COVID-19 Update: Monetary and Fiscal Policy Responses: The Great Recession vs. the Coronavirus Pandemic

Supports:  Hubbard/O’Brien, Economics, Chapter 25 – Monetary Policy (Macro Chapter 15 and Essentials Chapter 17), and Chapter 26 – Fiscal Policy (Macro Chapter 16 and Essentials Chapter 18).

The Great Recession of 2007-2009 was the worst economic contraction in the United States since the Great Depression of the 1930s.  Accordingly, it brought a vigorous response from federal policymakers.  As of late March 2020, it was too soon to tell how severe the economic contraction from the coronavirus pandemic might be.  But policymakers had already responded with major initiatives.  In the following sections, we compare monetary and fiscal policies employed during the Great Recession and those employed at the beginning of the coronavirus pandemic.

A Brief History of U.S. Recessions

             Historically, most recessions in the United States have been caused by one of two often related factors: (1) A financial crisis or (2) Federal Reserve actions taken to reduce the inflation rate.  The two main exceptions are the recession of 1973-1975, which was primarily the result of a sharp increase in oil prices, and the recession of 2020, which was the result of the effects of the coronavirus pandemic and of the business closures ordered by state and local governments in an attempt to contain the pandemic.

            Prior to 1914, the United States lacked both a central bank that could act as a lender of last resort to keep bank runs from escalating into bank panics and a system of deposit insurance.  By cutting off many businesses from their main source of credit and cutting off both households and firms from their bank deposits, bank panics resulted in declines in production and employment. The failure of the Federal Reserve to effectively deal with the waves of bank panics from 1930 to 1933 at the beginning of the Great Depression led Congress in 1934 to establish the Federal Deposit Insurance Corporation (FDIC) to insure deposits in commercial banks (currently up to $250,000 per depositor, per bank). The following table shows that prior to World War II (U.S. participation lasted from 1941 to 1945), most recessions were associated with bank panics.

 As a result of deposit insurance and more active Federal Reserve discount lending, after World War II problems in the commercial banking system were no longer a major source of instability in the U.S. economy.  As the following figure shows, declines in residential construction have preceded every recession in the United States since 1958 (the shaded areas represent periods of recession). Edward Leamer of the University of California, Los Angeles had gone so far as to argue that “housing is the business cycle.” Prior to the housing crash that preceded the Great Recession, the main cause of the declines in residential construction shown in the figure were rising mortgage interest rates, typically due to the Federal Reserve raising its target for the federal funds rate—the interest rate that banks charge each other on overnight loans—in response to increases in the inflation rate.

           

Monetary Policy during the Great Recession

Both the Great Recession of 2007-2009 and pre-World War II recessions were accompanied by financial panics.  Both the Great Recession of 2007-2009 and post-World War II recessions were accompanied by sharp downturns in the housing market.

But the Great Recession differed from earlier recessions two key ways:  First, it was caused by problems internal to the housing market rather than the effect on the housing market of contractionary monetary policy; and second, it did not involve commercial banks.  Instead, it involved the shadow banking sector of investment banks, money market mutual funds, and insurance companies. 

            Problems began in the market for mortgage-backed securities—bonds that consisted of mortgages bundled together. The value of the bonds depended on the value of the underlying mortgages. When housing prices began to decline in 2006, borrowers began defaulting on mortgages.  Many commercial and investment banks owned these mortgage-backed securities, so the decline in the value of the securities caused these banks to suffer heavy losses. By mid-2007, investors and policymakers became concerned about the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks. Many investors refused to buy mortgage-backed securities, and some investors would buy only bonds issued by the U.S. Treasury.

            The problems in financial markets resulting from the bursting of the housing bubble were severe, particularly after the failure of the Lehman Brothers investment bank in September 2008.  In previous recessions, the focus of the Fed’s expansionary policy had been on cutting its target for the federal funds rate to reduce borrowing costs and spur spending, particularly spending on residential construction.  The Fed did rapidly cut its target for the federal funds rate from 5.25 percent in September 2007 to effectively 0 percent in December 2008. But the financial crisis reduced the effect of these rate cuts because the flow of funds through the financial system had largely dried up.  As a result, the Fed entered into an unusual partnership with the U.S. Treasury Department and intervened in financial markets in unprecedented ways, which we summarize in the following table. In addition to the actions shown in the table, for the first time since the 1930s, the Fed bought commercial paper—short-term bonds issued by corporations—because many firms found their usual sources of funds were no longer available in the crisis. The Fed’s aim was to restore the flow of funds through the financial system to enable firms to obtain the credit they needed to maintain production and employment.

