“IF FIVE hundred millions of paper had been of such advantage, five hundred millions additional would be of still greater advantage.” So Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds, described the “quantitative easing” tactics of the French regent and his economic adviser, John Law, at the time of the Mississippi bubble in the early 18th century. The Mississippi scheme was a precursor of modern attempts to reflate the economy with unorthodox monetary policies. It is hard not to be struck by parallels with recent events.
Law was a brilliant mathematician who used his understanding of probability to help his gambling habit. Escaping from his native Scotland after killing a rival in a duel, he made friends with the Duke of Orleans, the regent of the young king Louis XV.
The finances of the French government were in a terrible mess. Louis XIV had spent much of his long reign fighting expensive wars. Tax collection was in the hands of various agents, who were more concerned with enriching themselves than the state. Not only was the monarchy struggling to pay the interest on its debt, there was also a credit crunch in the form of a shortage of the gold and silver coins needed to fund economic activity.
Law’s insight was that economic activity could be boosted by the use of paper money that was not backed by gold and silver. He was well ahead of his time.
Establishing confidence in a new monetary system was the trickiest part. Law had the benefit of working for an absolute monarchy which could decree that taxes should be paid in the form of notes issued by his new bank, Banque Générale. He also believed, having observed the success of the Dutch in exploiting the spice trade in the East Indies, that France could use paper money to develop its colonial possessions. Hence the Mississippi scheme, under which Law created the Compagnie d’Occident to exploit trade opportunities in what is now the United States. The money raised from these share issues was used to repay the government’s debts; on occasion, Law’s bank lent investors the money to buy shares.
Turn this into modern economic jargon and Law could be described as creating a stimulus package for French economic activity. But rather than rescuing sunset industries such as carmaking, Law was an early venture capitalist, financing the dynamic potential of the Mississippi delta.
The problem was that the delta was a mosquito-infested swamp. According to Niall Ferguson, a historian, 80% of the early colonists died from starvation or disease. Even though the company had monopolies over things like tobacco, it had little chance of generating enough income to fund the dividends Law had promised.
So a vicious circle was created, in which a growing money supply was needed to bolster the share price of the Mississippi company and a rising share price was needed to maintain confidence in the system of paper money. You can see parallels with recent times, in which money was lent on the back of rising asset prices, and higher prices gave banks the confidence to lend more money.
When the scheme faltered Law resorted to a number of rescue packages, many of which have their echoes 300 years later. One was for the bank to guarantee to buy shares in the Mississippi company at a set price (think of the various government asset-purchase schemes today). Then the company took over the bank (a rescue along the lines of Fannie Mae and Freddie Mac). Finally there were restrictions on the amount of gold and silver that could be owned (something America tried in the 1930s).
All these rules failed and the scheme collapsed. Law was exiled and died in poverty. The French state’s finances stayed weak, helping trigger the 1789 revolution. The idea of a “fiat” currency was perceived to be the essence of recklessness for another two centuries and the link between money and gold was not fully abandoned until the 1970s, when the Bretton Woods system expired.
Of course, the parallels with today are not exact. Law’s system took just four years to collapse; today’s fiat money regime has been running for nearly 40 years. The growth in money supply has been less excessive this time. Technological change and the entry of China into the world economy have generated growth rates beyond the dreams of 18th-century man. But one lesson from Law’s sorry tale endures: attempts to maintain asset prices above their fundamental value are eventually doomed to failure.
http://www.economist.com/businessfinance/displayStory.cfm?story_id=14215012
Showing posts with label economist. Show all posts
Showing posts with label economist. Show all posts
15 September 2009
There will be no recovery until debt tumour is excised
YOU have just come from your annual medical check-up, where your doctor assures you that you are in robust health.
Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look and declares: "You have a serious tumour. It must be removed or you will die."
You ignore him as you always have. One day later, a stabbing pain cripples you. You call your doctor, who initially refuses to send an ambulance because he knows you are well. Only when you lapse into a coma does he send one. Initially the doctor waits for you to revive spontaneously. But as your pulse starts to weaken, reluctantly he calls a retired doctor who has experience of a similar inexplicable malady in the distant past.
She prescribes massive doses of tranquillisers, painkillers, vitamins, and oxygen - all substances that had been removed from the medical panoply due to recent advances in medical theory.
After a year of expensive medical treatment, you return to health, and are released from intensive care. As you stride from the hospital, you bump into the practitioner of alternative medicine. "But they haven't removed the tumour," he declares.
One shouldn't have to spell out the details of such an analogy, but in times of widespread denial, it is necessary.
You are the economy; the tumour is a massive accumulation of private debt; your doctor is neoclassical economics; and the retired colleague is a so-called ''Keynesian'' economist (who doesn't know it - since her medical textbooks were poorly written - but she's actually following another economist called Paul Samuelson, not Keynes).
The alternative medicine practitioner follows Hyman Minsky's financial instability hypothesis (based on what Keynes actually did say - as well as the wisdom of Joseph Schumpeter and, in whispers, Karl Marx).
The collapse of Lehman Brothers is the moment you slip into a coma, and the day the doctor takes you off life support and declares all is well … is next month.
The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky's financial instability hypothesis has been ignored by conventional economists for reasons both ideological and delusional. A small band of "post-Keynesian" economists, of whom I am one, have kept this theory alive.
According to Minsky's theory, capitalist economies can and do periodically experience financial crises (something believers in the dominant neoclassical approach to economics vehemently denied until reality - in the form of the global financial crisis - slapped them in the face last year).
These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices. These bubbles must eventually burst, because they add nothing to the economy's productive capacity while simultaneously increasing the debt-servicing burden the economy faces.
When they burst, asset prices collapse but the debt remains. The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession.
If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash. But ultimately this process has to lead to a level of debt that is so great that another revival becomes impossible, since no one is willing to take on any more debt. Then a depression ensues.
That is where we were in 1987. The great tragedy of today is that naive neoclassical economists like Alan Greenspan and Ben Bernanke allowed this process to continue for another three or more cycles than would have occurred without their rescues.
