Is the Administration Doing Enough?

Having been bashed, offline, thoroughly over the weekend I feel I need to explain my apparent antagonism towards the administration’s approach to solving the economic crisis. So here goes:

1. I see the solution to our economic crisis breaking into two elements: fiscal expansion [a.k.a. stimulus or deficit spending]; and financial industry bail-out and reform.
2. So far I give the administration a B- on the stimulus: it was too small from my point of view, and I give them an incomplete on the bail-out and reform, largely because they are meandering along and have not been decisive.
3. As for other elements of policy: health care reform, the budget, and so on I give the administration an A-. In particular I think the budget is an ambitious attempt to re-orient American social and economic priorities away from the grip of laissez faire towards a more balanced and nuanced view of capitalism.

In detail:

The administration is clearly placing its emphasis on fiscal policy rather than any real immediate attempt to clean up banking. I state this simply on the basis of the empirical data. All the statements from administration officials and others who are aware of the policy emphasize the importance of avoiding dramatic action in the banking industry lest we inflict ‘irreversible damage’. Presumably this means that we have to avoid a repeat of a Lehman like melt down in the credit markets. This caution also allows the administration to husband what little spending authority it has left from the TARP confrontation with Congress; and it also allows any recovery in the economy to ease the stress on the balance sheets of the weaker banks.

On the surface this seems very sensible.

I don’t see it that way.

This is because I think it reverses a significant portion of the cause and effect. I think we need a healthy banking sector to undergird the recovery. Without healthy banks we will still see an end to the recession and a recovery begin. As I have said before i think this may happen later this year. Recovery is not the issue. What is far more important is the speed and effectiveness of the recovery and our ability to put in place policies that prevent the causes of the crisis from re-occurring. So waiting around in the hope that a recovery will help re-float the banks seems backwards to me. I think we should be addressing the banks first. Or at least more expeditiously. In particular we need to get the banks re-capitalized so that they can start lending again. Unfortunately, in my opinion, none of the administration’s many plans really solves the capital adequacy issue.

I have hopes that this temporizing may end with the release of the bank stress tests. It is already fairly well known that at least two of the big banks, Citibank and Bank of America, performed weakly in those stress tests. So the acid test of the administration’s resolve will come when they tell us what they plan to do about these two [assuming it is only those two!].

Hopefully we see a quick effort to force both of them through a government sponsored re-organization similar to that the FDIC used this weekend on four small banks across the country.

If that action transpires then I will immediately give the administration kudos for having its policy priorities right.

Up until firm action to resolve the banking crisis the fiscal stimulus is pressing into the wind. I reported here last week that the Treasury Department estimates that bank lending actually shrank in the first quarter. This is hardly good news for a rapid recovery.

One of the major planks used by opponents of strong action in either fiscal or banking policy is the enormous debt burden we are rapidly accruing. The mantra is that we simply cannot afford massive stimulus or expensive bailouts. After all we have spent trillions so far and there is only so much debt we can issue.

I disagree.

And more to the point so does the administration. Debt burden is not an issue to them. How do I know this? Larry Summers gave a speech last week saying as much. In his opinion since this is such a rare crisis – it happens once or twice a century – there is plenty of time to pay down the debt as long as we avoid Reagan or Bush like profligacy. I agree. And that’s an essential point. Much of current debt burden was the result of incompetent and ill thought through fiscal policy. The tax cuts of 2001 and 2003 are a prime example of a failed fiscal policy. They did not deliver an economic expansion sufficient to raise federal revenues to offset the deficit created by the tax cuts themselves. All they did was to increase our deficits permanently. We have no enduring economic value to show for them.

Both Reagan and Bush were fiscally irresponsible and we cannot afford to repeat their mistakes. But that does not mean we should not incur debt now in order to rebuild growth and ensure a rapid recovery. Indeed fiscal restriction now is exactly the policy to avoid, which is why I am so critical of the actions some states are taking to balance their budgets. Having said that we obviously need to ensure we get value for our money. In my opinion a healthy banking system able to help sustain our economy, and a more rapid return to ‘normal’ GDP growth is great value. The risk is years of slow growth and potentially high unemployment with all the human costs that might bring.

Further: Obama has an ambitious agenda. He wants to transform our health care system to make it affordable and efficient; he wants to invest in education; and he wants to invest in environmentally oriented manufacturing. All these ambitions need a strong economic and tax base on which to stand. So the sooner we climb out of our present hole the sooner we can start on those policies with confidence that we can sustain them.

Lastly I don’t see any of this as particularly radical. Indeed it is all fairly standard economics. Those who align against more dramatic action are either hesitant, don’t think the problem is as deep as I do, oppose fiscal policy for intellectual or political reasons, or are supporters of the current banking industry structure. All of them could equally be called ‘radical’. For instance, anyone who thinks the banks are fine if we leave them alone has to be making a fairly radical interpretation of their balance sheets and making some equally radical assumptions about the value of the toxic assets they hold. I would prefer us to be conservative and accept the extent of the losses in the system so we can deal with them.

But deal with them we must.

Inaction was a primary weakness in Japan in the early 1990’s. Eventually they got things right. But the eventual cost was far larger than what it might have been had action been more urgent up front. It is the lingering and slow leakage of taxpayer money that I object to. At the end of the day all the evidence from history tells us that quick action limits long term costs.

So to re-cap:

• I think the administration has the cart before the horse: we need to fix the banks sooner rather than later so the stimulus package has more opportunity to produce strong results. This is particularly important given the stimulus was, in my opinion, far too small.
• Rapid action against the banks not only increases the effectiveness of the stimulus package, it reduces the ultimate cost of the bank bailout.

I see these as conservative positions. In fact I see my advocacy of temporary nationalization of the weak banks as straight from the capitalist playbook: failure should result in shareholders being wiped out. The moral hazard represented by the implicit guarantee against failure has to be eliminated so that banks realize they will be forced into receivership by the guarantor, i.e. the government, as a price of having had the guarantee in the first place. If we don’t follow through with tough action we socialize the losses and privatize the gains. That simply isn’t fair and it shouldn’t be tolerated in a system that relies on sensible private risk taking. Insane private risk taking is a consequence of timid or compliant administrations not applying the traditional capitalist rule that risk and reward should be related. The Reagan Bush era was characterized by compliant government: we deregulated without stopping the guarantees afforded the banks. So they naturally gamed the system and extracted huge ‘rents’ from us. Obama needs to illustrate through his actions that we will not tolerate such gaming in the future. The rules need to change. And, in my opinion, that leads directly to strong and immediate corrective action against any bank that relies on taxpayer money to keep itself afloat.

I fail to see how my advocacy of action to speed economic recovery, or to protect taxpayers against banking industry ‘rent seeking’ can be interpreted as radical. On the contrary relying, as the administration is, on a hope for fair weather and the goodwill of the bankers who created this mess seems to be a more radical position.

By comparison, I think I’m being conservative.