Economics Financial Crisis History The Opinionsphere

Theories of the Financial Crisis: The Government Did It!


The first person out of the box promoting the idea that the current financial crisis was actually caused by the government (specifically Democrats in the government – and even more specifically Barack Obama) was Rush Limbaugh. On the day Lehman fell (this crisis’s equivalent of September 11), Rush Limbaugh was already trying to exploit it for partisan gain – claiming “Capitalism Isn’t the Problem: Government Caused This Crisis.” On this date of crisis, Limbaugh had already unveiled in a near-complete form what was to become the Republican party’s position on the crisis. He embraced positions that had previously been associated with the Austrian School of Economics – but without much of the ideological baggage they had with them. He only embraced as much of them as was politically convenient – and he applied them only so far as they made Democrats look bad. He also began blaming Barney Frank for this crisis – something which many other right-wingers picked up on. Though I for one find it hard to see how this person who was a member of a Congressional minority had so much power to influence the entire economy and cause this severe crisis and the causal chain has never been made clear. At least to me.

Within a few days of the near-collapse of the financial system – with the crisis still causing panic – Limbaugh was already trying out names he could use to brand the crisis – from the “Democrat-Caused Financial Crisis” to the “Obama Recession.” None of them quite caught on as most people with common sense found it hard to blame Barack Obama for a crisis that occurred before he had won the presidency. But the right faithfully repeated this meme. (It has often seemed to me that Rush Limbaugh – with his vast influence via memes and love of pranks – is a forerunner of and competitor to 4chan.)

I need to say two things going into this: (1) for my analysis, I am merely standing on the shoulders of economists more knowledgeable than I – when it comes to economics especially, I am – clearly – just an interested amateur; and (2) I came to this issue biased against this theory of the financial crisis – although not with my mind closed to it. The best expression of why I started out biased against this idea is probably the analogy Tyler Cowen used while debunking it. Cowen invoked the legal principle of the “thin skull” – in which someone at fault is considered responsible for all the damage caused by their actions, even if a person without a thin skull would not have been seriously hurt by such damages. For example, if you were responsible for a car accident and the other party was injured seriously as they had a thin skull which was damaged much more than a normal skull when it banged into the side window, you would be responsible for even the extraordinary damages resulting from that individual’s medical condition. Cowen explains that those seeking to blame the government for the business cycle and/or the current economic crisis:

…are postulating a very thin skull for markets and then blaming government for the disaster which results from government’s glancing blow to that skull.

A surprising amount of the debate over what caused the current crisis centers around the causes of and solutions to the Great Depression. The reason for this is not because there is widespread disagreement about this among historians or economists – but because the Republican party has embraced recent revisionist histories to make their case against the current intervention. The traditional understanding – between Keynesian and members of the Chicago School is that the Great Depression was made worse by the application of variations of this “thin skull” theory – as Herbert Hoover heeded advice to do little or nothing to combat the financial crisis – preferring to allow the market to fix itself. As Paul Krugman describes (from a 1998 Slate column):

The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression—with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore “sham” prosperity by expanding credit and the money supply.

But Amity Shlaes authored a recent history of the Great Depression to dispute this traditional understanding which had made her a hero of Republicans everywhere who have begun to cite her book more often than the Bible – almost. Shlaes passes herself off as an intellectual, but seems to be as partisan as Paul Krugman on his worst days. And her understanding of economics is quite shallow compared to the Nobel prize winner’s. Jonathan Chait in The New Republic took on Shlaes book – pointing out the holes in Shlaes revisions – how she attempted to blame liberalism for causing the crisis despite the fact that liberals had been out of power for the eight years before the depression started – and for the first three years after. She manages to pull this off by claiming that Herbert Hoover was a secret liberal interventionist – and blames Hoover’s meager attempts to stop starvation for undermining the recovery that her ideology maintains was imminent. Shlaes also fails to account for how we finally got out. As Chait explains:

[T]he classic right-wing critique fails to explain how the economy recovered at all. In one of his columns touting Shlaes, George Will observed that “the war, not the New Deal, defeated the Depression.” Why, though, did the war defeat the Depression? Because it entailed a massive expansion of government spending. The Republicans who have been endlessly making the anti-stimulus case seem not to realize that, if you believe that the war ended the Depression, then you are a Keynesian.

