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We Told You So

An advance memorandum on the jitters

Like many Americans, I was doing everything I could to help elect Barack Obama. It wasn’t all that much—but as an economist in Texas, I had some authority on the thinking of former Senator Phil Gramm, John McCain’s chief economic adviser. I’d made the front page of the Washington Post describing Gramm as a “sorcerer’s apprentice of financial instability and disaster.” (Gramm, with a certain sense of humor, denied it.) For that, and for my experience drafting policy papers, I was in contact every few days with Obama’s economists.

To economists in my own circle, it had long been clear that the financial crisis then unfolding was an epic event. We had watched the subprime mortgage disaster build up. In August 2007 we knew the meltdown had begun. Bear Stearns had failed. But for reasons that have to do with the pace and rhythm of politics, these issues remained on the back burner, the campaign being dominated by health care and the Iraq war. For those of us on the outside, it was hard to know whether the insiders understood what was coming.

And so it seemed a good idea to raise an alarm. But here you confront the Cassandra paradox: if you predict disaster, no one believes you. Economics is rife with alarmists; if the wolf really is at the door, it’s better to have a whole chorus saying so.

For this I had the help of the Charles Leopold Mayer Foundation for Human Progress, which convened a meeting in Paris. When you invite twenty friends to spend a few days in Paris in June, it’s rarely hard to persuade them to come. Among the Americans in the group were the editors of two important journals, a former United Nations financial expert, and the former federal regulator who had blown the whistle on the savings and loan fraud. There were also senior specialists from France, Britain, India, China, and Brazil.

The meeting had no political connection, but one result was a long memorandum, which I sent in early July to the Obama team. I do not know whether, or by whom, my memo was read. Not the slightest word came back.

Yet the memo disproves the notion that nobody knew. To the group in Paris, three months before Lehman, what I wrote was obvious. It was our consensus view. What follows is an excerpt.

The most important common ground was over the depth and severity of the financial crisis. We placed it in a different league from all other financial events since the early thirties, including the debt crises of the eighties and the Asian and Russian crises of the late nineties. One of us called it “epochal” and “history-making.” And so it has turned out. What distinguishes this crisis from the others are three facts taken together: (a) it emerges from the United States, that is, from the center, and not the periphery, of the global system; (b) it reflects the collapse of a bubble in an economy driven by repetitive bubbles; and (c) the bubble has been vectored into the financial structure in a uniquely complex and intractable way, via securitization.

Bubbles are endemic to capitalism, but in most of history they are not the major story. In the ninteenth century, agricultural price deflation was a larger problem. In the twentieth, industrialization and technology set the direction. It was only in the information technology bubble of the late nineties that financial considerations—including the rise of venture capital and the influx of capital to the United States following the Asian and Russian crises—came to dominate the direction of the economy as a whole. The result was capricious and unstable—vast investments in (for instance) dark broadband, followed by a financial collapse—but it was not without redeeming social merits. The economy prospered, achieving full employment without inflation. And much of the broadband survived for later use.

The same will not be said for the sequential bubbles of the Bush years, in housing and now commodities. The housing bubble—deliberately fostered by the authorities that should have been regulating it, including Alan Greenspan and Ben Bernanke—pushed the long-standing American model of support for homeownership beyond its breaking point. It involved a vast victimization of a vulnerable population. The unraveling will have social effects extending far beyond that population, to the large class of Americans with good credit and standard mortgages, whose home values are nevertheless being wiped out. Meanwhile, abandoned houses quickly become uninhabitable so that, unlike broadband, the capital created in the bubble is actually destroyed, to a considerable degree, in the slump.

Securitization is a long-standing practice but the question is, at what point does it go too far? It should be clear by now that non-conforming home loans cannot be safely securitized, because the credit quality and therefore the value of the asset cannot be reliably assessed. Further, in the regulatory climate of recent years (where as William K. Black pointed out, political appointees brought chainsaws to press conferences), ordinary prudential lending practices broke down completely. The housing crisis was infected by appraisal fraud, a fact overlooked and therefore abetted by the ratings agencies. “No one looked at the loan package.” Now the integrity of every part of the system, from loan origination to underwriting to ratings, is under a cloud.

