After the Music Stopped (part 2)

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Part III of Alan Blinder’s After the Music Stopped describes government efforts to put an end to the financial crisis: The Troubled Assets Relief Program (TARP) begun in the last few months of the Bush administration, the American Reinvestment and Recovery Act (the “stimulus”) passed within a month of the Obama inauguration, and the monetary policies pursued by the Federal Reserve Board. In general, the story that Blinder tells is one of success in avoiding economic depression, but failure to get the American people to understand and accept government policy. He tells this story clearly and persuasively.

When the financial bubbles in housing and mortgage-backed securities burst, many financial institutions were left holding assets that were severely diminished in value. If the government bought those assets, what would it pay for them? Paying too little would leave a bank with a shaky balance sheet, while paying too much would hurt the taxpayers. For the most part, TARP took a different approach, injecting capital directly into the financial institutions and making the government itself a larger stakeholder in them. The large government investment in auto companies also came from TARP. The infusion of capital didn’t get banks lending again as much as had been hoped, but it did stabilize them, and the taxpayers ultimately did get back all but $32 billion of the $430 billion disbursed. One criticism is that the program “squandered an opportunity to attach some minimum lending or foreclosure-mitigation requirements to the capital injections.” (Later in the book, Blinder criticizes the “half-hearted attack on the mortgage foreclosure problem.) The public saw TARP mostly as a giveaway to companies that didn’t deserve it, especially when many of the recipients continued giving bonuses to their key employees.

Blinder describes the Obama stimulus bill as “one-third tax cuts; one-third new spending, such as on unemployment benefits and infrastructure; and one-third aid to state and local governments, especially to help states pay their Medicaid bills. The Republicans quickly condemned the idea of fiscal stimulus now, although they had supported the Economic Stimulus Act of 2008 under the previous administration, which was more about tax cuts. Now they called for federal spending cuts that Blinder believes (along with most economists) would have made the recession worse. “The Earth is not flat. The moon is not made of cheese. Evolution really happened. And you don’t give your economy a short-run boost by cutting public spending.” The public was, to say the least, confused. “In 2009 and 2010, the public saw both a large stimulus package and a terribly weak economy. Republicans assured them that the former caused the latter. Democrats made their case poorly, or not at all.” The argument that the economy would have remained in worse shape without the stimulus was probably valid, but not easy to make. Michael Grunwald’s The New New Deal  is a more detailed look at the economics and politics of the stimulus.

The Federal Reserve adopted a number of strategies to maintain financial liquidity, making sure that banks had enough capital to lend, and that companies and individuals could borrow at reasonable rates of interest. In particular, they wanted to reduce the spread between the interest the government paid on virtually riskless treasury bonds and the interest paid on less secure forms of debt. (The crisis had increased the demand for safer bonds and increased the fear of riskier bonds, lowering interest rates on the former and raising them on the latter.)  Adopting an unconventional policy of “quantitative easing,” the Fed bought higher-interest bonds, reducing the interest rates bond issuers had to offer to find buyers. That also injected more cash into the banks for lending, although banks chose to hold much of it in reserve. The Fed could have cut the interest rate that it pays on such reserves, but chose not to do so. Overall, Blinder gives the Federal Reserve high marks for keeping interest rates under control and maintaining liquidity.

Using a statistical model of the US economy from Moody’s Analytics, Blinder estimates that “real GDP was about 6 percent higher, the unemployment rate was nearly 3 percentage points lower, and 4.8 million more Americans were employed because of the financial-market policies (as compared with sticking with laissez-faire).” But the American people, having an historical preference for small government, and being subjected to a steady drumbeat of anti-government rhetoric, were reluctant to acknowledge the effectiveness of federal policies, especially when they only prevented a deeper recession without restoring mass prosperity.

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