On September 25 I sketched out A solution to our financial crisis, in three parts.
(1) Stabilize the financial system – Being attempted, probably now it’s too late.
(2a) Stabilize the economy with monetary stimulus– Rates are coming down and money printed, but probably with relatively little effect.
(2b Stabilize the economy with fiscal stimulus — Just now being considered; will work but slow to implement and slow to have effect.
(3) Arrange long-term financing for steps #1 and #2 with our foreign creditors – Unacceptable to our leaders at this time.
Parts 1 and 2 are being implemented, much as described. Part 3 was described as necessary at some point in the future. I said that these probably would not work over the medium to long term, but would mitigate the downturn (slow or even reduce the economic decline, and alleviate the resulting suffering).
I was wrong. The rate of decline — destabilization of the global financial system – has become so great that these measures will prove insufficient. In my opinion (these are, of course, guesses). Since I doubt our leaders have a Plan B, here is a suggestion.
Extreme mobilization by the government of our economic resources, as we have done during wars.
For deep theoretical reasons our financial system is collapsing. I have discussed some of the reasons (see below for links), but the causes are irrelevant now. Whatever the cause of a cardiac arrest, the paramedics job is not to advise dieting and exercise — but to restart the heart.
The US economy is sliding into deflation. Perhaps the global economy as well. The evidence is all around us. Just to mention a few: collapsing commodity prices, the price of gold falling, and the collapse of yields on one-year Treasury Inflation Protected Securities (TIPS). All are extraordinary. TIPS were priced for inflation a month ago.
The center is cracking (the US, the EU, and Japan). So are some nations on the fringes (e.g., Eastern Europe, Argentina, Pakistan). And points in between, also (e.g, Iceland, South Korea). This is a tear in the fabric of the global economy, which accelerates as it grows. So far only the financial markets have felt its full force, but soon we will see the real world impacts on trade, employment, incomes, etc.
Panic is the danger, as more people realize the danger.
Bourses have stopped trading for some period this month in Austria, Brazil, Iceland, Indonesia, Romania, Russia, Thailand, and Ukraine (sources here and here). Markets provide liquidity to individuals, not to everyone at once. Panic liquidation would likely force any exchange to close; the closing of a major exchange might spread the panic and force others to close.
Panic means people save more and spend less. Businesses too, cutting both routine spending and investments. Keynes called this the “Paradox of thrift“. A gradual rise in savings rates can help an economy’s long-term performance. A sudden rise in savings rates just reduces everybody’s (i.e., aggregate) income.
More savings, less debt, less investment, a flight to safety. If occurring on a large enough scale, as we see today, these mean that businesses are starved of revenue and capital. No spending, no risk capital by lenders or investors.
As everyone scrambles for the safety of government bonds, the government gains the ability to borrow massive sums at low rate.
The result: by default the government becomes the primary economic actor. It’s spending and investment decisions drive the economy. Not just immediately, but — as a result of the investments it makes — for many years after normal processes are restored. We saw this in Japan during the 1990’s. It borrowed and borrowed, but frittered the money away on largely unnecessary projects (e.g., bridges to nowhere, train stations in the middle of nowhere). This kept their economy rolling, but the debt remains and they have little to show for it.
Now we are Japan. Interest rates must go to near-zero. Government spending programs must be rapidly initiated on a scale not seen since WWII. Government decisions will determine what America looks like for the next two decades (at least). Who gets loans, what kinds of infrastructure to build, what kind of training programs for young people and the older unemployed … it is a long list.
Trillion dollar spending programs for 2009-2010. Plus a trillion or so in capital infusions into the financial system. While other nations do the same. The global savings pool might not suffice for to provide so much capital, and the effects of such massive borrowing might destabilize interest rates and currency values. Hence the need for my recommendation #3: the “Master Settlement of 2009“ – a meeting of the major nations to, among other things, reschedule America’s debt and form a new geopolitical and financial global regime.
I doubt any government experiencing these conditions — and there probably will be many — will do otherwise.
Libertarians and laizze-fair capitalists will advocate elaborate plans for doing little or nothing. What would happen if they took power in January? Who knows? I have little interest in contrafactuals. One might just as well ask what would happen if the Blue Fairy waved her wand and increased the human race’s average IQ by 50 points.
Comparison: now vs. the Great Depression
One advantage we have over the folks of 1930: we know this song. The response of government leaders since the crisis started in December 2006 (when the mortgage brokers began collapsing) has been slow, reactive, and incremental. In many ways similar to that of President Hoover’s administration between 1929 and 1932. While recognition of the danger has been slow, action following recognition will be fast.
Also, we understand economics better. Keynes wrote The General Theory of Employment, Interest, and Money in 1936 (although the ideas it presents we in circulation much earlier). Plus we have the work of others during the past 70 years, such as Hyman Minsky and Milton Friedman. The gross policy errors made during the 1930’s — such as raising taxes and trade barriers — are far less likely today.
Only extreme statists will rejoice at these measures. The need for such result from the accumulated policy errors of the past half-century (or more), a bipartisan orgy of folly. We must do as our ancestors did during adversity: stay cool, make the necessary decisions as best we can, and move on.
Lessons Learned about government for the next cycle
Since 1929 everybody knows that close regulation of banks and brokers is necessary to prevent serious financial crisises. We had a bank crisis in the early 1980’s, as they almost went broke due to feckless lending to emerging nations. We had a bank crisis in the early 1990’s, as many folded due to feckless real estate lending. And here we are again. All this despite a large and well-funded state and federal regulatory apparatus, to which we granted draconian powers over the finanical sector.
We made a mistake.
“You f**ked up, you trusted us.”
— Otter advising Flounder, from the film Animal House