more relevant in driving people’s decisions about buying a house, or a car, or whether to engage in investment in plant and equipment. And with zero short-term interest rates, the Fed enacted quantitative easing – a term pioneered by Japan in 2001 – that placed considerable emphasis on driving long-term interest rates down and stimulating the economy.

The discussion concluded with the two participants answering various questions raised by the audience.