Blood and Treasure by Kris James Mitchener and Joseph Mason - Article Example

Abstract Economists Kris James Mitchener and Joseph Mason attempt to conceptualize an “exit strategy” for policymakers in order to ensure long-term growth once an economic recovery is complete (Mitchener & Mason, 2010). Ultimately, the authors’ account of this historical economic problem is instructive and explains phenomena very clearly; however, it is not satisfying in terms of predictions and guiding contemporary policymakers through large-scale institutional decisions. The conclusion that policymakers can accurately time an exit strategy from their recovery policies is based on the assumption that banks and markets are decipherable from the perspective of a central planner. History demonstrates, after all, that the post-Great Depression government and Federal Reserve were wholly unsuccessful, and mostly unable, to time their exit strategy appropriately. Mitchener, K., & Mason, J. (2010). ‘Blood and treasure’: exiting the Great Depression and lessons for today. Oxford Review of Economic Policy, 26 , 510-539. The metaphor of blood and treasurer in Mitchener and Mason (2010) is an appropriate one in that it connects economics with society. The connection between the government and the economy has always been a controversial one, but at moments of crisis, it becomes apparent that the government feels responsible for aiding the economy by adopting economic policies. During the Great Depression, this took the form of minimizing inflation and lowering interest rates, which is very similar to monetary policy in reaction to the current financial crisis. Both of these strategies intend to achieve an optimal point between too much and too little, where too little makes it appear that the government is ineffective at solving economic problems (i.e. lost treasure) and where too much leads to unemployment and losses in output (i.e. lost blood) (Mitchener & Mason, 2010, p. 512). In this article, the authors attempt to provide an account of not only providing emergency assistance for an economy from the perspective of policymakers, but also providing a framework for transitioning away from the policies that could harm long-term recovery. Ultimately, this account is useful, but it is not useful in building predictions. In their introduction, Mitchener and Mason (2010) introduce a concept more frequently heard in foreign policy than in economic studies: that of “exit strategy”. In this context, the term is meant to refer to the shift back to economic conditions like steady-state growth, which encompasses stability in inflation and government intervention in the economy. The purpose of the article, after introducing this concept, is to examine where the United States stands relative to the exit strategy from the banking crises of the 1930s and to see if any lessons may be learned from the historical precedent for the current financial crisis. The authors seek to accomplish this by looking at monetary policy, bank policy, and historical data regarding the economic recovery from the Great Depression. After this analysis, the authors propose a method of formulating exit strategies for contemporary policymakers. The first step in this process of clarifying exit strategies is contained in Section II, in which the authors distinguish typical recessions from recessions that include financial crises. Understanding the difference here, according to the authors, is instrumental to defining the context of an exit strategy. Recessions accompanied by a financial crisis tend to be systemically more difficult to explain and protect against. In the case of “garden-variety recessions,” monetary policy exit relies on short-term policy to satisfy long-term goals. In contrast, financial crises tend to place the central bank as the lender of last resort, which is a sign of emergency; in addition, this emergency situation involves overlap in monetary and fiscal policy, which is compromising to the Federal Reserve’s independence. Exit strategies built for the garden-variety, if implemented in response to a financial crisis, could prove disruptive in the long run. This leads the authors to connect their definitions to the Great Depression, in which it took the government and central bank nearly 20 years to exit fully. In that case, it seems likely that short-term strategies undermined long-term goals as well. In Section III, the authors point to evidence that the Federal Reserve was responsible, in part, for the worsening of the recession into a depression throughout the 1930s. This was primarily due to inaction in not acting as a lender of last resort and not acting to prevent bank failures. After these failures, the Federal Reserve stood divided between the leadership of its different regions, particularly over the issue of whether to use monetary policy to aid the economy in recovery. According to the authors, the Fed soon took a back seat in their monetary policy to the Congress and the Roosevelt administration, which is an important point in methodology for those who study economic history. The authors propose here that the government, not the Federal Reserve, largely drove the exit from the Great Depression’s economic conditions, which is a point we will return to later. Section IV is a historical review of bank and credit policies following both the current crisis and the Great Depression, which the authors believe is important to understand for exit strategies. In their evaluation, they include the National Credit Corporation, which “failed to provide broad enough assistance to stimulate a national recovery” (Mitchener & Mason, 2010, p. 518). They include Fed loans and the Reconstruction Finance Corporation (RFC), which was highly restrictive and conservative in lending practice, which limited its effectiveness. The authors look at bank holidays and licensing programs in the Roosevelt administration, and the Emergency Banking Act of 1933. These measures were minimally effective because they left thousands of banks either under investigation by the Federal government or closed altogether. The authors also address the Glass-Steagal Act of 1933 that approved Federal Deposit Insurance to ensure national confidence in the banking system. Lastly, the authors take up the issue of RFC assistance to firms, such as railroads and industry, which were aimed at providing business credit sufficient to combat the debt-deflation spiral. However, as the government and RFC discovered, demand for assistance was low due to stagnant consumption; indeed, lending would not return until wartime production necessitated funding. Section V looks at how these factors culminated in efforts to exit that failed until after World War II. The Federal Reserve’s role as the lender of last resort and a tool of treasury policy is maintained until the early 1950s when an agreement is made to keep the Fed independent