Last year they did it again - only with methods they would have disparaged a mere year earlier (rational expectations macroeconomics, a modern neoclassical fad, preaches that government intervention cannot influence the level of economic activity at all - yet another belief that reality has recently crucified). This time, while the rescue has worked, the recovery they expect afterwards cannot happen - because there is almost no one left who will willingly take on any more debt.
This time, there is no re-leveraging way out. The tumour of debt has to be removed.
Steve Keen is associate professor of economics at the University of Western Sydney.
http://www.smh.com.au/business/there-will-be-no-recovery-until-debt-tumour-is-excised-20090914-fnug.html
Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look and declares: "You have a serious tumour. It must be removed or you will die."
You ignore him as you always have. One day later, a stabbing pain cripples you. You call your doctor, who initially refuses to send an ambulance because he knows you are well. Only when you lapse into a coma does he send one. Initially the doctor waits for you to revive spontaneously. But as your pulse starts to weaken, reluctantly he calls a retired doctor who has experience of a similar inexplicable malady in the distant past.
She prescribes massive doses of tranquillisers, painkillers, vitamins, and oxygen - all substances that had been removed from the medical panoply due to recent advances in medical theory.
After a year of expensive medical treatment, you return to health, and are released from intensive care. As you stride from the hospital, you bump into the practitioner of alternative medicine. "But they haven't removed the tumour," he declares.
One shouldn't have to spell out the details of such an analogy, but in times of widespread denial, it is necessary.
You are the economy; the tumour is a massive accumulation of private debt; your doctor is neoclassical economics; and the retired colleague is a so-called ''Keynesian'' economist (who doesn't know it - since her medical textbooks were poorly written - but she's actually following another economist called Paul Samuelson, not Keynes).
The alternative medicine practitioner follows Hyman Minsky's financial instability hypothesis (based on what Keynes actually did say - as well as the wisdom of Joseph Schumpeter and, in whispers, Karl Marx).
The collapse of Lehman Brothers is the moment you slip into a coma, and the day the doctor takes you off life support and declares all is well … is next month.
The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky's financial instability hypothesis has been ignored by conventional economists for reasons both ideological and delusional. A small band of "post-Keynesian" economists, of whom I am one, have kept this theory alive.
According to Minsky's theory, capitalist economies can and do periodically experience financial crises (something believers in the dominant neoclassical approach to economics vehemently denied until reality - in the form of the global financial crisis - slapped them in the face last year).
These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices. These bubbles must eventually burst, because they add nothing to the economy's productive capacity while simultaneously increasing the debt-servicing burden the economy faces.
When they burst, asset prices collapse but the debt remains. The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession.
If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash. But ultimately this process has to lead to a level of debt that is so great that another revival becomes impossible, since no one is willing to take on any more debt. Then a depression ensues.
That is where we were in 1987. The great tragedy of today is that naive neoclassical economists like Alan Greenspan and Ben Bernanke allowed this process to continue for another three or more cycles than would have occurred without their rescues.
Last year they did it again - only with methods they would have disparaged a mere year earlier (rational expectations macroeconomics, a modern neoclassical fad, preaches that government intervention cannot influence the level of economic activity at all - yet another belief that reality has recently crucified). This time, while the rescue has worked, the recovery they expect afterwards cannot happen - because there is almost no one left who will willingly take on any more debt.
This time, there is no re-leveraging way out. The tumour of debt has to be removed.
Steve Keen is associate professor of economics at the University of Western Sydney.
http://www.smh.com.au/business/there-will-be-no-recovery-until-debt-tumour-is-excised-20090914-fnug.html
4 May 2009
The End of Ponzi Prosperity ~ Satyajit Das
04.05.2009
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
Lessons of the Global Financial Crisis: 1. The End of Ponzi Prosperity
By: Satyajit Das
We Are All Keynesians Now!
In January 1971, Richard Nixon recanted years of opposition to budget deficits declaring: "Now, I am a Keynesian." Nixon had borrowed the line from Milton Friedman who had used it in 1965. Then, we embraced Monetarism and flirted with "supply side" economics, christened "voodoo economics" by President George Bush Senior. Now, in the wake of the Global Financial Crisis ("GFC"), it seems that we are all Keynesians again.
The GFC is really a "Minsky moment". In Stabilizing an Unstable Economy (1986), Hyman Minsky outlined a hypotheses that excessive risk taking, driven in part by stability lead to market breakdowns - stability is itself destablising.
The current crisis is financial, economic, social and increasingly ideological. Nikolas Sarkozy, President of France, has pronounced the death of laissez-faire capitalism: "c’est fini". World leaders have penned fevered attacks on neo-liberalism. Even religious leaders have spoken out.
Dead economists have been resurrected in support of political positions. As Keynes himself observed: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."
No "pure" economic model has been implemented in living memory, except perhaps in North Korea. The theories themselves rarely work. John Kenneth Galbraith is reported as saying: "Milton’s [Friedman’s] misfortune is that his policies have been tried."
Criticisms of the ancien regime are substantive and deserved. There have been undoubtedly egregious market failures, management excesses and errors in the lead up to the GFC. But the key lessons of the crisis may be subtler than first evident.
Growth has been driven by cheap and abundant debt and uncosted carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in (1978) The Shadow of Keynes provides a vivid description of this pre-occupation: "…faster economic growth is the pancea for all..economic and for all that matter political problems and that faster growth can be easily achieved by a combination of inflationary demand-managementpolocies and poltically appealing fiscal gimmickry."
Goldilocks Economy
P.J.O’Rourke writing in Eat The Rich (1998) observed that: "Economics is an entire scientific discipline of not knowing what you’re talking about."
Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.
The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.
Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.
Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.
Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.
Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.
Ponzi Prosperity
Growth, in reality, was founded on a series of elegant Ponzi schemes.
Consumption rather than investment drove growth, particularly in the developed world. Debt fuelled consumption became the norm. In the new economy, there were three kinds of people – "the haves", "the have-nots", and "the have-not-paid-for-what-they-haves".
