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EMBARGOED UNTIL WEDNEDSAY, JUNE 27, 2018 AT 12:30 P.M.; OR UPON DELIVERY Ethics and Economics: Making Cyclical Downturns Less Severe Eric S. Rosengren President & CEO Federal Reserve Bank of Boston June 27, 2018 Fourth Annual O. John Olcay Lecture on Ethics and Economics at the Peterson Institute for International Economics Washington, D.C. bostonfed.org John Olcay and Ethics and Economics ▶ John Olcay was an astute student of financial markets ▶ I had the pleasure of getting to know John through periodic trips he made to Boston during the financial crisis ▶ He was concerned about the implications of serious economic downturns – my topic today ▶ Ethics is not a prevalent part of the curriculum of economics 2 More Attention to Distributional Implications of Policy ▶ My view – negative outcomes in the economy, and subsequently their costs, are distributed disproportionately, which has ethical dimensions ▶ Policymakers can make policy choices that mitigate the impact of economic downturns – which would help those who can least afford the costs ▶ Today will focus on state and local government spending, bank regulatory policy, and monetary policy – though there are many other examples 3 Figure 1: Inflation Rate: Change in Core Personal Consumption Expenditures (PCE) Price Index 1960:Q1 - 2018:Q1 12 Percent Change from Year Earlier 8 4 0 1960:Q1 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Note: Core PCE excludes food and energy. Source: BEA, NBER, Haver Analytics 4 Figure 2: Unemployment Rate 1960:Q1 - 2018:Q1 12 Percent 10 8 6 4 2 1960:Q1 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Source: BLS, NBER, Haver Analytics 5 What are the Consequences of Not Mitigating Downturns? ▶ Parts of our population are disproportionately hurt in economic downturns ▶ Those with less education are more likely to experience unemployment ▶ Dependents of the unemployed are severely impacted 6 Figure 3: Unemployment Rate by Race and Ethnicity 1972:Q1 - 2018:Q1 25 Percent Black or African American Hispanic or Latino Ethnicity 20 Overall 15 10 5 0 1972:Q1 1982:Q1 1992:Q1 2002:Q1 2012:Q1 Recession Note: Based on labor force age 16 and older. Persons whose ethnicity is identified as Hispanic or Latino may be of any race. Source: BLS, NBER, Haver Analytics 7 Figure 4: Unemployment Rate by Educational Attainment 1992:Q1 - 2018:Q1 20 Percent Less than High School Diploma High School Diploma, No College Some College or Associate's Degree 15 Overall, Age 25 and Older Bachelor's Degree or Higher 10 5 0 1992:Q1 1997:Q1 2002:Q1 2007:Q1 2012:Q1 2017:Q1 Recession Note: Based on labor force age 25 and older. Source: BLS, NBER, Haver Analytics 8 Figure 5: Poverty Rate of Children Under Age 18 and the Unemployment Rate 1960 - 2016 Percent Percent 12 30 10 25 8 20 6 15 4 10 2 5 Unemployment Rate (Left Scale) Poverty Rate of Children (Right Scale) 0 0 1960 1970 1980 1990 2000 2010 Recession Note: The poverty rate is annual, the unemployment rate is quarterly. The most recent poverty rate is for 2016. Source: U.S. Census Bureau, BLS, NBER, Haver Analytics 9 State and Local Government Spending ▶ Current policies are procyclical – aggravate a downturn or add additional fuel to an already humming economy ▶ Balanced budget requirements result in government spending declines at times when spending is most needed ▶ Focus on federal fiscal policy but state and local government spending is large ▷ State and local government spending accounts for 11 percent of U.S. GDP ▷ Residential investment is 4 percent and federal government spending is 7 percent 10 Figure 6: Growth in Real State and Local Government Spending and the Unemployment Rate 1960:Q1 - 2018:Q1 12 Percent Change from Year Earlier Percent Unemployment Rate (Left Scale) State and Local Government Spending (Right Scale) 12 9 6 6 0 3 1960:Q1 -6 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Source: BEA, BLS, NBER, Haver Analytics 11 Figure 7: Changes in S&P State Credit Ratings June 1, 2013 - June 1, 2018 Number of States by Number of Changes Number of Number of Changes Changes States 1 Change Downgrades 24 14 7 4 9 8 7 1 Upgrades No Change 2 Changes 3 Changes 3 29 Note: While 29 states saw no change, one state saw both an upgrade and a subsequent downgrade. As a result, the states add to 51. In some instances an Issuer Credit Rating is used instead of a general obligation debt rating. Source: S&P Capital IQ 12 Structure of State and Local Government Spending ▶ Little focus on macroeconomic consequences ▶ Tax code can be highly cyclical ▶ Spending cut in economic downturns ▶ Small rainy day funds and lingering pension problems ▶ My view – now is the time, when the economy is robust, to make changes that will mitigate the next downturn ▶ While hard, given competing goals, states should reassess their revenue structure and fiscal approach with an eye on cyclical downturns 13 Bank Regulation ▶ Focus on safety and soundness – viability of financial institutions is important ▶ Structure currently encourages banks to shrink during economic downturns to maintain minimum capital-to-assets ratios ▶ A bank can choose to either raise capital or shrink