James Glassman’s influential arguments (in some circles) against any stimulus plan seem to have been inspired mainly by Shlaes’s flawed history.

Today’s crisis appeared at first glance (to most economists and us less enlightened citizens) to have been caused not by government interference but by private bankers controlling vast sums of money taking dumb risks with little government oversight. In time, other factors have come to the forefront, but this basic explanation seems right. Yet right-wingers and the Republican party continue to insist that government intervention was the cause – often out of what they see as a political necessity.

But on the other hand, there are some who seem to have less of a partisan interest in blaming the government for this crisis – and have embraced the Austrian School of Economics out of conviction rather than temporary partisan gain. Ron Paul, for example, blames both Democrats and Republicans for causing this mess. He seems to accept this “thin skull” logic and he has become an influential proponent of the Austrian school of economic thought. This school had its heyday in the 1920s as a result of Hayek, Mises, and others grappling with the issues of that time and perhaps most importantly discovering the business cycle. But this theory was largely abandoned as many saw it as responsible for worsening the Great Depression – as during the first years of the crisis, portions of the Austrian School’s prescriptions were tried. The theory was largely developed before the invention of central banks and while currency was still on the gold standard – but it had important insights in its time. Contemporary proponents such as Ron Paul tend to blame the changes to the financial system created to manage the boom-and-bust business cycle for causing the boom-and-bust business cycle. Yet this cycle has been part of capitalism since it’s inception – and has been managed since Great Depression by central banks and others using Keynesian theory and its successors relatively successfully. 

The appeal of this Austrian School of though though – aside from the partisan appeal for Republicans who are allowed to blame everything on liberals – is a moral one. It functions as a kind of religion-like palliative, telling a comforting story of sin and redemption. The Austrian business cycle tells of a recurring morality tale in which virtue is corrupted, until the sin of easy credit leads to the fall of the system. Then, the Market cleanses the world and virtue is restored to it’s proper place. The proper role of the economist in this is to act as a kind of priest – urging the people to stay true to this belief system in the face of adversity – to keep their faith that eventually the god of the Market will make everything better.

This fits well with the religious right of the Republican party – and perhaps this is why despite the theory’s rejection by most mainstream economists as outdated, it is gaining adherents among the Republican party, including the “rising star” Michelle Bachman.

[Image licensed under Creative Commons courtesy of elandru.]

Economics Financial Crisis History

James Glassman’s Debatable History

James K. Glassman is the brilliant journalist and opinion-maker whose Dow 36,000 was published just before the tech boom crashed. In this book, he claimed that stocks were woefully undervalued and would rise sharply, with the Dow Jones Industrial Average reaching 36,000 by 2004 – at the latest. This prescient thinker has now written what is turning out to be an influential piece in some circles. For one, House Minority Leader John Boehner cites it on his blog. ((“Wait, he has a blog?” “Yes, he actually does.”)) I even saw some people reading print-outs of the article on my train – which is fairly unusual. It strikes me as an article written for those who already want to agree with the conclusions – and that it’s premises aren’t defended as much as stated as implicitly true.

For example, Glassman makes five historical claims which are – at best – debatable. I am not an expert on economic history – and I am sure Glassman can find an economist who will agree with each of these claims. But my understanding is that they are contrary to the general consensus.

  • From the stock market crash of 1929 to the attack on Pearl Harbor, “fiscal stimulus simply did not jump-start the economy.”

    While it’s clear that the New Deal spending did not get us out of the Great Depression, the economy had made significant progress before Roosevelt raised taxes in 1937 causing a sharp downturn. (See especially the graph of Gross Domestic Product that Paul Krugman produces. It makes clear how disingenuous Glassman is being with the above remark.)

  • “[C]onsidering the fact that federal spending tripled during the Great Depression, rising from 3 percent of the country’s gross domestic product to nearly 10 percent in 1939, it does not seem the likeliest explanation” that “World War II and the unprecedented infusion of government dollars” was what brought us out of the Great Depression.