The consumption was financed by borrowings supplied by a deregulated financial system. Many workers’ earnings fell in inflation adjusted terms as a result of global competition and associated outsourcing and off shoring practices. The ability to borrow against the appreciation in owner occupied houses and other financial assets underpinned consumption.
Investors, central banks with large reserves, pension funds and asset managers channeling privatised retirement savings, eagerly purchased the debt. Borrowing fueled higher asset prices allowing even greater levels of borrowing against the value of the asset. This virtuous cycle – a "positive feedback loop" – fueled the "doctor feel good" economy of recent years.
"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.
The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.
Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.
The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.
Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fuelled.
Moderate debt levels are sustainable provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the US housing market set the stage for the GFC.
Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the reality on which the fake pleasure of the Great Moderation and Goldilocks economy was smashed.
Taking the Cure
There is currently confusion between the disease and the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. The "cure" is the reduction of the level of debt that is now underway (the great "de-leveraging").
The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.
Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.
Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.
Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.
The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.
This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.
Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. The process echoes Joseph Schumpter’s famous maxim of "creative destruction".
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das "Built to Fail" in The Monthly (April 2009) 8-13
http://www.eurointelligence.com/article.581+M553774d2c37.0.html
23 April 2009
IMF chides US bailout strategy? Maybe.
BEING a donor rather than a creditor nation, America and its Treasury are under no obligation to follow IMF recommendations. Nonetheless, Derek Thompson reckons the IMF approves of the America's handling of the economic crisis so far. After all, the fund advocates tough provisions on firms taking government money and is sensitive to sticky political constraints. But, I thought I read some thinly veiled disapproval in the report on America's plan to remove toxic assets from bank balance sheets.
Among the methods being used so far, the United Kingdom has favored keeping the assets in the banks but providing guarantees that limit the impact of further losses. An alternative is to place the bad assets in a separate asset management company (AMC) (a so-called “bad bank”), an approach that Switzerland has adopted with UBS and that Ireland is also pursuing. This latter approach has the advantage of being relatively transparent and, if the bulk of the bank’s bad assets are transferred to the AMC, leaves the “good bank” with a clean balance sheet. The United States has provided a guarantee against a pool of assets that are either troubled or vulnerable to large losses in the case of Citibank and Bank of America, as well as proposing to establish private/public partnerships to purchase impaired assets from banks. The current proposal has elements to encourage private sector participation, but it is not clear yet whether banks will have enough incentive to actually sell their impaired assets. In general, different approaches can work depending on country circumstances.
That may not sound like fierce disapproval, but in policy speak it's pretty harsh.
http://www.economist.com/blogs/freeexchange/2009/04/what_does_the_imf_think_of_ppi.cfm
Among the methods being used so far, the United Kingdom has favored keeping the assets in the banks but providing guarantees that limit the impact of further losses. An alternative is to place the bad assets in a separate asset management company (AMC) (a so-called “bad bank”), an approach that Switzerland has adopted with UBS and that Ireland is also pursuing. This latter approach has the advantage of being relatively transparent and, if the bulk of the bank’s bad assets are transferred to the AMC, leaves the “good bank” with a clean balance sheet. The United States has provided a guarantee against a pool of assets that are either troubled or vulnerable to large losses in the case of Citibank and Bank of America, as well as proposing to establish private/public partnerships to purchase impaired assets from banks. The current proposal has elements to encourage private sector participation, but it is not clear yet whether banks will have enough incentive to actually sell their impaired assets. In general, different approaches can work depending on country circumstances.
That may not sound like fierce disapproval, but in policy speak it's pretty harsh.
http://www.economist.com/blogs/freeexchange/2009/04/what_does_the_imf_think_of_ppi.cfm
12 April 2009
Do economists know any more than us? ~ No damn way!
Do economists know any more than us?
Our credit is crunched and the recession's gone global, so can the world's greatest economists rescue us? Nick Fraser searches for salvation
I've been conducting an experiment. I've supplemented woeful headlines with a rich infusion of economics texts. Macro, micro, behavioural and neo-classical, I've tried them all. I've been to Adam Smith and Milton Friedman, but I've also scoured the work of lesser-known DWEES (Dead White European Economists). And I've tried financial gurus, too, like George Soros. Of course I reread Keynes.
But it hasn't been easy. The closed-off, deterministic ambience of economics still gets to me. So does the conspicuous absence of humans, except as producers or consumers. And the language (anyone for "quantitative easing"?) remains, with rare exceptions, dreadful. For all its apparent methodological sophistication, a lot of economics is best experienced as a pseudo-science, valuable often for what it doesn't purport to tell us – the odd flashes of illumination rather than the extrapolation of often misleading statistics.
Economists like to pad out their credentials with references to the area in which they claim expertise. So-called behavioural economics is voguish now, but I am not sure whether this means more than a rueful acknowledgment that "the dismal science" is cracking apart under the pressures we place on its practitioners. The message I've brought back from the economic front is that we must listen to economists, but they must change the way they speak to us. And it would be best if the change occurred immediately, before the world is further damaged.
There are 30,000 economists with PhDs, and this smallish tribe appears to be overwhelmingly male, with an inherited over-rational view of life. Many economists really do believe, mountains of evidence from Darwin or literature to the contrary, that we are a rational species. A survey conducted among the economics departments of MIT, Harvard and Stanford reveals that most young economists place overwhelming trust in mathematics. (A "broad knowledge of the economy" seemed important to only 3 per cent of respondents, whereas to 68 per cent it seemed unimportant.)
Is the practice of economics really that different from what we hacks do? Giles Keating, head of research at the Credit Suisse Private Bank, tells me that the models used by economists should be regarded as "partial representations" of reality. "One should guard against certainty," he says. "And one should also realise that no model ever applies 100 per cent."
Economists can seem dogmatic while ceaselessly changing their minds. No wonder that when they are depicted in popular culture, it is as uber-nerds, stuck in their own backrooms and requiring rescuers. A clue to how economists might change comes from Richard Layard, who has tried to reconfigure economics by marrying statistics to the utilitarian, pleasure-based philosophy of Jeremy Bentham. Layard thinks that social sciences can be made to deliver happiness. Criticising the number of economists who "don't do useful things," he tells me that each one should also be "a bit of something else."
