The US Crisis: Bailouts, Debt Overhang & Fiscal Drag

Yılmaz Akyüz

17/10/2013

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This is a second article analysing on how the US and Europe have mismanaged their economic policies, thus prolonging their crisis and that of the global economy. The 3rd article will deal with European policies.

The US intervention in the sub-prime crisis has taken two main forms. First, through its $700 billion Trouble Asset Relief Programme (TARP) of 2008-09, the Treasury injected capital into banks whose net worth was moving into red as a result of loss of asset values as well as some large corporations in the auto sector to prevent bankruptcy. Second, after cutting its policy rate sharply, the Fed started relying heavily on quantitative easing (QE) implemented in several rounds, buying US government bonds and mortgage-backed securities to boost their prices and lower long-term rates. It also used the so-called Operation Twist whereby the expiring short-term Treasury bills were replaced with long-term notes and securities. In December 2012 the Fed announced that it would keep buying $85 billion in Treasuries and asset-backed securities (QE3) until unemployment fell below 6.5 per cent or inflation rose above 2.5 per cent.

These interventions have no doubt helped contain the crisis. However, they have not just averted banks’ net worth moving into negative territory, but created ample profit opportunities for financial markets and institutions through, inter alia, arbitrage between the Fed and the Treasury. At the end of 2012, US banks had restored their pre-crisis level of profits, reaching the best position since 2006. The crisis has also resulted in an increased concentration in the US banking system. The so-called “too-big-to-fail” banks are now bigger than they were on the eve of the crisis; the assets of the top 5 banks now reach 55 per cent of GDP in the US, compared to 43 per cent 5 years earlier.

However, these interventions have done little to reduce the debt overhang, prevent foreclosures or increase lending. TARP did not require the banks to expand lending. The US Treasury also approved large bonuses for executives at banks that received bailouts. But it has not been willing to bring down household mortgages in line with their ability to pay by forcing the banks to write down debt and bondholders to take haircuts. The two voluntary schemes introduced to alleviate the debt burden of mortgage holders have had only little impact: the Home Affordable Modification Program to encourage the lenders to lower monthly mortgage payments of homeowners facing the risk of foreclosure; and Home Affordable Refinance Program designed to help homeowners with negative equity to refinance their mortgages.

It is true that household debt dropped from 100 per cent of GDP at the beginning of the crisis to less than 90 per cent at the end of 2012, but much of this improvement has been due to foreclosures and hence reflects a corresponding reduction in household wealth. Homes of many households are worth less than the principal balances on their mortgages. Many of those who continue to own and live in their homes acquired during the sub-prime bubble are still grappling with large debt and retrenching, and this is still an important impediment to strong growth in consumer demand.

All these have widened the income gap between the rich and the poor. From 2009 to 2011, average US real income per family grew by 1.7 per cent. But while the top 1 per cent incomes grew by 11.2 per cent the bottom 99 per cent incomes shrunk by 0.4 per cent. Moreover, “gains in household net worth have been concentrated among wealthier households, while many households in the middle or lower parts of the distribution have experienced declines in wealth since the crisis”. The households in the middle have now lower real incomes than they did in 1996. This is slowing the recovery by holding back aggregate spending since the middle class has a higher propensity to spend than the top 1 per cent and is the “true job creator”.

The US recovery is also hindered by fiscal orthodoxy. The initial fiscal response to consumer deleveraging and retrenchment through one-off transfers and tax cuts no doubt played an important role in restraining the downturn and initiating recovery. For instance the fiscal stimulus is estimated to have raised 2010 real GDP by as much as 3.4 per cent, held the unemployment rate about 1½ percentage points lower and added almost 2.7 million jobs to U.S. payrolls. However, as soon as the economy started to show signs of life, fiscal orthodoxy has returned. Government employment fell to 21.8 million in 2013 after reaching a peak of almost 23 million in May 2010. Cuts in public sector jobs and other government spending reduced GDP growth by 0.6-0.8 percentage points during 2011-12.

Thus, “discretionary fiscal policy hasn’t been much of a tailwind during this recovery. In the year following the end of the recession, discretionary fiscal policy at the federal, state, and local levels boosted growth at roughly the same pace as in past recoveries… But instead of contributing to growth thereafter, discretionary fiscal policy this time has actually acted to restrain the recovery.” Fiscal retrenchment has continued into 2013. The expiry of the payroll tax cut, increases in marginal tax rates and spending cuts through sequestration are estimated to result in a significant drag on GDP growth. Growth in the first half of the year has dropped below the 2 per cent average registered after 2009. Moreover, further tightening may be introduced when negotiations restart on the budget and public debt ceiling, slowing down an already slow recovery.

- Yılmaz Akyüz is the Chief Economist of the South Centre. Contact: akyuz@southcentre.int.

This is an extract from the South Centre's Research Paper No. 48, on Waving or Drowning: Developing Countries After the Financial Crisis. The full paper is available at www.southcentre.int.

- Source: SouthViews No. 80, 18 October 2013

South Centre: www.southcentre.int

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