Causes of The Current Malaise

Just a short refresher on why we are in the current mess.

There is a long term cause and a short term cause. Economics is never straightforward!

The short term cause is the bursting of the real estate bubble and the subsequent collapse of home prices. This had two effects. First, it destroyed bank balance sheets setting off a firestorm through the credit markets. Bank lending screeched to a halt. Bank losses piled up – we’re into the trillions of dollars worldwide so far – and whole markets withered away. The entire old style investment banking business disappeared. Even after all the money so far pumped into the banking system we are well short of fixing the problem and another few hundred billion seems necessary, plus the nationalization of the worst affected banks. Second, it similarly destroyed consumer confidence and spending opening up a massive hole in what we call aggregate demand. It is this gap in demand that causes the nasty side effect of unemployment and is what we experience as a recession.

The longer term cause is the complex of imbalances created in the economy over the past three decades due to deregulation of the financial industry which allowed the muddling together of consumer and investment banking; the failure of Americans to save properly and so depend on borrowing for consumption rather than investment; endemic Federal Deficits that first emerged under Reagan; a persistent trade deficit, which was a result of debt fueled consumption; over emphasis on homeownership as a social goal – particularly driven by Republican politicians which is odd for a party that supposedly opposes social engineering; the over confidence in financial economic theorizing which enabled the rapid growth of derivatives trading – those infamous mortgage backed securities are but one example of derivatives; and the deliberate non regulation of the burgeoning non bank financial system including the aforementioned derivatives business.

So there is plenty of blame to go around. Most of it falls into the rubric of ‘free market economics’. Except I would have to amend that by adding in the politically loaded word ‘deregulated’. It is perfectly possible to have a market driven economy within a tight regulatory framework. America during the 1950’s through the 1970’s was just such an economy. The triumph of ‘free market’ thinking – in my world attributed to people like Milton Friedman over the ideas of John Maynard Keynes – was bolstered by the simultaneous triumph of Reaganite ‘anti-government’ politics. Indeed the two are inextricable. The one gave the other intellectual legitimacy. The ideological thrust was to push the economy into an uncontrolled period of growth and lopsided wealth creation. The imbalances I mentioned above are directly related to this ideological shift.

The Federal Deficit was declared ‘not to matter’. The dot com and real estate bubbles were dismissed as ‘irrational exuberance’ not worth policy action. Tax cuts became the only fiscal policy instrument. And any government intervention in markets was scorned: even public health activities were thought better served by ‘market forces’.

This whole effort was enabled by the ascendancy of right of center thought. Policy discussions were constantly framed from a right wing perspective. The media, the electorate, and political debate all reflected this unitary vision. There was no clearly or strongly articulated alternative voice so everything was viewed through the one lens. We became what I call a ‘faith based economy’. Faith in the markets.

The result was to create an economy similar to those of the pre-Great Depression era. More exactly, it seems to have been a deliberate effort to re-create the economy of the late 1800’s.

The outcome was therefore predictable. Sooner or later markets go through periods of long adjustment like the one we are in now. The implosion of the real estate bubble was the trigger, and therefore the immediate cause. The belief in ‘free markets’ and the resultant decades of deregulation was the longer term enabling, or underlying, cause.

To blame only ‘the banks’ or ‘stupid homeowners’ is to look only at the immediate cause. To limit the damage, and to construct a more stable future we need to accept the deeper cause. We need to walk away from the Reagan era.