Economics was, by and large, a 19th century invention rooted in a confident sense that information would aid progress, and early practitioners assembled data with the zeal of demented Casaubons. By the mid-20th century economists acquired the status of secular seers. They were supposed to supervise developed economies, raising up less developed ones. Although it was never clear whether what they did should be considered as a science or not, it was accepted that economists had a patent on the future. Ensconced in foundations, finance ministries, planning departments of corporations, ubiquitous on cable TV shows, Homo Economicus ruled. Who else would tell us how our complex societies were likely to develop? Who else was capable of predicting the future?
By the 1980s, it became fashionable for financial firms to acquire economists. Economists lent their skills to anticipating the performance of markets, at the price of becoming salesmen. The economist Robert Shiller, who did predict the slump, believes that many pre-slump practitioners in the vicinity suffered from "Groupthink" – a polite way of saying that they were so far in on the game and failed to notice anything was amiss. Dissenters from the prevailing optimism were abused as spoilsports bent on wrecking a good party. As Keating explains, people cease to listen when you write the same memo predicting catastrophe for the fifth time.
Although economists are not as unpopular as their banker patrons, they, too, have suffered from the backlash since the Crash. Among others, the Queen has wondered aloud why economists hadn't anticipated disaster. For Robert Skidelsky, author of the biography of John Maynard Keynes, economics consists for the most part of rehashed fads. "A few geniuses aside, economists frame their assumptions to suit existing states of affairs," he says. "They are intellectual butlers, serving the interests of those in power, not vigilant observers of shifting reality. Their systems trap them in orthodoxy."
I'm not sure that Skidelsky isn't exaggerating. Some of the most important writing in our time comes from the vicinity of economics – not, to be sure, from the now discredited school of so-called "classical" economists, but from outsiders on the periphery of the profession. There have been shrewd best-sellers like Freakonomics, or the recent Nudge (recommended by David Cameron) using economics methodology to render the kinks of human nature.
This year's cult book in New York is Lords of Finance, a gruesomely topical account of the blindness of central bankers during the 1930s slump by Liaquat Ahamed, formerly an economist at the World Bank.
Economists now come from diverse academic backgrounds, and some of them nowadays are women. Gillian Tett, shortly to publish a book on the Crash, says she learnt about economics amid the wreckage of the failed Soviet system, working in a Tajikistan village on a PhD in anthropology. She tells me that we should redefine Home Economics. Everyone should be sufficiently numerate to understand how credit card debt is accumulated, and how economies, national or international, do or don't function. The best economists are now touchingly ready to admit that they do not really know what is going to happen. When I approached Martin Wolf four months ago, I asked him how long it would be before we knew if the world financial system could recover fully, he paused. "I don't really know the answer to that question," he said. "It could be months, but it could be years, too." When I asked how we would know, he almost shrugged. "I'm not sure," he said. It would seem from recent columns that Wolf is uncertain about our prospects. "I am becoming ever more worried," he wrote recently.
My first encounter with economics took place in the 1970s when, as a young journalist, I was required to construct for the BBC a device illustrating the effects of inflation. The machine, which looked like something built by Wallace and Gromit, had glass tubes and valves and coloured liquids. When operated by an economist, it began to leak; and it was consigned to the props department without further ado. But I absorbed the work of Keynes on the Central Line between power cuts during the Three Days' Week. A Keynes revival is under way now, but the great man's memory has been wrongly evoked before.
Keynes was a speculator, patron of the arts, entrepreneur, promiscuous homosexual, unsuccessful philosopher and purveyor of the best cerebral one-liners. He ripped up the rule book of classical economists. Keynes saw that slumps didn't disappear of their own accord. If we wanted to, we should cause them to end. Keynes gadded about from one conference to another during the 1930s in a not entirely successful effort to persuade governments to take action, borrowing money to create jobs and pumping money into the economy.
This is the Keynes daily celebrated in the editorial pages of posh newspapers. But Keynes changed his mind a lot. In the 1930s, he was dealing with governments pathologically averse to debt but it's not clear that he would approve of today's gigantic debt levels in the US and Britain.
As his Russian ballerina wife said, Keynes was "more than economist". He believed that he was set on earth for the purpose of saving liberal civilisation from extinction. Keynes was the ultimate British sceptic, rudely, gloriously provocative. He began his career as a philosopher, later pondering the difference between risk and uncertainty. At best, economists could prepare us for uncertainty. "We do not know what the future will bring," he once told a group of bankers, "except that it will be different from any future we could predict."
Keynes would not have been surprised to see his ideas fall from fashion, as they did in the late 1970s. I once had the pleasure of eating a chicken salad sandwich for lunch with the free-market guru Milton Friedman, and he seemed to be one of the most happy people I have ever met. Friedman did truly believe that left to their devices, markets worked, and that governments should be encouraged to do as little as possible, and he chided me gently when I expressed my admiration for Keynes. ("Brits always love him", he said tolerantly. "I'm not sure why.")
The Friedman sunshine is to be found distilled in Alan Greenspan's memoir The Age of Turbulence. Greenspan advised four Presidents as Chairman of the Federal Reserve Bank, and he should be seen as the most influential figure in Planet Money of the past two decades. The Greenspan boom was based on cheap money and minimal regulation.
Last autumn Greenspan appeared before Congress, delivering an astonishing mea culpa. "The whole intellectual edifice collapsed in the summer of last year," Greenspan admitted. He meant that the neoclassical, mainstream economics practiced by him had failed, because of a "fundamental flaw". Markets weren't, as he had believed, self-correcting. They didn't always display rationality – because individuals didn't behave rationally. Greenspan was saying that at certain times, irrationality would rule. More important, he was suggesting that the guiding principle of rational selfishness he had espoused, and promoted for so long, was an illusion.
