monetary policy

I will be going away for the summer at the end of this week which leaves little time for further commentary until later this year. So I want to give my view of where we are in this recovery, and what I think are the remaining issues to be faced.

First, let’s all recall that the crisis began a long time ago. Depending on your perspective the onset of the malaise was either in the latter part of the Bush administration, or it was much earlier, during the Reagan years when deregulation set in motion the slide towards today’s volatility.

My preferred narrative is that what we are going through now is the inevitable end result of the shift America introduced during the 1980’s. That shift saw the then existing dominant view, which was largely post-war Keynesian, replaced by a re-introduction of pre-war laissez faire. The notion at the time appeared to make sense: the stagflation of the late 1970’s was to be explained by the stifling hand of government and the resultant drop in innovation. Only with the release of free enterprise from the dead hand of government would we be able to restore strong growth.

My issue with that standard story has always been rooted in the facts: economic growth, by any measure, was at its peak during the immediate post-war era, precisely when government intervention was both frequent and fashionable, and, moreover, when trade unions were at the zenith of their influence. This does not mean that those factors caused that growth. But it does mean that the right wing argument that they impede growth is factually wrong.

In truth the stagflation was more a result of a series of one time shocks, and the steady catch up by America’s rivals, than to the failure of the then existing economic policies. Plus, the institution of a right wing free market set of ideas was not associated with a burst of growth. Since the 1980’s America has followed its historical trend for growth rather than exceeding it, and during the past decade we have significantly underperformed. Setting the markets free has not produced a burst of anything. There is no evidence at all that free market policies are any better than the old post-war policies. In fact all the evidence is that they are worse.

This is why we find ourselves in our current predicament. The reduction in regulation has failed to produce any increase in growth, but it has produced enormous costs. So adjusting those mediocre benefits by the above average costs produces a very large net loss for society. Wages have stagnated. We have been buffeted by two successive asset bubbles. We have had to pay enormous amounts to keep our banking system afloat. And we have had to run up huge federal deficits in order to avoid a depression. From this vantage point the entire Reagan/Bush economic project has been an unmitigated disaster.

It is facile to place the blame on anything other than those policy choices. Yes we are now facing more intense competition from abroad, but trade is still a small part of our economy so that competition is not a sufficient explanation for the anemic Bush era economy. Now does it explain the lunacy of the real state bubble which was a purely ‘made in America’ moment.

No, this was, and still is, a self inflicted wound.

As we lumbered into the morass the Bush administration attempted a variety of unprecedented triage treatments. The bank bail outs, and the Fed’s extraordinary monetary policies are the two biggest highlights from those months. That anyone can accuse Obama of spending a fortune to bail out the banks is misdirection of the most cynical kind: it was a Bush policy he inherited. And it was something we had to do given the mess created by deregulation.

The Fed is, of course, not beholden to the administration of the day, so its actions have to be evaluated in a slightly different light, but they, too, seem to me to have been unavoidable.

I think it is far too easy for people to forget just how close we came to outright collapse. There were days when any reading of the numbers was grim to say the least. And on many we were looking at data suggesting a more dramatic collapse than that of the Great Depression itself. At which point Obama arrived amidst a burst of optimism, born more from hope than any sensible take on the circumstances.

The first step towards saving the economy, after the change in power, was the stimulus. This was, for me, a watershed event. The resistance to a surge in government spending – the shift towards fiscal policy to augment monetary policy – was ill informed, vindictive, and just plain wrong headed.

At that moment we had precisely one positive policy choice: go deep into debt to stave off disaster. All other choices were either already in use, or would have led to depression. Doing nothing would have been the worst of all and would have condemned us to an economic freefall of epic proportions.

A recession, or a depression, is simply a dramatic loss of demand in an economy. People stop buying. That causes businesses to cut costs. It causes cash to stop flowing. Banks face loan losses. Families face lost incomes and even worse: they face the loss of their homes. The textbook tells us that to fight off this malaise we should lower interest rates in order to make borrowing cheap. This leads to a recovery in activity and the recession is limited and then ended. But we had a unique problem back in 2007/2008: we had interest rates so low that they could not be lowered any more. We had used up our anti-recession policies in order to fend of the Bush stagnation. So we had one card to play. Keynesian stimulus.

That this was anathema to the right wing is an understatement. That’s why the opposition was so shrill. The very idea that we had to shrug off the Reagan era ideas in order to save ourselves was a huge defeat for the right wing world view. The bitter fighting goes on still. Every opportunity to lump the disaster into Obama’s lap is taken with glee, and the deficit is used to stir up voter antipathy.

As if we had a choice.

Yet here we are alive and getting better.

Criticism that the stimulus failed is just nonsense. It worked exactly as predicted. We avoided depression. It was never going to stave off recession and it was never going to bolster employment because its opponents had succeeded in gutting it and thus watering down its impact. As I look around the economy today, I see plenty of evidence that we need more stimulus, not less. We need to increase demand, not dampen it. But the political will is not there, so we are condemned to a long slow struggle.