    This claim  is somewhat silly. Glassman fails to account for several basic factors: (1) Stimulus would not work to push the economy into growing in theory unless it was significant enough to counter the downturn. If the economy dipped more than 7% during the Great Depression, then this surge in federal spending would not have been sufficient to counter it. (2) States and other local governments cut their budgets and raised their taxes during the Great Depression, reducing the amount of total government spending more than the federal government was willing to make up. (3) Roosevelt also raised taxes significantly in 1937, thus offsetting the stimulus measures to some degree – and throwing the country into a devastating downturn within the Great Depression. (4) The spending during World War II dwarfed that of the New Deal – it just doesn’t make sense to claim that because spending increased significantly during one period that if it increases still more, it wouldn’t have any effect.

  • “[E]fforts [to stimulate the economy through government spending] during the ten subsequent recessions proved…ineffective.

    Another seemingly true but misleading statement. As the Congressional Research Service explained in their report on economic stimulus (CRS – Report R4104 – Economic Stimulus: Issues and Policies) during the past 8 recessions, legislation was only enacted before the end of the recession once. Government spending was ineffective in combating all of these recessions because it came after the economy had already recovered – and as Glassman acknowledges, the one timely stimulus plan is generally agreed to have had some effect, if not an effect as large as expected. With escalating job losses and many other dire economic indicators, action now would seem to be timely.

  • “It appears that the current sickness occurred because the Fed, in an effort to keep the economy stimulated after the collapse of the tech-stock bubble and in the wake of September 11, cut interest rates far too much during 2001 (from 6.5 percent at the start of the year to 1.75 percent at the end) and waited too long to raise them, making credit so easy that businesses expanded beyond all reasonable bounds, and banks, flush with cash and trying to make higher returns, shoveled money at borrowers with poor credit; risk aversion disappeared, and loans, especially to home buyers, went bad.”

    This is a theory – and not an entirely implausible one – but it seems hard for me to presume this – or to accept that this was the only cause – with so many other factors at work. It is a classic Austrian explanation for any recession. Glassman – while portraying Keynes as an enabler of ideological solutions to the business cycle – fails to acknowledge that his explanation is equally driven by ideology. And regardless – there are more than enough alternate explanations to call into question placing all of our faith in a single ideological explanation. 


Are We Entering Another Great Depression?

[digg-reddit-me]Question: Are we entering another Great Depression?

Answer: I don’t think so, but I’m not an economist. (Though I did write a very popular piece on 11 Things I Learned While Trying to Figure Out the Financial Crisis a few weeks ago – which makes me a certified internet expert.)

Here’s why I don’t think we’re entering another Great Depression.

First, my understanding of the Great Depression is that it was – in essence – a crisis in the financial markets caused widespread fear and panic unchecked by the government. And as people lost faith in the financial system, it led to a paralysis of the entire economic system. The problem was not as much in the “real economy” – the economy whose primary purpose is to create products and services for uses other than creating profit – but in the financial economy – the part of the economy whose primary purpose is to redistribute excess wealth to create profits. The Great Depression was also worsed by the physical calamaties that hit America at the same time – most especially the Dust Bowl which devestated America’s farming belt – but at it’s core, the Great Depression was a matter of a broken financial system.

Since that time, a few factors have changed financial markets:

  • there has been a dramatic increase in liquidity, as money is able to be transferred almost instantaneously anywhere in the world;
  • the entire financial system has become remarkably interdependent and interconnected – so much so that the failure of one relatively small company directly effects most of the world’s financial institutions;
  • enormous amounts of data are collected and analyzed about the economies of the world and each particular company – including often by the companies themselves;
  • an implicit government guarantee backs large portions of the financial system.

