“Take your medicine – it tastes awful, I know, but it will make you better and in a few days you’ll be glad you did.”
That doesn’t sound like high-tech medical care, more like a home remedy (castor oil?). That is, however, essentially the medicine being prescribed to deal with the current global economic misery – take a dose of austerity now (cut back government jobs and government spending) and you’ll feel better in the morning.
That may be the right prescription for a mild case of over-borrowing – for many developing countries in the late 20th century, who had vast loan packages thrust on them by developing national and multinational banks, it was important to reduce borrowing and raise taxes to bring government spending back into balance. Why? Because their debt became so great that no one was going to lend them any more money, and once that was known, nobody wanted to hold their currency, or invest in their markets, and their interest rates soared. So their currencies and stock markets crashed. But once they revamped their fiscal policy, and people became assured that government revenues were sufficient to service their debts, their credit lines re-opened, their currencies recovered, and their economies quickly bounced back to growth.
Yet that is not where the US is now — everyone wants to hold US currency and bonds, our interest rates are at historical lows, and the stock market is still, even after last weeks gyrations, almost double its level of two years ago. As Ken Rogoff has pointed out more clearly than anyone else, we are not in a severe but otherwise ordinary recession. And it was not caused by excessive government borrowing. Rather, we are in a true Depression, (call it the 2nd Great Contraction, like Rogoff, or the Lesser Depression, like Paul Krugman), that was brought on by individual households, banks, and corporations loading themselves up with way too much and too risky borrowing, backed up by insufficient assets and therefore never going to be repaid. And once that became known (starting with the collapse of Lehman Brothers), no one would lend money to anybody, and the economy completely froze up and started to collapse.
So governments around the world stepped in to shower money on banks and corporations, to try to reassure investors that there was enough money in the system to keep the economy going, and that the banks and corporations would be able to stay in business and eventually have enough profits to be able to write off their bad debt or repay it. But for all the individual households who had borrowed too much for homes or other purchases? They are still trying to figure out what to do to get out of their mess, and not spending as much, trying to save and reduce their debt, so the economy remains very weak.
Clearly, the economy is still awful – long-term unemployment is at levels not seen since the Great Depression, and overall economic growth has been flat for almost a decade. Unfortunately, we do not have a science of economics up to the task of telling us how to get out of this mess. The dirty little secret of economics is that while there is great consensus among scholars on how economies function in equilibrium – that is, when things are going normally and economic growth is in line with population growth or a bit better, and things are pretty steady except for the occasional hiccup of a short recession. Virtually all economists agree on models for this situation (called the “general equilibrium model”). This is what Larry Summers calls the “ketchup” part of economics – we can prove that under equilibrium conditions, the market price for a widely sold, competitively offered product, like ketchup, is such that a two-quart bottle of ketchup is exactly twice the price of a one-quart bottle of ketchup.
But economic science does not have any agreement on how economies function when they are out of equilibrium, whether that is when they are growing like gangbusters (that is, moving from underdevelopment to developed status) or when they are stuck in deep misery (like now).
Instead, we have various schools of economists that fight over whose ‘cure’ is the one that really works, much like vendors of competing cures in the wild west days of medicine. “Efficient market” theorists say that their model for equilibrium economies (the right prices clear all markets) is also the right model for a major depression. They say there is nothing the government can do to alleviate the misery; just let goods return to their ‘proper prices’ and efficient markets will clear things up. The problem with this theory is that recent evidence suggests that it is either completely wrong or a prescription for disaster. That is, if home prices, which have fallen by almost a third, are not yet at their ‘proper prices,’ how far do they have to fall? If they have already fallen to or below their proper prices, why is the housing market still moribund, despite the lowest interest rates in history? If they have to fall still further, how far? Will half the population have to go bankrupt if the ‘proper prices’ are another 20% lower than they are today?
“Keynesian” theorists do have a model of non-equilibrium economics, the model of how economies get stuck in a depression developed by John Maynard Keynes in the 1930s. They say the government can do something, that our problem is not distorted prices but a reluctance of anyone to lend anyone else money (because they don’t know if they will get paid back if the assets backing the loan are declining in value), and a reluctance of potential borrowers to borrow (because they are already maxed out or trying to reduce their debt). So economic activity remains depressed, and the lower that asset prices fall (deflation) the more economic activity will contract. So Keynsians want the government to do something – spend money and put it in the pockets of potential buyers. This will give companies more customers, and induce them to hire and borrow to meet that demand. In fact, the US followed Keynesian policies in 2009-2010, adopting a ‘stimulus package’ of spending, and just as the model predicted, the economy immediately stopped shrinking and started growing (see my post “Do the Facts Matter?”), and then stopped growing as soon as the stimulus started to run out.