We are also exposed to more negative risks than positive risks. That is to say, there is more chance of a decline on growth than there is a chance of a strong burst.

High among those risk factors is the overhang of our defunct banking system, which was the primary cause of the collapse, and is now a major inhibitor of strong recovery.

Our banks have become leeches that bleed the economy of wealth. They channel capital into their own pockets rather than allocating into the ‘real’ economy. This is one of the primary – it may be the primary – causes of the failure of the free market era. This is, or course, ironic. That the great deregulatory impulse should have been the factor preventing free market economic policies from unleashing above average growth is an astonishing indictment of that entire set of ideas. yet it is the truth. The unfettering of the banks allowed them to syphon capital away from more productive uses and into their own pockets. It facilitated a surge in earnings for bankers, at the cost of much lower growth in wages for everyone else. Banking crippled us. Banking robbed us of our future.

And that is where we find ourselves today.

The bitterness of the banks opposition to financial reform only proves my point: they are very well aware of the personal losses they will sustain as a result of reform. And this is from what I consider to be fairly weak reform. It is a testimony to the subversion of our politics by the banks, that we were not able to effect a stronger set of reforms. I am in the camp that argues that last week’s legislation is a beginning and not an end. We will be faced by new financial crises sooner rather than later, and only then will we grapple with the big issues that were avoided last week.

Meanwhile the economy is improving slowly and will likely grown around 2.5% this year. Perhaps even a little more. This is an upgrade of my prior forecasted growth, but is still well below that of the Fed and many other forecasters who are now looking for growth of around 3.5%.

My skepticism is based on the damage that the banks have done. They still deploy far too much capital into proprietary trading and not into making old fashioned loans. Without those loans business expansion will be more difficult. Traditional forecasters tend to downplay the importance of the banks in their predictions. This is because free market economic theory has no place for banks. Since banks are intermediaries, free market theory ignores them and focuses only on the end uses of capital. The idea that capital can be under-employed, or even wrongly employed, never affects traditional theorists. They are wrong. And this crisis is a perfect example of why they are wrong. Banking is a central economic activity. Economic theories that ignore this will underestimate the damage a failed banking system will do. More to the point they will ignore the negative drag that a bad banking system will have on a recovery.

So, unfortunately, fixing the banks remains an issue on our agenda.

And so does the federal deficit.

At some point we will have to reverse the incredible laxity of the Reagan/Bush era. As I have said before: they are the only two presidents in our history to have grown federal deficits by choice. All the other deficits were of necessity – caused by things such as war or recession. This legacy is the challenge we face in fiscal policy, and not the unwinding of the stimulus which is small by comparison, and which will fade away as the economy recovers. No, our big challenge is now the correction of the revenue losses caused by the Bush tax cuts, and the control of entitlement and defense spending.

Getting the deficit under control is more a medium term issue than a near tern issue. The recovery is still too fragile for us to entertain serious cost cutting or to indulge in too many tax increases. But both are definitely part of the future – perhaps in 2011 or 2012. Of course the political calendar will play its part in just how successful we are in getting sensible long term policies. America remains addicted to its military sector and so cutting spending will be very difficult even after we are extricated from the Iraqi disaster. Meanwhile social opposition to fixing soaring entitlement costs makes getting that part of the budget under control just as difficult. We are destined to re-debate health care sooner rather than later as medical costs continue to eat up a far too large a portion of our wealth. Fixing social security is a much more easy task from a financial perspective, but it does entail changes in retirement age, payroll taxes, and caps on those taxes, none of which will be popular.

So in many senses we are still having the same discussion, even after all the arguments of the last two years.

If there is a single theme I notice, it is that our leadership has been too weak to tackle our problems with force. We are crippled by deep divisions that stop us from coalescing around a solid consensus. The rise of the tea party in politics shows how disconnected many voters are from the realities of policy implementation. Instead there is a visceral anger against all policy. There is a self-destructive tenor to the tea party that scares me. It is a movement taunted by extremism. It is a rebellion against all legislation. And it is a desperate attempt to reinstate something that never existed.

As I said earlier, our very best years came during a period of heavy government intervention in the economy. Our worst years came after we eliminated that intervention. Whether there is cause and effect in those facts I will not argue here, but they refute the tea party line of reasoning totally.

Our recovery is not simply a function of our getting the economic policies right. It is also a function of our political system and its ability to stay on an even keel. Never in the post war era have we faced such an uncertain political climate. That uncertainty will be the single largest determinant of whether we get the economics right. We cannot afford a deeper plunge into political extremism.

That’s the story to watch over the summer.

The story so far is one of action against disaster by both Bush and Obama, followed by a reaction against the repudiation of the right wing dominance of policy thinking implied by those actions. That reaction has limited our ability to fight the crisis. But despite the reaction the new era policies have taken hold sufficiently to keep us afloat. If, and only if, we can maintain the ascendancy of the new policies we will stave off depression and heal the economy. The elections this fall will play a key role in determining that outcome.

Meanwhile I am off to Vermont to write a book.

I will post infrequently as the news dictates.

Enjoy the summer.