Roger E. A. Farmer is a Professor and Department Chair of the UCLA Department of Economics. He is a Research Associate for the National Bureau of Economic Research and the Centre for Economic Policy Research and the co-editor of the International Journal of Economic Theory. He is the author of Expectations, Employment and Prices which brings Keynesian economics into the 21st century by providing a new paradigm that explains how high unemployment could potentially persist forever without a little help from the government. He is also the author of How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies which is a jargon-free exploration of the current crisis, offering a powerful argument for how economics must change to get us out of it. In the interview below, which first appeared in UCLA Today, Meg Sullivan asks the author some probing questions.
UCLA economist Roger Farmer was in England at a conference on “The Great Moderation” — based on the premise that the economy had become much more stable since 1980 — when the bottom started to fall out of the market.
Mervyn King, the governor of the Bank of England was supposed to be the host of the event, but he never turned up, and Rachel Lomax, the bank’s deputy governor, disappeared many times throughout the evening. The next day Farmer, who has served as the chair of UCLA’s Department of Economics since July of 2009, learned that the Bank of England was negotiating with Northern Rock, the first financial institution to collapse in the current economic crisis.
In a new book, Farmer attempts to help investors make sense of the bewildering series of events that followed. Designed for the average reader, How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies serves partly as a lesson in the history of economics. Writer Meg Sullivan talked to Farmer about how society can avoid similar crises in the future.
Meg Sullivan: What caused the current recession?
Roger Farmer: Stock market wealth accounts for roughly three-fifths of all tangible wealth in the United States. The other two-fifths is in houses. In the fall of 2008, people lost confidence in the value of both those assets at the same time. They stopped spending, firms laid off workers and the drop in wealth was self-fulfilling.
SullivanL How is this crisis similar to the Great Depression?
Farmer: There have been 10 recessions since World War II, including the current one. In every previous recession, the Fed immediately cut interest rates to stimulate demand. But now the Federal Funds Rate — the interest rate on overnight loans — has fallen to zero. The Fed has run out of ammunition; it can’t lower the rate any further. The same thing happened in the 1930s.
Sullivan: Do you think the Fed was right to bail out the banks?
Farmer: Yes, I do. I understand that always bailing out banks provides incentives that encourage risky behavior but the consequences of not bailing them out would’ve been much worse.
Sullivan: What’s your opinion of Obama’s stimulus plan?
Farmer: Government as a whole responded to the crisis in two ways. One is the fiscal stimulus, which in my mind is just robbing Peter to pay Paul. The other is unconventional monetary policy or “quantitative easing.” The reason that mortgage rates are historically low right now is because the Fed has been putting money into the mortgage markets by buying the debt of Ginnie Mae and Freddie Mac. In my view, quantitative easing was more important than fiscal policy in preventing a deeper recession, and it has been largely responsible for the recovery of the stock market over the last year.
Sullivan: When will the economy rebound?
Farmer: I think the recession will be called over formally sometime in July, August or September of last year. But employment will not return to its 2007 level until 2012 or 2013. The stimulus plan did provide some short-term benefit. The patient is on medication, and we’ve seen some improvement. When we remove the medication, we’re risking a relapse.
Sullivan: What are the chances of a double-dip recession?
Farmer: The chances are 50-50. If inflation starts to pick up in our major trading partners such as China, there is a danger that it will be passed onto U.S. consumers. If inflation picks up in the U.S. when unemployment is at still at 8% or 9%, the Fed is going to face a difficult dilemma. There will be pressure to raise short-term rates to help prevent inflation. That will choke off the nascent recovery. But if the Fed does nothing, we could easily get back into a situation five years from now with high unemployment and high inflation together. The same thing happened in the 1970s. It can happen again.
Sullivan: What do you recommend for the modest investor?
Farmer: For anyone who is young, this thing is going to blow over long before you need the money. But for anyone close to retirement, I would be extremely dubious about having money in anything risky at all.
Sullivan: How can we prevent these kinds of crashes in the future?
Farmer: In the build-up to this crisis, I agreed with the people who said that the market was overvalued and should be dampened in some way. But I don’t agree with the method that they had for doing it, which was to raise the short-term interest rate.
The Fed should control fluctuations in the stock market by buying and selling blocks of shares; the best way would be to trade an index fund like the Russell 5000. They should do this independently of their control of the overnight interest rate by paying for stock purchases with newly created Federal Reserve debt. That provides a mechanism to insulate changes in the money supply from changes in share purchases.
Suppose the market index is trading at $100. In a depressed economy, $100 may be too low. So the Federal Reserve Open Market committee would announce, for example, that “four days from today we’re going to actively intervene in the market to raise the index to $120.” They’d be signaling an intention to go out and buy stocks to drive up the price to that point.
Buyers would think, “I could buy these shares today at $100; but four days from now they will sell for $120.” The announcement by itself would cause private buyers to bid the value up to $120 immediately in pursuit of profit. And that’s without any active trades on the part of the Fed. The idea is to stabilize swings in the market as a whole by trading an index fund without intervening on a micro level to set the price of individual companies.
Sullivan: But isn’t that a managed economy?
Farmer: Yes. But, we’ve never lived in a totally laissez-faire economy — and certainly not since the inception of the Fed in 1913. Since 1913, we’ve been actively intervening to maintain one price – the short-term interest. What I’m proposing isn’t that different from what already is going on now. It’s a simple extension of quantitative easing. I’m advocating that we actively intervene to maintain two prices, not one. An overnight interest rate and the price of a stock market index.
Sullivan: How vulnerable are we to another big financial crisis?
Farmer: People often talk about contagion in financial markets. When a small event occurs in one market, it causes a loss of confidence in other markets as people panic. They all jump out the window together. One situation to look out for is default on Greek debt. Although Greece is a small country, if it defaults, there’s a real concern that some other larger countries particularly Spain could follow. If that happens, it could easily feed into contagion and panic in U.S. markets. Confidence matters independently of fundamentals!
Roger Farmer: “Stock market wealth accounts for roughly three-fifths of all tangible wealth in the United States. The other two-fifths is in houses. In the fall of 2008, people lost confidence in the value of both those assets at the same time. They stopped spending, firms laid off workers and the drop in wealth was self-fulfilling.”
Sorry not to be able to agree with this. The additional wealth is in land values. The way that this grew and the bubble like collapse of land prices was also the cause of the economic crisis.
So that in fact the way our macroeconomics system ACTUALLY works is not quite as simple as Keynes and most of the others say. They should also have included the effect of land value speculation (which unlike capital investment in company stocks, does not fall when the average dividend rate goes down, in fact land value rise here). When this included,see the 18 year busness cycle really works as was first proposed by Henry George in 1879 “Progress and Poverty” which sold more than 3 million copies.
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@David Chester: I agree with you about the importance of land values. Both housing wealth (two fifths) and stock market wealth (three fifths) contains an important component that reflects land prices. In my book Expectations Employment and Prices I write down a formal model where the ONLY asset is non reproducible and can be thought of as land. I also agree completely that the economy is not quite as simple as the naive Keynesians believe.