Yet unemployment did not fall by much, but that is because the model and
experience tell us that unemployment is always the last element to recover from a depression; so the stimulus would have had to last longer for people to gain enough confidence that growth had returned to start hiring. But of course critics
point to the lack improvement on unemployment and say the Keynesian
policies just plain didn’t work.
Finally, we have the Tea Party/Republican prescription, which says that all government spending is bad, especially debt-financed spending, as it drives out private spending, and that it is better to let the government fire people from their government jobs even when unemployment is very high and make them look for work in the private sector, as that will make the economy as a whole better off. So their plan is to cut back government spending, reduce government borrowing, and not under any circumstances raise taxes. That sure sounds appealing and straightforward. The problem is that it is pure quack medicine, without a shred of evidence or any theoretical model held by any reputable economist to suggest that it will work to ignite economic growth or reduce overall unemployment.
So which medicine does it appear our economy is going to get for its misery? The scary answer, of course, is (c), the quack cure. Why? Because the serious economists cannot agree on which model is right for non-equilibrium conditions, and because the evidence from recent actions is too short or ambiguous to be decisive, and because when self-interest is at stake, ideology often prevails over science.
If there is any economist who I think actually has a cure for what ails the global economy, it is Ken Rogoff. His analysis of the problem, with Carmen Reinhart, is not based on abstract models or short-term evidence, but on the careful study of major contractions over hundreds of years of historical experience. His prescription is pretty simple – if the problem that sank the economy is that everybody has too much debt (not the government, mind you, but households, banks, and corporations), then you have to do something to lighten the debt so that people can start fresh. The best way to reduce everyone’s debt in real terms is to have a period of high inflation – three to four percent for a period of ten years would cut everyone’s real debt in half, raise the nominal value of their major assets (especially houses) and return the economy to something like normal equilibrium conditions. So let’s do it!
Of course we won’t, because in our world, real historical experience counts for less than either formal mathematical theories (which don’t agree) or ideology (which offers quack cures).
Here is a sentence you are unlikely to hear from any world leader: “Because the global crisis has hit hardest at the working and middle classes, who are burdened with falling home prices and stagnant incomes, we are going to make it the focus of our economic policy to restore the value of their hard-won assets and increase their wages.” Too bad – you’d think it would be a politically winning move, as well as good economic policy. But we seem to be living in a world where quack policies prevail.
I am sure I am wrong and the astute folks here will correct me, but isn’t capitalism, at least as currently constituted (late capitalism? advanced capitalism? consumer capitalism? global capitalism? cultural capitalism? pick one, anyone) fundamentally a ponzi scheme? I’m not trying to be glib (or stupid) and perhaps this isn’t the best analogy, but unless capitalism is somehow mediated so that those at the top realize that getting a bit less and making sure those at the bottom get a bit more so that it all works for everyone–which of course brings us dangerously close to social democracy or, goddess forbid, socialism–isn’t it simply a game where those at the top keep getting richer off the suckers at the bottom who keep buying in and keep them afloat.
Eric, I share your sympathy for those losing out in today’s capitalist games, but I have to say that capitalism itself — private property, free markets for labor, and competitive market pricing — is not a Ponzi scheme at all. It is a system to maximize everyone’s utility subject to freedom of choice and initial endowments. The problems of those at the top squeezing those at the bottom arrive when some condition — the development of monopoly power, or non-market political leverage, or shifts in technical or global exchange conditions — make capital more valuable, and labor less so. Then the initial endowments work in favor of those who already have major accumulations of capital, and against workers. That is where we are in most of the developed world today. But it isn’t inherently that way — capitalism in China, despite socialist political control of key assets and most banking capital, and massive corruption, lifted nearly a billion people out of extreme poverty in the last 30 years. So it ain’t all bad!
Fed easing (QE2) caused speculators to buy commodities and other currencies. The result is that inflation flowed from increases in food, energy and import prices. As you can imagine, the middle class had to foot the bill for that, while the top 5% that owns most financial assets did quite well (temporarily).
You raise a good point on refinanced mortgages. Theoretically, banks can seek deficiency judgements against those mortgagees in most states. In practice, they have not sought that remedy due to the cost of legal action against widespread walk-aways. I still think falling home prices are mainly a problem for the banks, not for the vast majority of “underwater” households.
In general, I would say the technocratic prescription is, “save the banks and inflate asset values.” This has been the centerpiece of the Obama/Summers/Bernanke economic policy. It is a form of “trickle down” economics.
In general I agree with your characterization of the policies and you are absolutely right about their trickle-down nature — but so far the policies have been more effective on the ‘save the banks’ part than on the ‘inflate asset values.’ That is why ordinary folks are so fed up; the policies have indeed saved bankers but there has been no halt to the deflation of value of the asset that is critical to most of America’s middle-class, namely the value of their homes.
