Averting a Meltdown

Averting a Meltdown December 1, 2009

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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