Averting a Meltdown

It’s more than a year now since Lehman collapsed and the global economy went into tailspin. Memories tend to be short, but it’s worth recalling quite how serious the situation was back then. Take a look at this chart:

This shows world industrial output during the Great Depression and today. As is clear, we followed the same pattern. The same panicked conditions prompted a global collapse. But something happened this year. The meltdown was averted, and the global economy is on the way back up.

This is not an accident. It comes from the policies put in place by policymakers all over the world. In doing this, they learned the lessons of the Great Depression – policies should combat the crisis, not make it worse. So what did they do? First, they loosened monetary policy dramatically, pushing interest rates to almost zero. Even then, they did not stop, but went for quantitative easing – central banks bought assets directly. Second, they deployed fiscal policy, allowing deficits to run up on account of the recession, and added to this with fiscal stimulus. Why was this necessary? Well, when monetary policy hits the zero bound, you have pretty much run out of ammunition. But it’s more insidious than that – at zero interest rates, you have a liquidity trap. Nobody wants to lend and everybody hoards money. As Keynes showed, the only way out of this situation is to use fiscal policy. Third, governments injected money into damaged financial sectors, recapitalizing banks and extracting dodgy assets from balance sheets. And all of this was done in a collaborative manner by countries all over the world acting together. This was another lesson learned from the Great Depression.

And yet, like the hobbits of the shire oblivious to the efforts of others to protect them from ruin, many people in the United States are attacking the government for implementing the very policies that staved off a meltdown. Let us remember that in severe recession, the poor always suffer the most, especially through unemployment. Let us remember that the poor in low-income countries, living in dire poverty without any social safety nets, are especially hard hit.

I see criticisms in four areas, each reflecting a particular fallacy. I will take each in turn.

Fallacy #1: The government should have let failing institutions fail. This is a point made by the right (free markets always work!) and the left (don’t bail out the bastards that caused the crisis!). While I am sympathetic to the latter point, I think it is ultimately the wrong perspective. We all saw what happened when a behemoth like Lehman, with tentacles reaching all over the world, failed. If the credit system breaks down, it is ultimately workers who will suffer, not bankers. This is not to say it could not have been done better – I certainly think some in the Obama administration were too close to Wall Street and did not work hard enough to get the bankers to bear an adequate share of the burden. But it’s not too late – we can fix that through better regulation and taxes.

Fallacy #2: Fiscal stimulus makes things worse. My response to this is, what planet are you living on? As noted by Martin Wolf, “between the fourth quarter of 2007 and the second quarter of 2009, the balance between US private income and spending shifted from a deficit of 2.1 per cent of gross domestic product to a surplus of 6.2 per cent – a swing towards frugality of 8.3 per cent of GDP.” If the public deficit had not widened by a similar amount, the economy would simply have collapsed. Now, we can certainly quibble over whether the fiscal stimulus contained the best measures to boost employment, or whether the lags are too long, but we cannot argue that it doesn’t work (and indeed, Republicans in Congress denounce it on one hand, while lapping it up at the local level). The main argument for why it wouldn’t work is that it borrowing would crowd out private demand by pushing up interest rates. But interests rates are at historical lows.

Fallacy #3: The crisis was caused by the poor and minorities taking on debt they could not afford. There really is a parallel reality out there where Barney Frank pushed dodgy loans on poor people, and they defaulted. In other words, the crisis had nothing to do with excess liquidity in the system, with lax regulations, with complex financial engineering, or with trying to ride an asset bubble. This is almost too silly to warrant a serious response. I will just say that the majority of subprime loans went to people with credit scores high enough to qualify for conventional loans. Or that the vast majority of subprime lending came from institutions not subject to the Community Reinvestment Act. Or that commercial real estate loans (made to rich white developers) are in far worse shape than subprime home lending.

