Kohn comments: the former Federal Reserve vice chair, and potential next chairman, sat down with TIE editor David Smick to talk about the world.

• Author: Smick, David
• Position: EXIT INTERVIEW - Interview

Smick: Looking at the financial crisis from a global perspective, governments in their rescue operations during the last four years have spent $15 trillion, and central banks have expanded their balance sheets by around $5 trillion. Yet global growth recovered only modestly and is now starting to slow. Are monetary and fiscal tools no longer working?

Kohn: It's hard to say whether the tools aren't working as well as expected, or whether the problems they are trying to fix are extremely difficult. Globally, fiscal and monetary authorities are working against some very difficult headwinds. There was the buildup of debt--especially in U.S. households and European periphery countries--along with the compression of spreads and the rise and then collapse in asset prices.

And we didn't go into this with a huge amount of space in fiscal and monetary policy. Interest rates weren't that high in the United States--5.5 percent--when we started the slide into crisis in the summer of 2007, and we had dissipated our fiscal space with tax cuts in the early 2000s. Greater fiscal stimulus might have been appropriate, but already-rising debt levels when the problems began made it much harder to take more aggressive action.

Smick: Twenty years from now, will historians say that what happened in response to the financial crisis was an organized elite effort to preserve asset values that were simply not sustainable? The theory goes that this fool's errand has now saddled future generations with horrendous debt and a dangerous monetary overhang. Any validity to this charge?

Kohn: No, that wasn't the purpose of the response to the crisis. Rather it was to prevent a very bad situation from becoming worse--a downward self-reinforcing spiral taking hold, inflicting more damage than would be required by the needed correction in asset prices. In fiscal policy, it wouldn't make sense to jeopardize future generations with debt trying to preserve a particular level of asset prices. And some fiscal efforts, like the TARP funds applied to banks, were repaid with profits for the taxpayer. The monetary and liquidity policies of the Federal Reserve were classic panic-stopping liquidity provisions and attempts to limit the downward slide of the economy and promote expansion. To be sure, one channel through which monetary policy works is by bolstering asset prices, but I very much doubt that anyone at the Federal Reserve wants to restore the house prices of 2006.

So I don't think it was an effort to return to the bubble levels of asset prices, but rather to cushion the effects on employment and output of the decline in asset prices and the tightening of credit. A series of headwinds have hit the economy since then, including from Europe, which we certainly didn't anticipate going into its own crisis when we were fashioning policy back in 2008. In addition, fiscal policy has moved toward restraint as we have gotten past the immediate crisis response. In the U.S. economy, that fiscal restraint is occurring at the state and local government levels as well as with the federal government. Moreover, spending is being held back by a tremendous amount of uncertainty that revolves around U.S. fiscal and regulatory policy. How much is the health care act going to cost? What will that do to business incentives to expand? What will be the taxing and spending policies of the government next year? A huge amount of uncertainty seems to be weighing on business sentiment in particular, and businesses are sitting on piles of cash, waiting. We haven't done anything really to alleviate that uncertainty, especially in the area of U.S. fiscal reform, except kick the can down the road.

Smick: But around the world, private and public debt has now reached an incredible 350 percent of GDP. What does this mean for the future of the world economy?

Kohn: I agree, the debt overhang is a problem that will need to be worked off very gradually; a recovery of GDP to much closer to its potential would help, but servicing that debt when interest rates rise is going to be burdensome for debtors, even as it is net income for creditors.

But let me back up to your earlier question about policy effectiveness. We need to be careful about asserting that the aggressive actions haven't had any effect. One of the really hard things for government officials and economists to convince people of is the counterfactual. Compared to what? What would have happened if these actions hadn't been taken? In my view, monetary and fiscal stimulus helped, but it is hard to prove by how much.

Smick: Is the Fed in particular promising more than it can deliver? And in the end, will the U.S. central bank become the scapegoat, the political whipping boy for an electorate frustrated by unmet economic expectations?

Kohn: It's trying to avoid that. Chairman Bernanke has been very clear on many occasions that monetary policy is no panacea. Many fiscal problems have to be fixed for the economy to rebound. And the Federal Reserve's own projections don't seem to envision big effects. For example, the Federal Reserve's projections after the recent QE3 went up by a quarter of a point for next year. Projected growth might have gone down without QE3, but we're not talking about a large effect. So I hope they're not perceived as overpromising. They see themselves as just doing what they can to achieve the goals that Congress has given them.

Smick: But hasn't the Fed built up unwise expectations that QE3 is going to have a dramatic effect in reviving demand? The huge surge in demand failed to occur with QE1 and QE2. Why will QE3 be different?

Kohn: I'm not sure whether the expectation is that it will have a dramatic effect on the economy. I do think there's an expectation that they'll keep doing it until they can see faster economic improvement and they have fed that expectation by having open-ended commitments to purchase securities until the outlook for the labor market improves substantially, and to keep the fed funds rate at an extraordinarily low level even after the economic recovery strengthens.

Building those expectations in has been a deliberate strategy on their part, and it's interesting that Chairman Bernanke both in the press conference and in his recent speech talked about the effect on confidence. They're hoping households and businesses understand that the...