The Federal Reserve Needs a New Game Plan
As the daughter, granddaughter, and niece of people who work and have worked on Wall Street, it has been a fact of my life that the stock market is the family business. I can confidently say, throughout my life, that I have undoubtedly watched more movies about finance than any other genre.
I was five years old when Lehman Brothers collapsed, signaling the start of the 2008 financial crisis. Thus, I was too young to remember the recession well. Regardless, from the first moment I could understand even a glimmer of what the stock market was, my father taught me everything he could about it. His dedication to his job, along with my love of learning, helped me piece together the puzzle of the economic crisis at a young age. I was eleven years old when I watched Too Big to Fail and The Big Short, two well-known films about the financial crisis, and they are now probably the two movies I’ve watched most in my life.
Clearly, I’ve spent the most time learning about finance and economics, and I’ve been surrounded by those topics since I was a child. I could discuss the 2008 crisis and recession for hours and hours if given the chance. So, if there’s anything I’ve learned from living vicariously through my Wall Street family, it is that no two recessions are the same and that they shouldn’t be treated as such.
In an attempt to anticipate the future economic and financial consequences of the current pandemic, the first instinct for many, even the Federal Reserve, is to look at remedies used in earlier crises. Naturally, the 2008 financial crisis is an obvious choice. It is especially relevant in the aftermath of the Fed’s emergency monetary policy actions on March 15, which included severe interest rates cuts, quantitative easing, and bailouts. All of these moves were eerily reminiscent of the Federal Reserve’s behavior after Lehman Brothers went bankrupt.
Regardless, despite how similar the two may seem at first glance, what worked many years ago would simply not work today. Actually, this pandemic-induced chaos is an inverted image of the financial crisis, and the Federal Reserve’s response needs to be crafted accordingly.
To begin with, what occurred in 2008 was a direct financial shock that took a severe and drawn-out toll on the real economy that required an even longer recovery. The banks and Wall Street itself were the source of the problem, as “the explosive growth of mortgage lending to subprime borrowers, fueled by a securitization process that inflated banks’ profits and understated risks, produced a huge bubble in the housing market.” What followed was a complete loss of investor confidence and a horrifying credit and liquidity crisis, as the housing bubble burst, which unleashed catastrophe on the global financial markets. Also, unlike today, unemployment numbers grew gradually as the recession was prolonged by a persistent lack of trust in the economy on behalf of consumers.
Most notably, one of 2008’s major divergences from today’s crisis is that it was a typical endogenous risk crisis: it was ultimately caused by the market participants themselves, who had come to doubt assumptions that had previously been made almost without question. Essentially, the crisis had preyed on the weaknesses of the volatile financial system of the time: “ill-advised and poorly risk-assessed structured credit products, extreme maturity mismatches, illusionary bank capital, regulatory fragmentation, extensive regulatory arbitrage, and large off-balance sheet liabilities.”
The current crisis has had a dramatically more sudden, sharp effect on our economy. Banks aren’t the culprit this year, but a public health problem is. Contrary to the 2008 financial crisis, an external, unforeseen circumstance has indirectly caused a financial downturn. Global containment measures, while necessary to protect the health of billions worldwide, have proved devastating for the economy. This is referred to as an exogenous risk crisis: participants in the financial markets haven’t lost investor confidence because of the market itself, but because of the situations outside it – in this case, the fear and uncertainty surrounding COVID-19.
Furthermore, the behavior of the market today differs greatly from 2008. Eleven years ago, it took nearly 18 months for major stock indexes to fall by 50%. From February 19 to March 23 of this year, the S&P 500 dropped 34% – the fastest market decline that history has ever seen. In 2008 and 2009, about 52 million people claimed unemployment benefits at some point – an average of roughly 500,000 per week. However, since many were able to find new work over that period, the unemployment rate peaked at 10 percent in October 2009. 49 million people have applied for unemployment insurance since claims began to surge in March, leaving the average unemployment claims filed per week at roughly more than five million. The current unemployment rate is valued at around 13%, and with many predicting a rise to possibly 20%.
When you take a closer look at the origins of and series of events following these crises, the contrast between the two is clear. The 2008 financial crisis was endogenous (internally induced), and the current crisis is exogenous (externally induced). Thus, the Federal Reserve’s response to 2020 cannot and should not come entirely from the playbook created in the aftermath of the 2008 crisis. During the 2008 financial crisis, the unprecedented actions taken by the Fed was appropriate in addressing the primary source of the shock. In the COVID-19 crisis, the Fed cannot play the same role it did in 2008, because it is addressing a secondary shock: the financial repercussions of the primary shock to the real economy. As Financial News London puts it, “the ‘big bazooka’ of central banks that worked effectively in putting a floor beneath plummeting markets in late 2008 and early 2009 is not only the wrong weapon to address a public-health crisis; unfortunately, it also lacks live ammunition.”
The “big bazooka” solution to the 2008 financial crisis also left the Fed with limited options to address the inevitable next shock. Moreover, what’s happening right now is a new kind of crisis – not only has it devastated the market, more than 700,000 lives have been lost along the way. It’s a perfect example of how, time and again, the new one is never the same as the one that came before. Yet the Federal Reserve always seems to fixate on a redesign of policies, regulations, and economic structures that is conditioned by the last crisis – leaving them, and in turn the country, woefully unprepared for the next. To put it into perspective, former Fed chairman Ben Bernanke spent much of his academic career studying the Great Depression, and it could be argued that much of the Fed’s decisions during the onset of the 2008 crisis was based on Bernanke’s understanding of how the Depression affected the global economy. And although the Fed’s intervention did largely help the situation at hand in 2008, after the worst of the recession had passed, the Fed failed to normalize policy rates and economic recovery was severely delayed.
Essentially, the 2008 crisis playbook was built for facing threats to the quantity of economic growth. It cannot be the answer for facing a shock stemming from deficiencies in the quality of that growth. Monetary and fiscal policies can temper short-term distress in financial markets and hard-hit businesses and communities, but they don’t address the urgent priority of disease containment and mitigation that is required in 2020. And if there’s anything to know about crises, financial or not, it’s that they are best arrested by attacking the origin, and it’s no different now. The origin of the 2008 crisis were the banks, but today it’s a virus, and the Federal Reserve must take note of that.
If I’ve learned anything from spending my childhood immersed in the high-profile events and notorious stories of Wall Street, and from spending the last eight months of my life watching a historic global pandemic unfold, it’s that 1929 was never 2008, and 2008 is most definitely not 2020. The Federal Reserve has to stop modeling solutions for the present solely based on what worked in the past. No longer can we afford to implement regulations for the present without considering the future. These “playbooks” of the past should not be considered foolproof answers, but as lessons learned.