of government policy. This ensured that the Fed could make policy independently from Treasury borrowing costs; not doing so may have led to other financial crises like those seen in developing countries in the late-20th century or in Japan in the 2000s. The decoupling of the Treasury and the Federal Reserve represents, for the author, the unwinding of the expansionary policies and the recovery effort from the Great Depression. Section VI is an attempt to apply these historical lessons to the abstract case of successfully exiting from a financial crisis. This breaks down to providing resources for growth, reallocating financial industry assets, and resolving failed institutions in order to provide emergency support to the economy (Mitchener & Mason, 2010, p. 527). Providing resources for growth involves not creating questionable accounting measures, like those that resulted from the bank holiday in the Great Depression. This also includes lowering interest rates to encourage borrowing and promoting investment by creating credit (such as the TARP program and automobile bailouts). However, the authors do acknowledge that this tends to promote favoritism, which can potentially harm long-term recovery. Reallocating financial assets involves aligning credit supply with demand and avoiding asymmetries that cause disequilibrium. Also involved in reallocation is providing bank capital, but providing bank capital that meets the criterion of need. A huge volume of excess reserves (such as 20 times excess) poses the threat of inflation once reserves come back into the system. This threat of inflation once a natural recovery begins to take place is a threat to a long-term recovery from a financial crisis and an exit strategy. The third step, resolving failed institutions, involves quarantining toxic assets that cause “asymmetric information”, which is a discrepancy in the knowledge of a buyer and a seller. Without good information about financial conditions, depositors and investors do not put their capital into alternative investments, which can prolong the business cycle and prevent a timely recovery. The authors also draw a connection between the Deposit Liquidation Board of 1933 and the ‘too big to fail’ policy of the recent crisis. In both of those situations, it was necessary to rethink bankruptcy and resolution conditions for the particular economic conditions underlying the crisis. It seems that the more improvements that are made to resolution technologies, the easier it can be to recover from a crisis in the general case. Section VII ends the paper with a few themes and conclusions. The most important of these conclusions is the thought that policies growing credit, subsidizing earnings, and raising investment are difficult to exit from. Politicians benefit from distributing these economic goods, which makes these policies difficult to remove. In addition, the Federal Reserve is systemically open to political influence, which poses the long-term risk of having effective crisis management in some future crisis. The overall theme in these findings is that recessions prompt policymakers to adopt policies that, under normal circumstances, are (or were) carried out by markets. However, in times of steady-state growth, as the authors describe the norm, it is unlikely that policymakers will revert to the previous arrangements. By the author’s analysis, prompt intervention in the economy probably prevented a deeper financial crisis in the present era, but this did not allow the market to resolve asymmetric information and may have prolonged the crisis. In addition, it is unclear when it will be optimal for the Federal Reserve and the Federal government to exit from the present crisis, given the “troubling lack of knowledge regarding bank behavior then and now” (Mitchener & Mason, 2010, p. 536). The positives of this research outweigh the negatives with respect to its treatment of history as a tool for understand the present crisis and financial crises in general. To economists, the present crisis came as a shock to a period of low inflation, smooth growth, and low unemployment. However, a look at the Great Depression shows that it is not an entirely unexpected phenomenon to follow such periods with a rapid decline. And like the recovery after 1933, stark changes in monetary and bank policy were needed (including changes to the gold standard, demand growth, re-capitalization and reregulation of banks, etc.). Mitchener and Mason (2010) is a useful study because it illustrates the historical precedent of extraordinary banking practices that the world bore witness to in the days following economic collapse. Although the research contained in Mitchener and Mason (2010) is novel and important, there are systematic problems with what the research actually means for forming policy. At the beginning of the paper, the authors set out to help policymakers conceptually understand exits. However, in the conclusion of their paper, they seem to undermine the practical usefulness of the concept of an exit by admitting that expansionary government programs must be carried out through the long-term in order to allow businesses to make investments based on current economic conditions. Rapid changes in economic and monetary policy could jeopardize private investments and thus prolong a financial crisis. In addition, the authors admit to “a troubling lack of knowledge regarding bank behavior then and now” (Mitchener & Mason, 2010, p. 536). What this implies about the above analysis is that it is limited by its ability to account for and forecast the future. If this is the case, that bank behavior is indecipherable, then that raises the question of whether the concept of an “exit strategy” is actually valuable or not. Perhaps the authors assume that policymakers better understand bank behavior and are therefore more able to wind down expansionary policies more effectively. Mitchener and Mason (2010) is a reconstruction of the Great Depression recovery that seeks to firmly root the concept of an “exit strategy” in the only laboratory of economics: history. Ultimately, this account succeeds in that it is a detailed, informative history of how and when expansionary policies were wound down following the Great Depression. Just as it was extremely difficult or impossible to develop models to forecast an economic event back then, it is the same today. Therefore, the practical consequences of showing this research to a policymaker are likely limited. On a more optimistic note, this paper does suggest further room for research on this topic, including whether policymakers prolonged or worsened the recession by acting; nevertheless, this is again descriptive research, not predictive. Works Cited Mitchener, K., & Mason, J. (2010). ‘Blood and treasure’: exiting the Great Depression and lessons for today. Oxford Review of Economic Policy, 26 , 510-539. Read More