The Lack of Adequate Policy Defenses Could Make the Next Crisis Much Worse

Ten years after the Great Financial Crisis policymakers are still debating the causes and the missed signs. Nevertheless, there is also a quiet sense of accomplishment and achievement among past and current policymakers as the cumulative force of all policy actions and new regulations helped to not only stabilize the economy and the financial markets but also put both on stronger footing for the future.

Yet, as successful as policies have been so far the bigger risk is that the stimulus bullets from monetary and fiscal policy actions are not repeatable. In other words, while many are discussing what factors could cause the next crisis, the bigger focus should be on the lack of adequate policy defenses if another crisis did occur.

Monetary and fiscal policies have been repeatedly employed to help reverse economic downturns and lessen the impact on the economy from financial crises. Monetary policy is always at the forefront of the shift in policies as it easier to reduce interest rates quickly and substantively than it is to pass legislation to boost the economy.

Prior to the start of each of the last three economic recessions the Federal Reserve started the process of lowering official rates and the pace of interest rate declines accelerated as it became increasingly apparent that the economy was in decline. In all cases, the scale of the official interest rate decline was substantial amounting to a cumulative reduction of 500 to 650 basis points.

Yet, each successive cycle resulted in official policy rates falling to a lower and lower low. To be sure, policy rates troughed at 3% after the 1990-91 recession; 1% after the 2001 downturn; and fell to near zero during the financial crisis.

Constrained by the zero bound during the financial crisis policymakers embarked on outright purchases of Treasury securities to help lower the term structure of market rates, thereby giving individuals and corporations an even better and longer opportunity to substantially reduce the interest rate cost of outstanding debt. The cumulative force of these policy actions triggered an unprecedented decline in interest costs.

According to data from the Department of Commerce, total interest rate expenses for non-financial corporations, small business and household’s hit a peak of $1.9 trillion in 2007 and dropped by more than one-third to $1.3 trillion by 2014.

The large reduction in interest costs for the non-financial private sector was a direct result of the monetary policy response, but it is not repeatable. That’s because even if policymakers are forced at some point to return the zero interest rate policy the interest rates on the vast majority of private sector borrowings have already been reset to the zero policy rate.

There also may be limits on the scale of fiscal actions that could be taken in the future as well. Tax reduction has often been used to jump-start or speed-up an economy recovery but in the past 50 years all of these legislative initiatives (1975, 1981, 2001, and 2009/10) occurred during final months of recession or the early stages of recovery.

Yet, at the end of 2017, after 8 years of economic recovery and expansion Congress passed a large tax reduction for business and individuals. While that policy initiative is undeniably positive for the economy in the short term it does limit the fiscal options that could have been available in the future.

Indeed, the Congressional Budget Official (CBO) estimates that even with somewhat faster economic growth over the next few years’ recent fiscal initiatives will increase the budget deficit to over $1 trillion in fiscal year 2020 and the budget deficit, even with continued economic growth, will continue to get progressively larger in scale over the next decade. That does not necessarily preclude any additional fiscal actions, but does raise questions over the fiscal capacity to respond to another crisis.

After a watershed event like the Great Financial Crisis occurs it is only natural to think about what factors could cause the next crisis. Yet, the bigger issue for next crisis is the lack of adequate policy defenses which could end up making even a mild crisis much more severe in terms of depth and duration.

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