Looking for a New Normal

A very useful read appeared in the Washington Monthly by James K. Galbraith. In it he provides an excellent analysis of the assumptions inherent in Team Obama's response to the economic crisis over the past several months. He diagnoses the problems with these assumptions, and presents a series of alternative ideas that could shape the President's response to the current economic crisis in a fundamentally different way.

So, what are these assumptions and how do they fit into Obama's policy response? Galbraith sums it up this way,

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.

But, there is more, how does current policy plan to return the economy to "normal." Here's more from Prof. Galbraith,

The chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."he chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."

But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker’s campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan’s chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.

The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

So, it is not likely that we can return to the "normal" of the last few recessions. Yet, this is precisely what is planned and hoped for in the current policy climate. Obviously, we have a very large disconnect here. A disconnect that I suspect will become more and more apparent to policy advocates and policy makers alike in the coming months. It is only unfortunate that in their rush to return the economy to a "normal" footing, so the usually party political agendas might resume in time for the 2010 elections, Team Obama has gotten it, partly, wrong -- specifically in their attempts to save insolvent banking behemoths in the most inefficient manner possible. Here's Galbraith

Geithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.

Geithner is continuing Paulson's policy of intervening in the financial sector without (1) requiring any substantial changes in bank management (2) addressing the real reason the demand for credit has collapsed, households and businesses can not assume the risk associated with additional debt giving their deteriorating balance sheets. Unfortunately, we are already beginning to see the negative consequences in the bad behavior of financial firms that are currently being propped up with infusions of government money.

When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.

The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?

This point is quite serious, for it portends a period of financial recklessness as government backed actors, who are not held accountable in any appreciable way, seek financial returns for themselves in any way that they can, regardless of the long term consequences! So, one concern is that large banks and other insolvent financial actors will turn to complete financial recklessness as their "new normal." The consequences for the US Government that has guaranteed the losses from this reckless behavior is that the value of the treasuries that it issues to pay for the losses will come into serious doubt, as there is little long term investment going on and a lot of short sighted gambling in the economy.

For households, one can envision a "new normal" as well. Essentially, households will learn to save for those needs beyond their basic day to day expenditures rather than rely on credit and future income to pay for present consumption as they have in the recent past. In the short term, this inevitably means a collapse in demand as households, even those not greatly effected by the current downturn, build up their savings. Once this adjustment has been made, I suspect that consumer spending will return. Of course, this depends on whether or not the overall economy can return to a more productive state. That would mean building up industries that offer higher wages in exchange for higher worker productivity and also industries that look forward to the needs of this century rather than the needs of the century past. Galbraith also suggests that we should be investing in human capital (i.e., education and knowledge production) and human health as well as basic infrastructure that moves us away from the 20th century model of energy profligacy and toward a 21st century model of energy efficiency. Galbraith makes a number of suggestions at the end of his article that might just do the trick. Of course, to see policy shift in the direction Galbraith suggests, Obama is going to have to sack his entire economic team. I would hope that he calls Galbraith up and ask for suggestions about who to bring in as their replacements! His article is definitely worth a read for all who are interested.