It's still hard to comprehend the levels of greed and stupidity that characterised the era which ended with last October's crash. The excess is best understood in relation to the ridiculous art bubble that accompanied Wall Street's Glory Years. One instrument invented in the past years of madness was the Collateralized Debt Obligation, in its latter stages of evolution made not from real debts, but from so-called synthetic materials. Rather than acquiring securities or bonds or other debt instruments in order to sell them, salesmen invented them – and then sold them.
The idea of fake debt or securities legitimately traded has allure, it's equivalents today "zombie bank" and "vulture fund", have rather less.
The worst thing about this slump is that one cannot imaginatively share the experience of financial misery. Unlike other events – wars, royal weddings, rock concerts – crashes induce nothing but fear experienced strictly in isolation. Rather than bringing people together, slumps keep them separate. It would appear that Maoists have reappeared in China, calling for the abolition of capitalism, but we are nonetheless lumbered with the system that failed us – a crucial difference from the 1930s, when millions, not just in the Soviet Union, believed that markets could be superseded.
Much has been shattered in the past months, most of all the illusion that a borderless world, having broken out of the cycles of boom and bust, would run on, held together by little more than the free exchange of goods. Not just New Labour, but the politics of the West are held together by what has proved to be a fiction. For the moment, too, the slump has also diminished the appeal of the notion that, left to itself, abetted by the astute manipulation of interest rates capitalism spreads wealth efficiently, if unevenly, pulling the poor out of their misery. Economists did their best to promote such ideas, but we are guilty of collusion. Did anyone really, outside the think tanks of the market fundamentalist right, buy into the neo-liberal world vision?
A vision of our future was wholly absent from many of the texts I read. But I did find a distinctive hell relevant to our present. Within the world of economists a cult surrounds the darkly pessimistic views of the Austrian-born economist Joseph Alois Schumpeter, who died in 1950. He is remembered for his definition of capitalism as "creative destruction".
Schumpeter bequeathed two important if controversial insights. The first was that capitalism couldn't function even half effectively without a succession of brutally successful entrepreneurs ready to overthrow the existing order. The second was that capitalism wasn't in the least moral, whatever Adam Smith had intimated. It was so unappealing that it was always likely to cause revolts on the part of those whom it had destroyed, ultimately ensuring its own destruction.
Schumpeter would have been fully at home in the present, pooh-poohing worries over millions of jobs lost each month. "I often wonder," he wrote in his diary, "whether there is anything that ever happened that could not be turned into a business opportunity."
Now that the momentary euphoria of the G20 summit is past, economists have returned to the dismal daily figures. Is there anyone who doesn't think that a prolonged slump will cause widespread political upheavals?
Fear and greed are the primary capitalist emotions, but for the slump befuddlement seems more appropriate. As I read about economics, I learnt to identify an expression on people's faces. One could see it not just in the job centres of Middle Britain or Ohio, but among those locked out of Guangzhou toy factories. It was present among the nouveaux pauvres of Palm Beach or Park Avenue defrauded by Bernie Madoff. Japanese Finance Ministers succumbed, so on occasions did Gordon Brown, and economists themselves.
And yet knowing a bit more does help, as I discovered. At least you begin to comprehend what cannot be known to any reliable degree. This is what Liaquat Ahamed told me. "Economics doesn't always tell you about what really happens. There are too many theorists, and practitioners concoct them to order. They are a bit like lawyers." For real understanding, Ahamed thinks we have to turn to history. The fascination of his account of the last slump lies in his insistence that so much suffering could have been avoided in the 1930s – if the powerful had been less blind, cleverer, more compassionate.
If not a magician, we'd like another Keynes, perhaps. However, in a lifetime of polemical activity, Keynes never uttered a word of false reassurance. Economics, he once said, could provide "the circumstances of civilisation". He meant that it was up to the rest of us to decide what we wanted. Economists could only help us achieve that goal. So we do need to tell economists how we want the world to be. And if economists are to fix our world, they need to know more about it.
Nick Fraser is editor of the BBC documentary series 'Storyville'
Ten books you must read to understand this crisis
NUDGE
Richard Thaler and Cass Sunstein
David Cameron's favorite guide to public policy making
THE TRILLION DOLLAR MELTDOWN
Charles R Morris
Shows how financiers failed
JOHN MAYNARD KEYNES
Robert Skidelsky
Britain's key economist
LORDS OF FINANCE
Liaquat Ahamed
How the last crash happened
HAPPINESS
Richard Layard
The relationship between economics and success
THE AGE OF TURBULENCE
Alan Greenspan
Fails to predict the crisis
PROPHET OF INNOVATION
Thomas K McCraw
Joseph Schumpeter's life
THE STORM,
Vince Cable
How we got into this mess
THE CREDIT CRISIS OF 2008
George Soros
THE ASCENT OF MONEY
Niall Ferguson
How money shaped society
http://www.independent.co.uk/news/business/analysis-and-features/do-economists-know-any-more-than-us-1667301.html
Our credit is crunched and the recession's gone global, so can the world's greatest economists rescue us? Nick Fraser searches for salvation
I've been conducting an experiment. I've supplemented woeful headlines with a rich infusion of economics texts. Macro, micro, behavioural and neo-classical, I've tried them all. I've been to Adam Smith and Milton Friedman, but I've also scoured the work of lesser-known DWEES (Dead White European Economists). And I've tried financial gurus, too, like George Soros. Of course I reread Keynes.
But it hasn't been easy. The closed-off, deterministic ambience of economics still gets to me. So does the conspicuous absence of humans, except as producers or consumers. And the language (anyone for "quantitative easing"?) remains, with rare exceptions, dreadful. For all its apparent methodological sophistication, a lot of economics is best experienced as a pseudo-science, valuable often for what it doesn't purport to tell us – the odd flashes of illumination rather than the extrapolation of often misleading statistics.
Economists like to pad out their credentials with references to the area in which they claim expertise. So-called behavioural economics is voguish now, but I am not sure whether this means more than a rueful acknowledgment that "the dismal science" is cracking apart under the pressures we place on its practitioners. The message I've brought back from the economic front is that we must listen to economists, but they must change the way they speak to us. And it would be best if the change occurred immediately, before the world is further damaged.