           

Fiscal Policy during the Great Recession

Presidents George W. Bush and Barack Obama both initiated fiscal policy responses to the Great Recession. In 2008, President Bush and Congress enacted a tax cut that took the form of rebates of taxes had already paid. After taking office in January 2009, President Obama and Congress enacted the $840 billion American Recovery and Reinvestment Act (AARA), often called the “stimulus package.”  The following figure summarizes the spending and tax cuts in the ARRA.

During the Great Recession, the Fed’s monetary policy moved well beyond its usual focus on targeting the federal funds rate. But fiscal policy was more conventional: Increasing government spending and cutting taxes to increase aggregate demand, real GDP, and employment. The ARRA was notable mainly because of its size.

Monetary Policy in Response to the Coronavirus Epidemic

            During 2019, prior to the epidemic beginning to affect the United States, the Fed had twice cut its target for the federal funds rate in response to a slowing rate of economic growth.  With the spread of the coronavirus at the start of 2020, the Fed again cut its target twice, returning it effectively to 0 percent in mid-March.  With many businesses closed and many consumers largely confined to their homes, the Fed knew that lower borrowing costs would not be the key to maintaining economic activity.  Accordingly, the Fed revived some of the lending facilities that it had used during the 2007-2009 financial crisis and set up some new facilities with the goal of maintaining the flow of funds through the financial system and the ability of firms whose revenues had plunged to continue to access credit.

            Here is a summary of Fed’s policy actions during March and early April 2020:

  • Cuts to the Federal Funds Rate  The Fed reduced its target for the federal funds rate from a range of 1.75 percent to 1.50 percent to a range of 0 percent to 0.25 percent.
  • Purchases of Mortgage-Backed Securities  To provide funds to the market for mortgage lending, the Fed began purchasing mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, which are government-sponsored enterprises (GSEs).
  • Central Bank Liquidity Swap Lines  To meet a surge in demand by foreign businesses and governments for U.S. dollars, the Fed expanded its Central Bank Liquidity Swap Lines, which allow foreign central banks to exchange their currencies for dollars.
  • Facility for Foreign and International Monetary Authorities  To further help foreign central banks meet the demand for U.S. dollars by foreign businesses and governments, the Fed established the Foreign and International Monetary Authorities repurchase agreement facility, which allowed these authorities to “temporarily exchange their U.S. Treasury securities held with the Federal Reserve for U.S. dollars, which can then be made available to institutions in their jurisdictions.” This new facility reduced the need for foreign central banks to sell U.S. Treasury securities to obtain U.S. dollars. Those sales had been contributing to volatility in the market for U.S. Treasury securities.
  • Primary Dealer Credit Facility  To ensure the liquidity of the 24 primary dealers, which are the large financial firms who interact with the Fed in securities markets, the Fed established the Primary Dealer Credit Facility to provide loans to these dealers.
  • Commercial Paper Funding Facility  To ensure that corporations would have access to short-term funds necessary to meet payrolls and pay their suppliers, the Fed established the Commercial Paper Funding Facility to buy commercial paper from corporations.
  • Primary Market Corporate Credit Facility  To ensure that corporations have access to longer-term funds, the Fed established the Primary Market Corporate Credit Facility to make loans to corporations whose bonds are rated investment grade by Moody’s, S&P, and Fitch, the private bond rating agencies.
  • Secondary Market Corporate Credit Facility  To ensure the smooth functioning of the corporate bond market, the Fed established the Secondary Market Corporate Credit Facility to buy in the secondary market investment grade bonds issued by corporations and to buy shares in exchange-traded funds that are primarily invested in such bonds. First established in March, the facility was expanded in April to allow for the purchase of some non-investment grade corporate bonds and the purchase of shares in exchange-traded funds that are invested in such bonds.
  • Term Asset-Backed Securities Loan Facility (TALF) To support the flow of credit to consumers and businesses, the Fed began buying asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA).
  • Municipal Liquidity Facility To support the ability of state, county, and city governments to borrow, the Fed began buying short-term state and local bonds.
  • Main Street New Loan Facility (MSNLF) and Main Street Expanded Loan Facility (MSELF) To ensure that small and medium size businesses had the financial resources to survive the crisis, the Fed offered 4-year loans to companies employing up to 10,000 workers or with revenues of less than $2.5 billion. Principal and interest payments were deferred for one year. The facility was intended to augment the Paycheck Protection Programs, which was part of the CARES act and involves loans administered through the federal government’s Small Business Administration to firms with 500 or fewer employees.

In taking these actions, the Fed relied on its authority under Section 13(3) of the Federal Reserve Act, which authorizes the Fed under “unusual and exigent circumstances” to lend broadly.  Following the 2007-2009 financial crisis, Congress amended the Federal Reserve Act to require that the Fed receive the prior approval for such actions from the Secretary of the Treasury. After consultation with Fed Chair Jerome Powell, Treasury Secretary Steven Munchin provided the required approval.  As in the 2007-2009 financial crisis, the Fed was again conducting monetary policy in collaboration with the U.S. Treasury, rather than operating independently, as it had prior to 2007.

