February 25, 2019 at 5:00 am ET
It appears that the current economic expansion will become the longest in U.S. history, and the U.S. economy has rarely been in such an exceptional place. Gross domestic product growth will be well above 3 percent in 2018; unemployment is under 4 percent, and wage growth is (finally) exceeding inflation.
However, with the wild market swings rounding out the year, it pays to be cautious. Although most economists predict the United States will continue growing at a slower pace through 2020, a few are more worried. Given that the actual start of most recessions comes as a surprise, policymakers need to remain vigilant, especially since the global economy has several weak points that threaten continued growth.
Some of these threats date back to before the Great Recession of 2008-09, when regulators merely patched over several serious structural issues rather than exerting political capital to actually solve them, something I laid out in a paper recently published by The Harvard Law School Forum on Corporate Governance and Financial Regulation. These threats include a potential collapse of the Chinese debt bubble, the questionable long-term durability of the eurozone, an increasingly isolated international community and rising dollar-denominated debt in the developing world.
Unfortunately, policymakers’ ability to respond to a recession is significantly lower than in 2007. Low interest rates preclude the Federal Reserve from lowering rates as far or as fast as in 2008, and a sharply higher debt-GDP ratio will constrain fiscal policy. What’s more, the steady erosion of support for international institutions will make it much harder for governments to organize a collective response to another crisis.
As a result, it’s more important than ever that regulators do what they can to spot and prepare for weakness in the economy. It is worrisome that, a decade after the Great Recession, we are still adjudicating disputes over the distribution of liabilities between those who made reckless loans and the bond insurers that ended up paying the bill.
A good example is the ongoing legal battle between Bank of America and bond insurer Ambac. During the run-up to the 2008 crash, Countrywide Financial Corp., now owned by Bank of America, was openly defrauding investors about the quality of the loans they were securing, a point BoA conceded in a 2014 settlement with the Department of Justice. One of those defrauded investors was Ambac, which ended up paying investors an estimated $2 billion to cover securities backed by Countrywide and Bank of America mortgages.
The problem with such actions is that, until we adjudicate a clear allocation of the liabilities from the last crisis, investors cannot have a clear picture of the health of individual institutions or predict their potential liabilities in the housing finance market in a future crisis. This uncertainty dampens trust and calls into question the value of current warranties and insurance. While regulators cannot override parties’ rights, they can strongly encourage negotiations to settle claims and press for quick judicial attention when cases are litigated.
The government cannot prevent all future recessions, but it must strive to avoid deep, prolonged downturns such as those that occurred in 1907, 1929 and 2008. Rather than just delaying growth, these events result in sustained declines in income and seismic changes to society. They occur whenever a contraction leads to profound uncertainty and fear about the stability of financial institutions.
The response to the 2008 financial crisis was inadequate for several reasons. Regulators lacked a full understanding of both the magnitude and breadth of the financial risks being created. They largely saw high asset prices as a sign of growing wealth and were reluctant to restrain the rise in borrowing that abetted them.
Institutions such as Countrywide Financial issued billions of dollars in securities backed by unwise and even fraudulent loans. Yet regulators had little idea of the nature of these loans or where they ended up in the economy.
When the regulatory response came, it was haphazard and failed to address the fundamental problem, which was a lack of transparency and liquidity. Investors eventually lost faith in the system and withdrew their funds.
Officials appeared more concerned with minimizing the cost of intervention than with building a believable wall against the worst case. This perspective reflected an inability to grasp that a full-fledged financial collapse was possible.
The follow-up response was also flawed. Financial reform significantly increased both the cost and complexity of regulation without fixing the underlying problem of excessive risk in the system. A bipartisan bill in the last Congress corrected some of these mistakes, but Rep. Maxine Waters (D-Calif.), who recently became the chair of the House Committee on Financial Services, has already announced hearings on the need for tougher regulation of the nation’s largest banks.
Many people have expressed worry over the amount and quality of corporate debt. There are also signs that housing lenders are responding to a slowing market and rising rates by reducing lending standards.
In this climate, regulators need to increase clarity within the financial system. To do this, they need to encourage a full write-down of all losses from the previous recession, and this cannot happen until the losses are assigned to the right party.
In the last decade, our mélange of regulators has strived to accomplish these goals; however, if they do not move quickly, another financial crisis may arrive while our regulatory apparatus is less than fully prepared.
Joe Kennedy is president of Kennedy Research LLC, and his past positions include senior economist of the Joint Economic Committee and chief economist of the Department of Commerce.
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