Fraud is deceit, a betrayal of trust. And it is trust that underlies valuation in a market full of specialized debt instruments, off-books financial entities, and over-the-counter transactions. That trust has, as of now, collapsed. The result, as John Eatwell phrased it, is that financial crisis takes the form of market gridlock—a systematic unwillingness of institutions to accept the creditworthiness of their counterparties. This is, of course, especially grave where a counterparty has no direct resort to a lender of last resort—and so the crisis naturally erupts in parts of the system that are outside the direct purview of central banks. Deregulation is, in other words, a vector of financial crisis.

The message of all this for the Obama presidency is fairly clear. No one in the group expects the financial crisis to have disappeared, or even to be under stable control, by January of 2009. At that time there will no doubt be immediate priorities: more fiscal expansion, fast action against the wave of home losses to foreclosures, plus fast action against financial speculation in commodities would seem as of now to head the “to-do” list. But the financial problems will not go away. And that means that a seemingly benign credit expansion, such as got underway for Clinton in 1994 and carried him through his presidency, is not in the cards for Barack Obama.

Given the fact that vacated and unsold houses (unless destroyed outright) stay in inventory for a long time, there is little prospect of a housing recovery, or that a new expansion of loans to the broad population will be collateralized by home values any time soon. Recovery from this source should indeed not be expected within the policy horizon of the next presidential term. Something could happen, for reasons largely unforeseen, as it eventually did in the 1990s. But to bank on such a happy development would be an act of faith. More likely, there won’t be good news on the growth front in 2009, 2010, or 2011. Achieving economic growth in some other way will therefore be an overriding policy preoccupation.

The only other known way is fiscal policy, and this raises two questions: how much fiscal expansion will be needed, and over what time horizon?

Calls are now being heard for a “second stimulus package”; these reflect the fact that the first stimulus package [the Bush package of Spring 2008], while effective, was necessarily short-lived. But the same will be true of the second stimulus package. And once the election is over, will the coalition presently supporting short-term stimulus stay in place? If not, what then?

If the above analysis is correct, the political capital of the new presidency risks being exhausted, quite quickly, in a series of short-term stimulus efforts that will do little more than buoy the economy for a few months each. Since they will not lead to a revival of private credit, every one of those efforts will ultimately be seen as “too little, too late,” and therefore as ending in failure. Meanwhile a policy of repetitive tax rebates can only undermine the larger reputation of the country; it is unlikely that the rest of the world will happily continue to finance a country whose economic policy consists solely of writing checks to consumers.

What is the alternative? It is to embark, from the beginning, on a directed, long-term strategy, based initially on public investment, aimed at the reconstruction of the physical infrastructure of the United States, at reform in our patterns of energy use, and at developing new technologies to deal with climate change and other pressing issues. It is to support those displaced by the unavoidable shrinkage of Bush-era bubbles but to do so efficiently—with unemployment insurance, revenue sharing to support state and local government public services, job training, adjustment assistance, and jobs programs. It is to foster, over a time frame stretching from five years out through the next generation, a shift of private investment toward activities complementary to the major public purposes just stated. It is to persuade the rest of the world that this is an activity worthy of financial support.

As noted, this strategy will have to be developed in a hostile environment of unstable oil and food prices. However, it would be a grave mistake to interpret that unstable price environment as “inflationary,” as leading toward a sustained or inertial inflation. In particular, money wages have not changed or caught up; real wages are therefore falling—and quite sharply—in view of the commodity price jumps. As Ben Bernanke acknowledged in a recent speech, nothing in the present movement of price indices can be attributed to wages. In Bernanke’s choice phrase, “the empirical evidence for this linkage is less definitive than we would like.”