It remains to be seen whether these extraordinary actions will be sufficient to keep funds flowing through the financial system and to provide sufficient credit to allow businesses whose revenues had plunged to remain solvent. 

Fiscal Policy in Response to the Coronavirus Epidemic

            During the week of March 15, 2020, more than 3 million workers applied for federal unemployment benefits—five times more than had ever previously applied during a single week.  Congress and President Donald Trump responded to the crisis by passing three aid packages by the end of March 2020, with the likelihood that further aid packages would be passed during the following weeks.

            Unlike with fiscal policy actions during previous recessions, including the ARRA passed during the Great Recession, the main goal of these aid packages was not to directly stimulate aggregate demand by increasing government spending and cutting taxes. With many businesses closed and people in some states being asked to “shelter in place” or stay home except for essential trips such as buying groceries, a stimulus package of the conventional type was unlikely to be effective. Congress and the president instead focused on (1) helping businesses to remain open after many had experienced enormous declines in revenue and (2) providing households with sufficient funds to pay their rent or mortgage, buy groceries, and cover other essential spending.

Here is a summary of Congress and the president’s first three fiscal policy actions:

  • Research Funding and Aid to State and Local Governments In early March, Congress and the president passed an $8.3 billion bill to provide funds for research into a vaccine for the coronavirus and for state and local governments to help cover some of their costs in fighting the virus.
  • Increases in Benefits and Tax Credits  In mid-March, Congress and the president passed a $100 billion bill aimed at increasing unemployment benefits, increasing benefits under the Supplemental Nutrition Assistance Program ( also called food stamps), and providing tax credits to firms offering paid sick leave to employees.
  • Coronavirus Aid, Relief and Economic Security (CARES) Act  On March 27, Congress and the president passed the Coronavirus Aid, Relief and Economic Security (CARES) Act, a more than $2 trillion aid package—by far the largest fiscal policy action in U.S. history—to provide:
    • Direct payments to households
    • Supplemental unemployment insurance payments
    • Funds to state governments to offset some of their costs in fighting in the epidemic
    • Loans and grants to businesses

The macroeconomic policy actions undertaken by the Fed, Congress, and the president in the spring of 2020 were unprecedented in size and scope. Whether they would be effective in keeping the coronavirus epidemic from causing a major recession in the United States remains to be seen.

Note: Some of the figures and tables reproduced here were first published in Hubbard and O’Brien, Economics, 6th and 8th editions or Hubbard and O’Brien, Money, Banking, and Financial Markets, 3rd edition.

Sources: Federal Reserve Bank of New York, “New York Fed Actions Related to COVID-19,” newyorkfed.org; Board of Governors of the Federal Reserve System, “Text of the Federal Reserve Act: Section 13. Powers of Federal Reserve Banks,” federalreserve.gov, February 13, 2017; Nick Timiraos, “Fed Cuts Rates to Near Zero and Will Relaunch Bond-Buying Program,” Wall Street Journal, March 26, 2020; Eric Morath, Jon Hilsenrath and Sarah Chaney, “Record Rise in Unemployment Claims Halts Historic Run of Job Growth,” Wall Street Journal, March 18, 2020; Emily Cochrane, “House Passes $8.3 Billion Emergency Coronavirus Response Bill,” New York Times, March 9, 2020; and John Harney, “Here’s What’s in the $2 Trillion Virus Stimulus Package,” bloomberg.com, March 25, 2020.

Questions 

1. There are both similarities and differences between monetary policies employed during the Great Recession of 2007-2009 and those employed at the beginning of the coronavirus pandemic in 2020.

(a) How has the Fed attempted to stimulate the economy during a typical recession? 

(b) Briefly discuss ways in which the Fed’s approach during the Great Recession and during the coronavirus pandemic was similar.

(c) Briefly discuss ways in which the Fed’s approach during the Great Recession and during the coronavirus pandemic differed.

2.  There are both similarities and differences between fiscal policies employed during the Great Recession of 2007 – 2009 and those employed at the beginning of the coronavirus pandemic of 2020.

(a) How have Congress and the president attempted to stimulate the economy during a typical recession?

(b) Briefly discuss ways in which Congress and the president’s approach during the Great Recession and during the coronavirus pandemic was similar to traditional expansionary policy.

(c) Briefly discuss how Congress and the president’s approach during the Great Recession and during the coronavirus pandemic differed from traditional expansionary policy.

Instructors can access the answers to these questions by emailing Pearson at christopher.dejohn@pearson.com and stating your name, affiliation, school email address, course number.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s