There are 30,000 economists with PhDs, and this smallish tribe appears to be overwhelmingly male, with an inherited over-rational view of life. Many economists really do believe, mountains of evidence from Darwin or literature to the contrary, that we are a rational species. A survey conducted among the economics departments of MIT, Harvard and Stanford reveals that most young economists place overwhelming trust in mathematics. (A "broad knowledge of the economy" seemed important to only 3 per cent of respondents, whereas to 68 per cent it seemed unimportant.)
Is the practice of economics really that different from what we hacks do? Giles Keating, head of research at the Credit Suisse Private Bank, tells me that the models used by economists should be regarded as "partial representations" of reality. "One should guard against certainty," he says. "And one should also realise that no model ever applies 100 per cent."
Economists can seem dogmatic while ceaselessly changing their minds. No wonder that when they are depicted in popular culture, it is as uber-nerds, stuck in their own backrooms and requiring rescuers. A clue to how economists might change comes from Richard Layard, who has tried to reconfigure economics by marrying statistics to the utilitarian, pleasure-based philosophy of Jeremy Bentham. Layard thinks that social sciences can be made to deliver happiness. Criticising the number of economists who "don't do useful things," he tells me that each one should also be "a bit of something else."
Economics was, by and large, a 19th century invention rooted in a confident sense that information would aid progress, and early practitioners assembled data with the zeal of demented Casaubons. By the mid-20th century economists acquired the status of secular seers. They were supposed to supervise developed economies, raising up less developed ones. Although it was never clear whether what they did should be considered as a science or not, it was accepted that economists had a patent on the future. Ensconced in foundations, finance ministries, planning departments of corporations, ubiquitous on cable TV shows, Homo Economicus ruled. Who else would tell us how our complex societies were likely to develop? Who else was capable of predicting the future?
By the 1980s, it became fashionable for financial firms to acquire economists. Economists lent their skills to anticipating the performance of markets, at the price of becoming salesmen. The economist Robert Shiller, who did predict the slump, believes that many pre-slump practitioners in the vicinity suffered from "Groupthink" – a polite way of saying that they were so far in on the game and failed to notice anything was amiss. Dissenters from the prevailing optimism were abused as spoilsports bent on wrecking a good party. As Keating explains, people cease to listen when you write the same memo predicting catastrophe for the fifth time.
Although economists are not as unpopular as their banker patrons, they, too, have suffered from the backlash since the Crash. Among others, the Queen has wondered aloud why economists hadn't anticipated disaster. For Robert Skidelsky, author of the biography of John Maynard Keynes, economics consists for the most part of rehashed fads. "A few geniuses aside, economists frame their assumptions to suit existing states of affairs," he says. "They are intellectual butlers, serving the interests of those in power, not vigilant observers of shifting reality. Their systems trap them in orthodoxy."
I'm not sure that Skidelsky isn't exaggerating. Some of the most important writing in our time comes from the vicinity of economics – not, to be sure, from the now discredited school of so-called "classical" economists, but from outsiders on the periphery of the profession. There have been shrewd best-sellers like Freakonomics, or the recent Nudge (recommended by David Cameron) using economics methodology to render the kinks of human nature.
This year's cult book in New York is Lords of Finance, a gruesomely topical account of the blindness of central bankers during the 1930s slump by Liaquat Ahamed, formerly an economist at the World Bank.
Economists now come from diverse academic backgrounds, and some of them nowadays are women. Gillian Tett, shortly to publish a book on the Crash, says she learnt about economics amid the wreckage of the failed Soviet system, working in a Tajikistan village on a PhD in anthropology. She tells me that we should redefine Home Economics. Everyone should be sufficiently numerate to understand how credit card debt is accumulated, and how economies, national or international, do or don't function. The best economists are now touchingly ready to admit that they do not really know what is going to happen. When I approached Martin Wolf four months ago, I asked him how long it would be before we knew if the world financial system could recover fully, he paused. "I don't really know the answer to that question," he said. "It could be months, but it could be years, too." When I asked how we would know, he almost shrugged. "I'm not sure," he said. It would seem from recent columns that Wolf is uncertain about our prospects. "I am becoming ever more worried," he wrote recently.
My first encounter with economics took place in the 1970s when, as a young journalist, I was required to construct for the BBC a device illustrating the effects of inflation. The machine, which looked like something built by Wallace and Gromit, had glass tubes and valves and coloured liquids. When operated by an economist, it began to leak; and it was consigned to the props department without further ado. But I absorbed the work of Keynes on the Central Line between power cuts during the Three Days' Week. A Keynes revival is under way now, but the great man's memory has been wrongly evoked before.
Keynes was a speculator, patron of the arts, entrepreneur, promiscuous homosexual, unsuccessful philosopher and purveyor of the best cerebral one-liners. He ripped up the rule book of classical economists. Keynes saw that slumps didn't disappear of their own accord. If we wanted to, we should cause them to end. Keynes gadded about from one conference to another during the 1930s in a not entirely successful effort to persuade governments to take action, borrowing money to create jobs and pumping money into the economy.
This is the Keynes daily celebrated in the editorial pages of posh newspapers. But Keynes changed his mind a lot. In the 1930s, he was dealing with governments pathologically averse to debt but it's not clear that he would approve of today's gigantic debt levels in the US and Britain.
As his Russian ballerina wife said, Keynes was "more than economist". He believed that he was set on earth for the purpose of saving liberal civilisation from extinction. Keynes was the ultimate British sceptic, rudely, gloriously provocative. He began his career as a philosopher, later pondering the difference between risk and uncertainty. At best, economists could prepare us for uncertainty. "We do not know what the future will bring," he once told a group of bankers, "except that it will be different from any future we could predict."
Keynes would not have been surprised to see his ideas fall from fashion, as they did in the late 1970s. I once had the pleasure of eating a chicken salad sandwich for lunch with the free-market guru Milton Friedman, and he seemed to be one of the most happy people I have ever met. Friedman did truly believe that left to their devices, markets worked, and that governments should be encouraged to do as little as possible, and he chided me gently when I expressed my admiration for Keynes. ("Brits always love him", he said tolerantly. "I'm not sure why.")
