How The Great Recession Was Brought to an End

Overview

The U.S. government's response to the financial crisis included aggressive fiscal and monetary policies.
These policies remain controversial but were crucial in averting what could have been Great Depression 2.0.
Without the government's response:
- GDP in 2010 would be about $11.5\%$ lower.
- Payroll employment would be less by approximately $8\frac{1}{2}$ million jobs.
- The nation would be experiencing deflation.
Financial-market policies (TARP, bank stress tests, quantitative easing) were more powerful than fiscal stimulus.
Fiscal stimulus raised 2010 real GDP by about $3.4\%$ , held the unemployment rate about $1\frac{1}{2}$ percentage points lower, and added almost 2.7 million jobs.

Progress Since 2009

The U.S. economy has made progress since early 2009.
The financial system is operating more normally, real GDP is advancing, and job growth has resumed.
The Great Recession gave way to recovery due to responses by monetary and fiscal policymakers.
Aggressive policy responses were effective; without them, the financial system might still be unsettled, the economy might still be shrinking, and costs to U.S. taxpayers would have been vastly greater.

Government Goals and Actions

The government aimed to stabilize the financial system and mitigate the recession to restart economic growth.
The financial crisis caused liquidity evaporation, ballooning credit spreads, falling stock prices, and failures of major financial institutions.
The Federal Reserve:
- Established credit facilities to provide liquidity.
- Lowered interest rates to near zero.
- Engaged in quantitative easing by purchasing Treasury bonds and mortgage-backed securities (MBS).
The FDIC increased deposit insurance limits and guaranteed bank debt.
Congress established the Troubled Asset Relief Program (TARP) to inject capital into banks.
Stress tests for the largest bank holding companies were conducted to determine if they had sufficient capital.
Fiscal stimulus measures, including tax rebate checks and the American Recovery and Reinvestment Act (ARRA), were implemented.
Efforts were made to rescue the housing and auto industries.

Criticism and Defense of Government Response

The government’s response has been subjected to criticism.
The Federal Reserve has been accused of overstepping its mandate.
Critics have attacked efforts to stem the decline in house prices and claimed that foreclosure mitigation efforts were ineffective.
Criticism has been aimed at the TARP and the Recovery Act.
TARP has been a substantial success, helping to restore stability to the financial system and end the freefall in housing and auto markets.
Criticism of the ARRA has focused on the high price tag, the slow speed of delivery, and the fact that the unemployment rate rose much higher than predicted.
The size of the fiscal stimulus is consistent with the severe downturn and the limited ability to use monetary policy.
The pace of stimulus spending surged, ending the recession, and beginning recovery last summer.

Quantifying Economic Impact

Quantifying the economic impacts of the fiscal stimulus and the financial-market policies was done by simulating the Moody’s Analytics’ model of the U.S. economy under four scenarios:
1. a baseline that includes all the policies actually pursued
2. a counterfactual scenario with the fiscal stimulus but without the financial policies
3. a counterfactual with the financial policies but without fiscal stimulus
4. a scenario that excludes all the policy responses.

Results of Simulations

Under the baseline scenario, the economy is expected to recover, with real GDP expanding and job growth increasing.
In the scenario that excludes all extraordinary policies, the downturn continues into 2011, with real GDP falling and significant job losses; the unemployment rate peaks at $16.5\%$ .

Effects of Policies

The differences between the baseline scenario and the scenario with no policy responses are significant.
By 2011, real GDP is estimated to be substantially higher, there are almost 10 million more jobs, and the unemployment rate is about $6\frac{1}{2}$ percentage points lower because of the policies.
The financial policy responses were especially important.
In the scenario without financial policies, but including the fiscal stimulus, the recession winds down later, and there is a peak-to-trough decline of about 6%.
The financial-rescue policies are credited with saving almost 5 million jobs.
In the scenario that includes all the financial policies but none of the fiscal stimulus, the recession ends later, and unemployment peaks at nearly 12%.
Because of the fiscal stimulus, real GDP is higher, there are more jobs, and the unemployment rate is lower.
The combined effects of the financial and fiscal policies exceed the sum of the financial-policy effects and the fiscal-policy effects in isolation because the policies tend to reinforce each other.

Conclusions

The financial panic and Great Recession were massive blows to the U.S. economy.
The total budgetary cost of the crisis is projected to top $2.35$ trillion, about 16% of GDP.
Policymakers had to act; not responding would have left both the economy and the government’s fiscal situation in far graver condition.
The TARP has been instrumental in stabilizing the financial system and ending the recession.
The fiscal stimulus also fell short in some respects, but without it, the economy might still be in recession.
If the comprehensive policy responses saved the economy from another depression, they were well worth their cost.

Troubled Asset Relief Program (TARP)

TARP was established in response to the mounting financial panic.
The funds were used for direct equity infusions into financial institutions and for a variety of other purposes.
The Capital Purchase Program was the most effective part of the TARP.
The TARP has probably been least effective in easing the foreclosure crisis.
More than half the banks that received TARP funds have repaid them with interest and often with capital gains
Poor policymaking prior to the TARP helped turn a serious financial crisis into an out-of-control panic.
Congress established the TARP on October 3, 2008.

Capital Purchase Program

CPP has been the most successful part of the TARP.
Without capital injections from the federal government, the financial system might very well have collapsed.
CPP bought time necessary to allow efforts to work.

Toxic Assets

TARP has also been useful in mitigating systemic risks posed by toxic assets owned by financial institutions.
The Fed’s TALF program and Treasury’s PPIP program provided favorable financing to investors willing to purchase a wide range of toxic assets.
TALF was instrumental in the turnaround.
The government still owns nearly all of AIG, and although it has been selling its Citi shares, it continues to hold a sizable ownership stake.

Auto Bailout

TARP was instrumental in assuring the orderly bankruptcy of GM and Chrysler and supporting the entire industry.
TARP was necessary to fill this void.

Foreclosure Crisis

As of the end of June 2010, credit file data show an astounding 4.3 million first mortgages are in the foreclosure process or at least 90 days delinquent.
Policymakers are hoping the revised HAMP and other private mitigation efforts will work well enough to reduce foreclosures and short sales and thus prevent house price declines from undermining the broader economy.

Fiscal Stimulus

The fiscal stimulus was quite successful in helping to end the Great Recession and to accelerate the recovery.
There is a general perception that stimulus failed, this is mainly to the severity of the downturn.
Without the fiscal stimulus, the economy would arguably still be in recession, unemployment would be well into the double digits and rising, and the nation’s budget deficit would be even larger and still rising.
In total, the stimulus provided amounts to more than $1$ trillion, about 7% of GDP.
There is risk of deflation, therefore the Federal Reserve's job is further complicated .
Three rounds of tax credits for home purchasers were also instrumental in stemming the housing crash.

Methodological Considerations

The Moody’s Analytics model of the U.S. economy was used to quantify the economic impact of the various financial and fiscal stimulus policies implemented.
Economic activity is caused primarily by aggregate demand.

Aggregate Demand

Real consumer spending is a function of real household cash flow, housing wealth, and financial wealth.
It is in turn driven by capital gain realizations on home sales and home equity borrowing, both of which are determined by mortgage rates and the availability of mortgage credit
Fixed mortgage rates are modeled as a function of the 10-year Treasury yield, the refinancing share of mortgage originations, the foreclosure rate, and the value of Federal Reserve assets
All these policy efforts have significant impacts on residential investment, which is determined in the model by household formation, the inventory of vacant homes, the availability of credit to homebuilders, and the difference between house prices and the costs of construction
Exports determine real imports