January 28, 2009
After testifying yesterday at the House Budget Committee on the state of the economy and fiscal stimulus, this morning I testified before the Senate Budget Committee on another key aspect ofthe currenteconomic downturn--the ongoing crisis in thehousing and financial markets.
Policymakers have responded to the turmoil with a set of unprecedented actions. Thus far, a systemic collapse of the financial system has not occurred, and conditions have improved noticeably in some financial markets. Nevertheless, according to some analysts, U.S. banks and thrift institutions could be facing more than $450 billion in additional estimated losses on their assetson top of the approximately $500 billion that has already been recognized. The scale of those losses suggests that many financial institutions and markets will remain deeply troubled for some time, which will keep borrowing exceptionally costly for many borrowers and thereby dampen spending by households and businesses.
Challenging conditions seem likely to persist for some time in the housing and mortgage markets as well. Housing sales remain weak, and construction activity continues to decline. With the housing markets large glut of vacant properties, the prices of homes are likely to fall considerably further, pushing the value of more borrowers homes below the value of their outstanding mortgages. As more of those underwater borrowers experience losses of income during the current recession, rates of delinquency and foreclosure on residential mortgage loans are likely to rise further.
In short, turmoil in the financial markets is likely to continue for some time, even with vigorous policy actions (and especially without them). A crucial and challenging question for policymakers is, What further actions can be taken to normalize the financial and housing markets so as to spur economic activity?
There are many options, none of them are perfect, and an effective policy probably requires a multifacetedapproach that uses a range of tools to address the different aspects of financial distress. The costs to federal taxpayers of actions to reduce mortgage foreclosures and improve financial conditions are highly uncertain and may be large, but the economic consequences of doing nothing may be even greater.
My written testimony (link here) provides information on interventions implemented by the government to date and alternative strategies going forward.
To deal with the faltering financial system, analysts have proposed several, possibly complementary, strategies:
- One is to inject additional equity into institutions, perhaps by continuing the Capital Purchase Program under the TARP. This approach was widely supported by economists, often on the grounds that it would give the banking system the capacity to absorb losses and continue making loans without requiring the government to decide how much to pay for particular troubled assets. However, the extent of losses and the fog of uncertainty about which institutions have suffered the losses may mean that further broad-based equity injections are not the most cost-effective way to proceed now.
- Another strategy is to deal with the troubled assets directly.This could be accomplished by the government buying assets, guaranteeing assets, or subsidizing the separation of assets into so-called "good banks" and "bad banks." This approach could clarify the true condition of institutions' balance sheets by removing the difficult-to-value assets, and allow bank managers to focus their attention on new lending rather than old problems. However, this approach would require the government to set a price for the assets on guarantees.
- Yet another strategy is for the government to increase its own lending to households and businesses. This could include developing new programs or expanding existing ones such as the Fed's commitments to buy certain mortgage-backed securities and consumer-loan-backed securities. The basic idea is to provide public credit until the financial system is sufficiently healed to provide enough private credit.