Also, be wary of the inflation cure. We saw in 1H11 the effect of higher food and energy prices, combined stagnant wages, on middle-class household spending. With middle class real wages stagnant for over a decade, reducing real wages through inflation hardly seems like a cure-all.
Diego is right that if inflation lowers real wages that we would be making things worse. So the FED and Treasury would have to keep an eye out for wage trends if embarking on any inflationary policy. The reason to be optimistic is that productivity is way up, and people who have jobs are getting wage hikes, but asset prices are in the doldrums; so inflation should help asset prices without leading to real wage declines.
I agree with much of what you say, but I have to offer one correction. Falling house prices would certainly not, “bankrupt half the population”. The vast majority of homeowners own the right to sell their house to their mortgage holder at the value of the mortgage. This “put” was offered to them as an enticement to sign a mortgage contract. There are two downsides to exercising it: 1) they have to incur the costs of moving to a rental home (hopefully of similar quality); and 2) they will be unable to access credit for 3-5 years. These two downsides are material, don’t get me wrong. But they also certainly fall short of “bankruptcy”.
The real problem with clearing the housing market is that, not half the population, but half the BANKS would go bankrupt. Except they wouldn’t: they would be effectively nationalized, recapitalized, and reprivatized. The shareholders and creditors of these banks would absorb the cost of loan write-downs. Since the top 5% of wealth holders own roughly 70% of financial assets, this loss would fall primarily on the rich.
The argument that lower house prices will bankrupt mortgage holders is a fiction that bank shareholders and mangers willingly want the public to believe. When politicians talk of “rescuing housing,” let’s be clear who exactly is being rescued: not voters, but campaign contributors.
Diego — you say that ‘the vast majority of homeowners own the right to sell their house to their mortgage holder at the value of the mortgage.” That means they can walk away. But I would like to see your data on that. Anyone who has refinanced a home or taken out a home equity line or second mortgage gives up that right, which only applies to first mortgages. Given the extent of the refinancing boom that took place, I think the majority of people cannot just walk away — if they could, the markets would have cleared by now. Sadly, what happens is that people who CAN walk away do so, letting their home go into foreclosure, driving down home values to a level that puts owners who have refinanced or taken out equity loans under water. Those folks are, effectively, bankrupt. Also, a lot of people acted on the belief that rising home prices would provide funds for their kids college or their retirement; they may not be bankrupted but their financial future is in tatters.
It is not medicine, it is a prize.
You make the mistake of thinking about the economy like a patient, like a single person not well.
It is not, the economy is made up of people, and it is best understood like a game. Sometimes, the msuic stops, and the guys who got out early, who have dry power, they are supposed to WIN.
The prize is the ability to buy up the losers assets for pennies on the dollar.
It is how things work and we all do it. Just look at the outbreak of TV shows about Pawn shops.
HOW DARE YOU try and keep people from losing – that will ruin the game.
Morgan, I don’t mind if people lose — that is why we have bankruptcy laws. But you have to be clear about how much people lose when they lose. The reason we have bankruptcy laws is that if you lose your house because you lose your job, you walk away, the bank ‘wins’ the house, and you have to start over. Or if you have a company that loses its customers, your assets go on the block and you walk away and start over. That is why capitalism works — there we agree. But if people lose for reasons that have nothing to do with their own choices, then the game is being rigged. We used to have a law (Glass-Steagall) that said banks who sell speculative securities have to lose if, when the music stops, their assets aren’t good. But to make that game work, the GS law also said such banks had to play with their own money — they couldn’t use the government guaranteed deposits of ordinary people to play. Well, we scrapped that law, and the big banks (Lehman Bros, Goldman Sachs, Citibank) got to play with everybody’s money, not just their own. So when one of the big banks failed (Lehman), it dragged everybody down, regardless of what assets they had — because nobody was sure who was backing which assets and whose money was at risk. Soon enough, Uncle Sam came in with billions of dollars to bail out AIG, Goldman Sachs, and the others who were left holding empty bags, but who were deemed ‘too big to fail.’ I think that was bad policy, and the banks should have been broken up, not merged and saved. So DO NOT BLAME ME for trying to keep people from losing. It was the leaders of Goldman Sachs, Morgan Stanley, Citibank, and the others who said they should be kept from losing, and Bernanke and Geithner agreed. I DO think they ruined the game for the rest of us. BUT APART FROM THAT the question of how one can boost economic growth back up to 3% per year from its current 0.8% year remains a key issue. The way you describe things working is indeed how they should work once we are back to equilibrium conditions; but if growth remains stuck at under 1% per year, then sooner or later we are all losers.