The Friedman sunshine is to be found distilled in Alan Greenspan's memoir The Age of Turbulence. Greenspan advised four Presidents as Chairman of the Federal Reserve Bank, and he should be seen as the most influential figure in Planet Money of the past two decades. The Greenspan boom was based on cheap money and minimal regulation.
Last autumn Greenspan appeared before Congress, delivering an astonishing mea culpa. "The whole intellectual edifice collapsed in the summer of last year," Greenspan admitted. He meant that the neoclassical, mainstream economics practiced by him had failed, because of a "fundamental flaw". Markets weren't, as he had believed, self-correcting. They didn't always display rationality – because individuals didn't behave rationally. Greenspan was saying that at certain times, irrationality would rule. More important, he was suggesting that the guiding principle of rational selfishness he had espoused, and promoted for so long, was an illusion.
It's still hard to comprehend the levels of greed and stupidity that characterised the era which ended with last October's crash. The excess is best understood in relation to the ridiculous art bubble that accompanied Wall Street's Glory Years. One instrument invented in the past years of madness was the Collateralized Debt Obligation, in its latter stages of evolution made not from real debts, but from so-called synthetic materials. Rather than acquiring securities or bonds or other debt instruments in order to sell them, salesmen invented them – and then sold them.
The idea of fake debt or securities legitimately traded has allure, it's equivalents today "zombie bank" and "vulture fund", have rather less.
The worst thing about this slump is that one cannot imaginatively share the experience of financial misery. Unlike other events – wars, royal weddings, rock concerts – crashes induce nothing but fear experienced strictly in isolation. Rather than bringing people together, slumps keep them separate. It would appear that Maoists have reappeared in China, calling for the abolition of capitalism, but we are nonetheless lumbered with the system that failed us – a crucial difference from the 1930s, when millions, not just in the Soviet Union, believed that markets could be superseded.
Much has been shattered in the past months, most of all the illusion that a borderless world, having broken out of the cycles of boom and bust, would run on, held together by little more than the free exchange of goods. Not just New Labour, but the politics of the West are held together by what has proved to be a fiction. For the moment, too, the slump has also diminished the appeal of the notion that, left to itself, abetted by the astute manipulation of interest rates capitalism spreads wealth efficiently, if unevenly, pulling the poor out of their misery. Economists did their best to promote such ideas, but we are guilty of collusion. Did anyone really, outside the think tanks of the market fundamentalist right, buy into the neo-liberal world vision?
A vision of our future was wholly absent from many of the texts I read. But I did find a distinctive hell relevant to our present. Within the world of economists a cult surrounds the darkly pessimistic views of the Austrian-born economist Joseph Alois Schumpeter, who died in 1950. He is remembered for his definition of capitalism as "creative destruction".
Schumpeter bequeathed two important if controversial insights. The first was that capitalism couldn't function even half effectively without a succession of brutally successful entrepreneurs ready to overthrow the existing order. The second was that capitalism wasn't in the least moral, whatever Adam Smith had intimated. It was so unappealing that it was always likely to cause revolts on the part of those whom it had destroyed, ultimately ensuring its own destruction.
Schumpeter would have been fully at home in the present, pooh-poohing worries over millions of jobs lost each month. "I often wonder," he wrote in his diary, "whether there is anything that ever happened that could not be turned into a business opportunity."
Now that the momentary euphoria of the G20 summit is past, economists have returned to the dismal daily figures. Is there anyone who doesn't think that a prolonged slump will cause widespread political upheavals?
Fear and greed are the primary capitalist emotions, but for the slump befuddlement seems more appropriate. As I read about economics, I learnt to identify an expression on people's faces. One could see it not just in the job centres of Middle Britain or Ohio, but among those locked out of Guangzhou toy factories. It was present among the nouveaux pauvres of Palm Beach or Park Avenue defrauded by Bernie Madoff. Japanese Finance Ministers succumbed, so on occasions did Gordon Brown, and economists themselves.
And yet knowing a bit more does help, as I discovered. At least you begin to comprehend what cannot be known to any reliable degree. This is what Liaquat Ahamed told me. "Economics doesn't always tell you about what really happens. There are too many theorists, and practitioners concoct them to order. They are a bit like lawyers." For real understanding, Ahamed thinks we have to turn to history. The fascination of his account of the last slump lies in his insistence that so much suffering could have been avoided in the 1930s – if the powerful had been less blind, cleverer, more compassionate.
If not a magician, we'd like another Keynes, perhaps. However, in a lifetime of polemical activity, Keynes never uttered a word of false reassurance. Economics, he once said, could provide "the circumstances of civilisation". He meant that it was up to the rest of us to decide what we wanted. Economists could only help us achieve that goal. So we do need to tell economists how we want the world to be. And if economists are to fix our world, they need to know more about it.
Nick Fraser is editor of the BBC documentary series 'Storyville'
Ten books you must read to understand this crisis
NUDGE
Richard Thaler and Cass Sunstein
David Cameron's favorite guide to public policy making
THE TRILLION DOLLAR MELTDOWN
Charles R Morris
Shows how financiers failed
JOHN MAYNARD KEYNES
Robert Skidelsky
Britain's key economist
LORDS OF FINANCE
Liaquat Ahamed
How the last crash happened
HAPPINESS
Richard Layard
The relationship between economics and success
THE AGE OF TURBULENCE
Alan Greenspan
Fails to predict the crisis
PROPHET OF INNOVATION
Thomas K McCraw
Joseph Schumpeter's life
THE STORM,
Vince Cable
How we got into this mess
THE CREDIT CRISIS OF 2008
George Soros
THE ASCENT OF MONEY
Niall Ferguson
How money shaped society
http://www.independent.co.uk/news/business/analysis-and-features/do-economists-know-any-more-than-us-1667301.html
6 April 2009
No Return to Normal
Barack Obama’s presidency began in hope and goodwill, but its test will be its success or failure on the economics. Did the president and his team correctly diagnose the problem? Did they act with sufficient imagination and force? And did they prevail against the political obstacles—and not only that, but also against the procedures and the habits of thought to which official Washington is addicted?