assets to restore the ratio ▶ Raising capital is costly during economic downturns and generally opposed by existing shareholders ▶ Banks most often shrink assets (loans are key assets) which results in less lending at just the time the economy may need stimulus 14 Figure 8: Nonperforming Loans at U.S. Banks and the Unemployment Rate 1989:Q1 - 2018:Q1 12 Percent of Loan Balance Percent 6 Unemployment Rate (Left Scale) 10 Nonperforming Loans (Right Scale) 5 8 4 6 3 4 2 2 1 0 1989:Q1 0 1994:Q1 1999:Q1 2004:Q1 2009:Q1 2014:Q1 Recession Note: Nonperforming loans are loans 90 or more days past due plus loans in nonaccrual status. U.S. banks include commercial and savings banks throughout the period and the former OTS-regulated thrifts beginning in 2012. Source: Quarterly Bank Call Reports, BLS, NBER, Haver Analytics 15 Figure 9: Stylized Depiction of the Impact of the Countercyclical Capital Buffer (CCyB) Impact of a 3% Loss on Capital [with CCyB] Impact of a 3% Loss on Capital [without CCyB] Mgmt Excess Buffer (2.0%) Required Buffer 1 (2.5%) Required Buffer 2 (2.5%) Minimum Capital Requirement (4.5%) Pre-Loss Capital Position Losses (3.0%) Minimum Capital + Required Buffers Post-Loss Capital Position Mgmt Excess Buffer (2.0%) Losses (3.0%) CCyB (2.5%) Required Buffer 1 (2.5%) Required Buffer 2 (2.5%) Minimum Capital Requirement (4.5%) Pre-Loss Capital Position Minimum Capital + Required Buffers Post-Loss Capital Position Minimum Capital Requirement + Capital Conservation Buffer, Buffer for Systemically Important Financial Institutions, and CCyB Note: Required Buffer 1 is the Global Systemically Important Bank (GSIB) surcharge, which is the additional capital held by the largest, most systemically important banks. The 2.5 percent level is an average calculated using FR Y-15 data as of December 2017. Required Buffer 2 is the Capital Conservation Buffer, which is set at 2.5 percent and applies to all supervised financial institutions. The 2 percent Management Excess Buffer is computed as the median buffer for the largest, most systemically important banks in the U.S., as of March 2018. Source: Federal Reserve Bank of Boston 16 Bank Regulation Could Reduce Procyclicality ▶ Countercyclical Capital Buffer – a regulatory tool that can be used to build buffers in good times, when there are relatively rich asset valuations ▶ Countercyclical Capital Buffer currently used in many European countries and Hong Kong ▶ Would enable more flexibility in the next downturn to avoid pullback in lending 17 Figure 10: The Federal Funds Rate and the Unemployment Rate 1960:Q1 - 2018:Q1 12 Percent Percent 20 Unemployment Rate (Left Scale) Federal Funds Rate (Right Scale) 9 15 6 10 3 5 0 1960:Q1 0 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Source: Federal Reserve Board, BLS, NBER, Haver Analytics 18 Figure 11: Forecasts for the Longer-Run Federal Funds Rate from the Summary of Economic Projections January 2012 - June 2018 5 Percent 4 3 Central Tendency Median Federal Funds Target Rate 2 Jan-2012 Dec-2012 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Dec-2017 Date of Forecast Note: The central tendency excludes the three highest and three lowest observations. Source: FOMC, Summary of Economic Projections (SEP) 19 Avoid Hitting Zero with Short-Term Interest Rates ▶ Monetary policy cannot change productivity or demographics – so a federal funds rate of zero is a real possibility in future downturns ▶ Have tools, such as the balance sheet, but these alternative tools may be less effective and are certainly less well understood ▶ Proposals that provide more flexibility with the inflation target – possibly with more focus on an inflation range – lower the risk of short-term rates hitting zero in the future 20 Figure 12: The Unemployment Rate and the Natural Rate of Unemployment 1960:Q1 - 2018:Q1 12 Percent Above the Natural Rate Below the Natural Rate 10 Unemployment Rate Natural Rate of Unemployment 8 6 4 2 1960:Q1 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Note: The vertical lines mark the beginnings and ends of recessions. Source: BLS, CBO, NBER, Haver Analytics 21 Current Policy ▶ When the economy runs significantly above capacity, a recession normally ensues ▶ Correcting imbalances – higher wages and prices or higher asset prices – can be quite difficult ▶ Focus on getting a long recession-free period rather than pushing the economy too hard ▶ In my view, the policy path that will increase the probability of a longer recession-free period is the path where the economy does not run above capacity and thus fall far below the sustainable unemployment rate 22 Concluding Observations ▶ The costs of economic downturns – and the uneven distribution of their impact – are in fact ethical issues ▶ In my view, policy can significantly mitigate downturns ▶ More active discussion of possible alternative policies, such as I have highlighted for fiscal, supervisory, and monetary policymakers, are needed ▶ Take precautions during the good times for the inevitable future downturns ▶ Policymakers could continue and perhaps expand their efforts to make cyclical downturns less severe 23
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