Anatomy of the Global Economy
The Road to Depression
J. Bradford DeLong
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BERKELEY – For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying to make the macroeconomic consequences of the American mortgage-backed securities financial crisis as small as possible – trying, above all, to avoid a deep depression.
They have also had three subsidiary objectives:
• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street who led us into the crisis from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only “crime” was to accept bad risks, which they would not have done in a world of properly diversified portfolios.
Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.
The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper – subsidiary – weight, I suspect that we would not now be in this mess, and that the danger of a global depression would still be very far away.
The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse in an uncontrolled bankruptcy without oversight, supervision, or guarantees. The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished when their firms were judged too big to fail. The shareholders of Bear Stearns, AIG, Fannie Mae, and Freddie Mac essentially had ownership positions and all their wealth confiscated for pennies.
But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.
Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail, and persuading some debt holders and counterparties that the government guarantee of support to institutions that were too big to fail was not certain.
In retrospect, this was a major mistake. The extended web of finance as it existed in the summer of 2008 was the result of millions of calculations that the US government did, in fact, guarantee the unsecured debt of every very large bank and bank-like entity in America. With that guarantee broken by Lehman Brothers’ collapse, every financial institution immediately sought to acquire a much greater capital cushion in order to avoid the need to draw on government support, but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.
It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them – whether they liked it or not – until the crisis passed.
Yes, this is what might be called “lemon socialism,” creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.
But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.
Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a former Assistant US Treasury Secretary.
Copyright: Project Syndicate, 2008.
www.project-syndicate.org
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tvselvakumaran 02:25 26 Dec 08
There are two economic situations where prolonged deflation could occur:
1. Globalization: In the last several centuries, there have been specific periods, each stretching up to several decades, when there were significantly increased flows of goods and services across national borders. During these times, the less developed countries had figured out how to produce goods that require older technologies efficiently. Hence, they could trade these goods at significantly lower prices. Also, improvements in transportation enabled the free trade of these goods. For example, the late 19th century was one such period. I quote from Professor Jeffry Frieden's Global Capitalism (p. 8), "From 1873 until 1896 prices dropped by 22 percent in the United Kingdom, 32 percent in the United States, more elsewhere. ... ... Prices and earnings declined but debt burden remained constant. Expectations of further price declines caused uncertainty and pessimism. More important, the price declines were not across the board. The prices of goods that entered readily into world trade fell particularly rapidly, such raw materials as wheat, cotton, and coal by 59, 58, and 57 percent respectively. But the prices of other goods and services fell more slowly or not at all. For example, American farm prices declined by more than a third, mining prices by nearly half, but construction costs stayed constant."
2. Depression: In a depression situation, due to severe miscommunication of price signals, the economy invariably goes into a chaotic condition. Firms lay off employees in large numbers expecting a severe downturn. The result is that consumers don't have the incomes necessary for purchasing goods. Inventories pile up and firms have to cut prices. However the more the firms cut prices the more is their losses, and they have to lay off more employees and reduce production. In the worst case, a quarter or a fifth of the working age population is unemployed. This cutting of production and prices and laying off employees leads to a downward spiral of contraction, deflation and unemployment, where these three factors reinforce each other. Thus there is a prolonged period of spiraling downwards, in particular a deflation in prices, before some external event puts an end to it. This was the situation in the Great Depression of the 1930s. During its worst phase, the GDP contracted by a third.
It is clear that the current economic crisis of 2008 would not lead to unemployment above 20%, nor a contraction of a third of GDP. Moreover, due to massive accumulations of capital, like social security and pension funds, consumers could continue to maintain their usual level of spending on essential goods even if they lose their jobs. Thus the re-appearance of a dire economic situation like the Great Depression cannot be cited as a reason for prolonged deflation in contemporary times.
Next, during the current phase of economic globalization, the phenomenon of 'China price' has been hitting the global economy since the 90s. These deflationary forces have been successfully managed so that there would not be severe destabilization of the global economy. This is the great contribution of Alan Greenspan, that he allowed the stock market to boom right into 2000, even though he worried about a bubble in the stock markets as early as 1996. China's supply of manufactured goods at low prices helped to keep inflation low, and enabled America to continue to grow with unemployment rates well below that specified by the Non-Accelerating Inflation Rate of Unemployment (NAIRU). On the demand side, the wealth effect created by the stock market boom enabled consumers to keep spending so that the economy could keep growing, which in turn allowed an increasing trade deficit with China. Thus Greenspan's stewardship ensured that America and China developed a stake in each other's well-being. Moreover, the case for globalization producing a prolonged period of deflation this time around is not compelling at all, since the resulting deflationary forces have been successfully managed for the last 15 years or so.
So why are several famous economists still warning against the dangers of a recurrence of the Great Depression? Depending on their preferences, these economists are either advocating inflationary monetary expansion, or huge fiscal spending to the extend that the budget deficit next year could be a trillion dollars. These are in addition to the massive expansion of the Federal Reserve's balance sheet (from $900 billion to $2.3 trillion so far), the $700 billion TARP program, and the large scale off-balance sheet programs announced by the Fed and the government for rescuing financial corporations and buying all kinds of securities.
Well, it appears that a consensus has been developing among economists in the advanced industrial economies that by enacting massive fiscal spending programs, they could re-engineer entire economies of the West so as to shift their focus on manufacturing and construction, and possibly away from services. As Professor Paul Krugman put it in his recent New York Times column, Life Without Bubbles, "By selling more to other countries and spending more of our own income on U.S.-produced goods, we could get to full employment without a boom in either consumption or investment spending". Other famous economists like Professor Robert Shiller, Professor Nouriel Roubini, Professor Bradford DeLong and Professor Joseph Stiglitz have written articles expressing support for a massive fiscal spending program with the goal of maintaining full employment.
Well, there is some strength in this argument. Infrastructure is definitely crumbling in many parts of the United States. It would be appropriate to recall here that not long ago, a large bridge on an Interstate highway collapsed in Minnesota killing dozens of people. Schools, public libraries, courtrooms, police stations, airports, railway stations and other public buildings require upgrades urgently. Moreover, potholes have been springing on most public roads, and the local governments have only been doing patch-work on them for lack of funds. Similarly, the manufacturing industry has been languishing for several decades now. So there is definitely a case for upgrading infrastructure and reviving the manufacturing industry in the Western economies.
However, I should also point out that expending all the political capital that the left has won in the recent elections (for US President and US Congress) on a one trillion deficit spending program may not be the 'best bang for the buck' (to borrow Professor Stiglitz's lingo). At present, the most economic benefit that the United States can obtain is to recover its standing among the world nations by conducting its foreign policy with vastly improved diplomacy. In particular, spending the far less amount of $20 or $30 billion towards Millennial Development Goals and eradicating poverty would improve the goodwill for America around the world. As a result, America would obtain much better long-term economic benefits by spending just 2 or 3 percent of the trillion dollar deficit program.