It is Democratic Party mantra that Presidents do not comment on the actions of the Federal Reserve. But in this situation, comment is needed. An appropriate comment on the larger role of monetary policy does not amount to interference in routine decision-making, e.g., of the Federal Open Market Committee. Rather, it should reflect the core reality: the Federal Reserve and other financial regulatory agencies failed in their responsibilities in the past decade and now they must take up those responsibilities again.

The entire point of a regulatory system is to regulate. It is to subordinate the activities of an intrinsically unstable and predatory sector to larger social purposes, and thus to prevent a situation in which financial interests dictate policy to governments. That is, however, exactly the situation we have allowed to develop. The job of the Federal Reserve and of the other competent agencies in the next administration must be, in part, to reestablish who is boss. Specifically, there needs to be a very thoroughgoing revamping of the financial rules of the road, to dampen financial instability, deflate the commodity bubble, reduce the enormous monopoly rents in the financial sector, set new terms for credit management, and generate productive capital investment where it is most required. This is in large part the Federal Reserve’s job, though it has strong inter-agency and international dimensions.

These measures cannot be viewed, or undertaken, in isolation from the international financial position of the United States. Obviously, a successful speculative attack on the dollar would severely disrupt the orderly implementation of this or any other strategy. Equally obviously, a unilateral defense of the dollar via a campaign of high interest rates would severely aggravate the problems of the real economy.

The way out of this dilemma—the only way out—lies in multilateral coordination and collaboration: a joint effort by the United States and its creditors. And this means that the next administration must return, rapidly and with a credible commitment, to the world of collective security and shared decision-making that the Bush administration has been at pains to abandon. An orderly disengagement from Iraq would send a major signal of the intent of the U.S. government to play, in the future, by a different set of rules.

Collective security, in short, is not merely a slogan. It is the lynchpin of our future financial and economic security—security that cannot be assured by any unilateral means. Only a collective effort will keep America’s creditors committed to the stability of the dollar-reserve system for long enough to effect the next round of economic transformation in the United States. Conversely, continued failure to appreciate the financial and economic dimensions of unilateral militarism is one certain route toward the failure of the next administration’s economic and financial strategies. The two largest issues we face—how to maintain American economic leadership in much of the world and how to manage American military power—cannot be separated from each other.

Collective security is, however, also more than simply a way of reducing risks and instabilities. It is the foundation stone for many physical transformations of the economy to come. It is obvious, in particular, that the military basis of international power on which the United States continues to rely is completely out of date, and has been for decades. As Iraq has demonstrated to everyone, including the professional military, military power alone cannot deliver stability and security at all—let alone at an acceptable human and social cost. Yet parts of the military establishment continue to develop, and to harbor, the technological talent and capacity for problem-solving which every aspect of our energy problem now needs. Shifting the basis of our security system away from one based on military equipment is a key step toward making those resources available.

And the same is true for other countries. China, for example, has long made energy choices favoring coal partly because the resulting power plants are diffuse and militarily expendable. In a secure world, that country would be far more willing to develop its vast hydroelectric potential, as the then-invulnerable United States did in the 1930s. Hydro power is carbon-clean, but militarily exposed. A stable reduction of military fears is a key step towards opening up markets that can potentially permit resolution of collective problems on the grand scale.

In short conclusion: from the beginning, the Obama presidency will face acute situations requiring immediate action, especially in oil and housing. It should aim for early victories in these areas as the foundation stone for intermediate- and long-term programs. For the medium term, institution-building and the restoration of competent and effective regulatory power over the financial system—both national and international—will be key.

For the long term, the goal should be nothing less than the transformation of our energy base and the solution of our environmental challenges—the rebuilding of America. And that can be done only in an international financial climate made possible by a return to multilateral decision-making and a commitment to collective security. The American people are ready for this. President Obama should be prepared to explain that leadership in a world community—leadership of collective action on the grand scale—is America’s true destiny. It is not in futile warfare, but in great endeavors, that a great nation finds its future, its purpose, its place in history, and prosperity, as well as security, for its people.