The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed—in short, from the limitations of their ideas.
The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.
But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.
onsider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance—the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981–82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.
With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress’s work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO’s baseline forecast.
Why did the CBO reach this conclusion? On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.
Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle—a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.
Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.
Third, the initial package was affected by the new team’s desire to get past this crisis and to return to the familiar problems of their past lives. For these protégés of Robert Rubin, veterans in several cases of Rubin’s Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.
he chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."
But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker’s campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan’s chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.
The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.
In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation—something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.
eithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.
Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it’s a number between five hundred billion and one trillion.")
The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.
That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner’s plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.
Delay is not innocuous. When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.
The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?
he oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis—an integrated, long-term economic threat—rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That’s the thinking.
But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.
The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.
Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers—the bang for the buck—may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that’s the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn’t help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.
n short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.
If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:
[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.
In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.
The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.
What did not recover, under Roosevelt, was the private banking system. Borrowing and lending—mortgages and home construction—contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.
It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.
All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
hat being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president’s foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.
Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.
That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.
This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.
Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?
Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.
s these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.
Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.
The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let’s answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.
Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.
Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.
Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.
Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.
Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.
This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.
A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.
http://www.washingtonmonthly.com/features/2009/0903.galbraith.html
The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed—in short, from the limitations of their ideas.
The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.
But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.
onsider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance—the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981–82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.
With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress’s work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO’s baseline forecast.
Why did the CBO reach this conclusion? On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.
Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle—a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.
Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.
Third, the initial package was affected by the new team’s desire to get past this crisis and to return to the familiar problems of their past lives. For these protégés of Robert Rubin, veterans in several cases of Rubin’s Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.
he chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."
But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker’s campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan’s chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.
The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.
In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation—something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.
eithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.
Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it’s a number between five hundred billion and one trillion.")
The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.
That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner’s plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.
Delay is not innocuous. When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.
The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?
he oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis—an integrated, long-term economic threat—rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That’s the thinking.
But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.
The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.
Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers—the bang for the buck—may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that’s the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn’t help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.
n short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.
If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:
[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.
In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.
The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.
What did not recover, under Roosevelt, was the private banking system. Borrowing and lending—mortgages and home construction—contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.
It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.
All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
hat being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president’s foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.
Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.
That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.
This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.
Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?
Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.
s these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.
Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.
The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let’s answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.
Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.
Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.
Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.
Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.
Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.
This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.
A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.
http://www.washingtonmonthly.com/features/2009/0903.galbraith.html
29 March 2009
Who's at risk for social and political unrest?
If things feel bad now, how much worse could they get?
In line with our previous risk reports (Heading for the Rocks and Shooting the Rapids), we have identified three macroeconomic scenarios for the evolution of the crisis that began in the US sub-prime mortgage market and is now reverberating throughout the world economy.
Scenario 1: Our central forecast (60% probability)
Government stimulus stabilises the global financial system and restores economic growth in leading developed markets during 2010, albeit at lower levels than in recent years. This scenario underpins our regular analysis and is not the subject of this report.
Scenario 2: The main risk scenario (30% probability)
Stimulus fails, leading to continued asset price deflation and sustained contraction in the leading economies—a depression persisting for some years. The stubborn decline in global economic activity is punctuated by occasional rallies that are taken as signs of recovery, but these quickly fade as the underlying downward trend reasserts itself. The prominent role of governments in propping up banks and reviving domestic demand leads to strong political pressure for protectionism, effectively putting the process of globalisation into reverse.
Scenario 3: The alternative risk scenario (10% probability)
Failing confidence in the dollar leads to its collapse, and the search for alternative safe-havens proves fruitless.
Economic upheaval sharply raises the risk of social unrest and violent protest. A Political Instability Index covering 165 countries, developed for this report, highlights the countries particularly vulnerable to political instability as a result of economic distress. The results of the index are displayed in map form and in a ranking table in the centre pages, along with a brief methodology.
The political implications of the economic downturn, informed by the results of the Social and Political Unrest Index, are discussed at length in the second half of the report.
The full report, in both PDF and HTML format, is available online at www.eiu.com/special. The microsite includes a full methodology for the Political Instability Index, a complete ranking of results including a comparison with the results for 2007, and a large-format version of the map.
full report
In line with our previous risk reports (Heading for the Rocks and Shooting the Rapids), we have identified three macroeconomic scenarios for the evolution of the crisis that began in the US sub-prime mortgage market and is now reverberating throughout the world economy.
Scenario 1: Our central forecast (60% probability)
Government stimulus stabilises the global financial system and restores economic growth in leading developed markets during 2010, albeit at lower levels than in recent years. This scenario underpins our regular analysis and is not the subject of this report.
Scenario 2: The main risk scenario (30% probability)
Stimulus fails, leading to continued asset price deflation and sustained contraction in the leading economies—a depression persisting for some years. The stubborn decline in global economic activity is punctuated by occasional rallies that are taken as signs of recovery, but these quickly fade as the underlying downward trend reasserts itself. The prominent role of governments in propping up banks and reviving domestic demand leads to strong political pressure for protectionism, effectively putting the process of globalisation into reverse.
Scenario 3: The alternative risk scenario (10% probability)
Failing confidence in the dollar leads to its collapse, and the search for alternative safe-havens proves fruitless.
Economic upheaval sharply raises the risk of social unrest and violent protest. A Political Instability Index covering 165 countries, developed for this report, highlights the countries particularly vulnerable to political instability as a result of economic distress. The results of the index are displayed in map form and in a ranking table in the centre pages, along with a brief methodology.
The political implications of the economic downturn, informed by the results of the Social and Political Unrest Index, are discussed at length in the second half of the report.
The full report, in both PDF and HTML format, is available online at www.eiu.com/special. The microsite includes a full methodology for the Political Instability Index, a complete ranking of results including a comparison with the results for 2007, and a large-format version of the map.
full report
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