Friday, August 5, 2011

The Choices of 2008, the Consequences for Today (Caution: Very Dark)

It’s always a good idea to try to see the present as a moment in history, in relation to the main forces at work.  By now it can no longer be denied that the US and European, and therefore world, economies are in serious trouble.  We are awash in analyses that examine at close distance the various aspects of our predicament: beleaguered US consumers, sovereign European borrowers who can’t keep treading water as their interest rates rise, and misguided politicians and policy chieftains on both continents who provide half measures at best on top of perversely procyclical fiscal and monetary blunders.  All this is true.

But let’s go back to the critical moment in the fall of 2008 when global markets froze and, in the midst of crisis, decisions had to be made about fundamental economic strategy.

The runup to the crisis was, in broad terms, marked by several developments:

US households had substituted debt for income, borrowing through every available channel and particularly against their increasingly fictitious housing equity.

  • Global imbalances reached stratospheric proportions, with housing bubbles, directly or indirectly inflated by capital inflows, becoming the vehicles of choice for financing surplus expenditures in deficit countries, including peripheral Europe.
  • The exposure of financial institutions to real estate price volatility was both amplified and concealed by a hyper-complex pyramid of derivative instruments, facilitated by reckless deregulation.
  • There was massive malfeasance on the part of financial market participants and rating agencies in this process—although such malfeasance may be the norm in this arena, invisible in good times and coming to light only when prices collapse.

All of this came to a head in 2007 and culminated in the post-Lehman meltdown. At this point, policymakers had to act quickly. They faced several choices:

1. They could organize a massive debt writeoff to bring the financial system to health as quickly and thoroughly as possible.  This would involve letting insolvent lenders fail, replacing them on either an interim or long-term basis with public banks—the so-called “good new bank” idea.  Borrowers would have their principle reduced to a manageable level, freeing them from excessive servicing burdens.  Vigorous countercyclical measures would safeguard household incomes and restore demand.  Over the medium term, the sources of income-expenditure imbalances could be systematically addressed.  This was by far the preferred option, although it was also the most radical and posed high short-run risks.

2. They could put private financial institutions under temporary public control.  Investigators would go through their assets, sequestering those that had little value in a “bad new bank” and recapitalizing to the extent needed to restore an equity cushion to support those that remained.  This would have wiped out the private owners but restored the banks to viability.  Public funds could be used to ease the terms on overstretched households, particularly in real estate markets.  As with #1, temporary fiscal and monetary stimulus would be provided to the extent required to maintain effective demand, and (although most proponents of this approach did not say this) similar medium-term measures could be taken to undo the sources of financial imbalance.  This was the second-best approach, more costly and less equitable than the first, but one that would follow a well-charted course.  Its potential risks were longer-term, having to do with the public cost of subsidizing borrowers and lenders in order to preserve as much of the existing private debt obligations as possible.

3. They could patch and hope.  Flood the markets with enough liquidity that even thoroughly insolvent financial institutions would remain in business.  Provide enough countercyclical stimulus that household bankruptcies could be kept at a level that would not threaten lenders.  Regulation and structural reform would be kept to a minimum, since the more profitable the financial sector, the more equity positions could be shored up.  This third approach hardly deserved to be called a solution, except for holders of financial wealth, and even then only in the short to medium run.

So guess which way the elites turned.  A few economists (including yours truly) advocated #1, mainstream economic opinion supported #2, but in Washington, Brussels and Frankfurt it was #3 all the way.  This was not because one side or another won a war of ideas, but because all major governments are so closely tied to the financial wealth-holding class that any other approach was out of the question.

However: #3 was not a solution.

1. It did little about the true state of banks’ balance sheets.  The financial sector may be sucking in record profits, but trillions of dollars of asset values have been effectively wiped out, and it would take too many years to erase insolvency through profits alone.  The fact is, no one really knows the state of the world’s banks except for those who run them, and they aren’t talking.  So-called stress tests are conducted with the lightest of touches, using risk profiles drawn up by the banks themselves so as not to have to actually open the books.  There is still no transparency about CDS’s and other derivatives.  The agonizing over whether a Greek debt swap that lenders could accept or reject constituted a “default” and would therefore trigger doomsday claims on the derivatives market was half-farce, half-nightmare.

2. It did little about the state of household balance sheets.  Particularly in the US, where the lethal combination of extreme inequality and massive current account deficits (and a corresponding shortfall of aggregate earned income) put a substantial proportion of the population in near debt-peonage, consumer expenditures have collapsed.

3. It was an enormous drain on the public fisc.  The fact that the majority of the financial sector bailouts have been back-door (e.g. AIG, Greek bonds) does not mean that they have been small potatoes.  The deficit countries whose institutions were most at risk and needed the most cash to prop themselves up are also the ones that have run up the largest sovereign debt loads.  Hyperventilating Republicans to the contrary, the US is in the fortunate position of supplying the world’s reserve currency, so it still has considerable fiscal space to play in.  (It is true that this space is not without limits, of course, and the cost of a second, deeper dip will give us a chance to see how close we are to them.)  Not so the peripheral Europeans, who must cope with the monetary union and fiscal fragmentation of the Eurozone.  They have already bailed beyond their means, and the Eurocrats must now figure out how to convince their publics to accept cross-border transfers in order to keep the bailouts of core banks flowing.

So here we are.  We are on the brink of second, perilous dip into the wild eddies of the Great Recession.  Financial institutions in the US and Europe remain exposed, but we don’t know how much.  Our leaders have been so dishonest about the choices they have made, the reasons for those choices, and the costs they have passed on to us, that they have been reduced to pure gibberish.  (“The recovery is on course.”  “The banks are closely regulated and no longer at risk.”  “Austerity will restore growth.”)

I wish Marx were right, that our governments could have the competence and vision to serve as executive committees of the ruling class.  Maybe they did that once.  But today the class that occupies the driver’s seat is diffuse and has little in common other than a desire to earn the highest rate of risk-adjusted return on its portfolio.  They speak dozens of languages, pray to many gods or none at all, hold all sorts of political views and know only a handful of their peers.  There is no guiding hand or collective wisdom, just the demand to keep the cash flow flowing.

I predict it will flow until it stops, when the last short-term palliative has been exhausted.  Even more, I am worried about the political reaction if economic conditions continue to deteriorate.


Post a Comment