Fallacy #4: The budget deficit is the worst economic problem facing the country. Every day, we see scary dollar numbers of projected public debt at some point down the line. As a start, these numbers should be deflated by GDP, which is also growing. There is so much confusion here. People confuse the effects of the recession on the deficit with discretionary policy. People confuse the TARP with the fiscal stimulus. This fallacy is related to the second fallacy, and the response is the same – do you seriously think that we should un-learn the lessons of the Great Depression and cut spending in the middle of a severe downturn? As Paul Krugman notes, “the Federal government is able to borrow cheaply, at rates that are up from the early post-Lehman period, when market were pricing in a substantial probability of a second Great Depression, but well below the pre-crisis levels.” In other words, there is no real risk of inflation or concerns about government solvency. The real issue is unemployment above 10 percent. The real issue is the remaining risk that the economy could plunge downwards again.

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  • http://writerdood.wordpress.com/ writerdood

    Thank you for making sense. This was a nice write-up.

  • http://www.catholicpeacemaking.com Nate Wildermuth

    While what you write makes sense, and while I am no economist, my ‘gut’ tells me that we’ve only delayed (and magnified) the inevitable collapse of our idolatrous economy. The higher the market goes, the harder it will fall. IMO.

  • digbydolben

    it’s not too late – we can fix that through better regulation and taxes.

    What sign is there that Obama intends to do this? I see absolutely none–and meanwhile he intends to take on more debt, with more trillions of dollars spent on a pointless, useless, doomed military expansion into Iraq. I voted for him, I contributed to his campaign, and I feel that I’ve been had. He’s just another tool of the establishment.

  • digbydolben

    I meant “Afghanistan” above, of course.

    Do you know that it’s estimated to cost one million dollars to move and support EACH of the 30,000+ soldiers he’s planning to send into that meat-grinder?

    America never, EVER learns from her colossal mistakes. I feel like I’m reliving Vietnam.

  • digbydolben

    How does it help the “economy” of the U.S. for the infrastructure not to be rebuilt by huge numbers of unemployed (as promised), while the war profiteers make huge profits enabling THIS:


    I’m actually beginning to believe what the libertarian press says about murder and mayhem being acceptable by “liberals,” so long as the war crimes are being committed by Democrats!

  • Liam


    I am unconvinced by the “seven good years leads to seven bad years” theme. It’s not as neat as that, by a longshot, and our guts tend to want to interpolate/project patterns onto things where they do not necessarily exist. It’s a feature of the dopamine running around our neurons. Learn to distrust it a bit.

  • Steve

    I am also no economist, but if there is no real risk of inflation or government solvency, then why are the Chinese, Russians and others calling for a new reserve currency?

  • http://www.patheos.com/blogs/voxnova Morning’s Minion

    Steve: that’s a much bigger question! The problem with the dollar as a reserve currency now means that, to supply dollar assets to the countries that want them (think China), the US has to run ever larger current account deficits (basically, borrowing from the rest of the world). Now, because it is a reserve currency, the US can finance these deficits pretty cheaply, certainly cheaper than any other country. This is something most Americans don’t understand – their debt-fueled spending spree could happen for a long time because foreigners need reserve assets. But there is a limit to everything. Eventually, the debt will get too big (and I mean external debt, not government debt) and people will start worrying. They will pull out of the dollar.

    Here’s where it gets interesting today: the old model is dead. The old model had China exporting lots of stuff and US consumers buying it. The flip side of this was the Chinese taking that foreign currency and buying US assets and the US getting more into debt. But US, after the crisis, US savings have risen. The debt-fueled days are over. So China can’t do so well by exporting. So what needs to happen? A switcheroo – China needs to move toward domestic demand and the US needs to move toward exports. In this world, the remnimbi must appreciate relative to the dollar. This is not good for a reserve currency, which is why there is a push for a shift away from the dollar.

    Note that this really has nothing to do with the dollar per se. Its a dilemma faced by any reserve currency, which is why a lot of people want to move from a single currency to a basket of currencies.