The first three items on that list seem to demand a corollary to the Feiler Faster Thesis – promoted by Mickey Kaus – which explained how “political trends that used to last for weeks now last for hours.” This thesis was used recently to explain in part why Barack Obama’s and Hillary Clinton’s big moments in the campaign never seemed to give them any momentum – or more precisely why their momentum in the press and in public polls lasted for days rather than weeks as political reporters had come to expect. The corollary related to the current financial situation would be that as players in financial markets are bombarded with increasing amounts of data and are able to make trades and move money faster, the markets themselves speed up. This helps explain the dramatic ups and downs of Wall Street in the past few months – as the indices swung from positive to negative and back to positive in an unprecedented manner. The Feiler Faster thesis also could be said to have speeded up the real economy – as computerized inventory, logistical innovations, and more precise estimates of needed supplies have made many retailers and suppliers more responsive to economic conditions. But it seems clear that though these effects have speeded up the real economy at the margins, the financial markets have begun to move exponentially faster. The Great Depression – which lasted for over a decade – could be considerably shortened by this speeding up of the financial markets relative to the real economy – and to the extent that the effect of this volatility in the financial markets on the real economy could be mitigated, the results of this crisis would be minimized. The crisis will and already has effected the real economy – but so far, while the financial markets have fallen almost 30% from their relatively stable position in August, the real economy has only marginally slowed down.

The final item on the list should also give hope to those who fear we are entering another Great Depression. Unlike in 1929, we have a government willing to act and experiment in order to jumpstart the economy. And we will soon have a government led by Barack Obama that is more pragmatic and less ideological in proposing solutions. At the same time, various national and internationals reforms instituted by governments to protect against the kind of instability that caused the Great Depression have proved their worth in the past few months – as deposit insurance, regulation, coordination between central banks, a social safety net, and prompt government action have all contributed to mitigate the crisis.

Right now, the various governments’ decisions to act as a backstop against financial instability have helped begin to rationalize the markets – and prevented fear from entirely dominating. It has been argued that if Lehman Brothers had not been allowed to fail, this fear and sense of distrust pervading the financial markets could have been contained. Of course, few would have predicted the collapse of Lehman Brothers would have such a cascading effect – except now, after the fact, as it seems obvious.

It seems likely to me that the next Great Depression will likely be catalyzed not by a market collapse – but by the collapse of a nation, especially America. As long as governments are willing to place themselves as backstops against financial instability, the markets will go up and down – but the system will hold. It may be reformed. It may evolve. But the key characteristic of the Great Depression was the hoarding of financial resources caused by a lack of trust in the market. As long as the market is able to be backed by the government, it cannot truly fail – unless the government goes first. The paradox is that a government is only as strong as it’s economy is – which brings us back to trust.

Which is why – as Paul Krugman argues – Obama must act dramatically and quickly, while he still can.

Of course, as an alternative to all this – one might propose an effective tax on hoarding, inspired by the Austrian town of Worgl’s actions during the Great Depression – perhaps with exemptions for the first $100,000 of savings per person so as not to discourage saving.

Barack Obama Economics The Opinionsphere

Krugman’s Hope: Franklin Delano Obama

Not being an economist, I find it a lot harder to argue with Paul Krugman now that he has been awarded the Nobel Prize for Economics. That makes him a certified top expect – and I am a mere amateur. And while the other Nobel prizes have made some real boners (Yassir Arafat and the Nobel Peace Prize?), the economics prize doesn’t have the same reputation. (Although the award given to Myron Scholes and Robert Merton, the inventors of the “financial weapons of mass destruction” – derivatives –  in 1997, the same year the hedge fund they had helped create went spectacularly bankrupt – seems quite the bad decision today.)

Regardless of prizes though, Krugman’s piece today makes some important counter-points I had not heard regarding the lack of efficacy of FDR’s New Deal. Certainly, my reading of history made it clear that the New Deal had not lifted America out of the Great Depression – but I had never found convincing the traditional conservative explanation that the problem was FDR’s expansion of government. After all, Hoover’s refusal to expand the government had not reigned in the Depression – and it was the massive government expansion called World War II that finally broke America out of the Depression. I’m willing to concede the conservative point that some of FDR’s government interventions may have backfired – such as interference in wages and prices – but as Krugman points out in his column, many of FDR’s reforms have lasted to this day and helped mitigate the effects of the current financial crisis – from Social Security to federal deposit insurance.

Krugman posits that FDR failed to get us out of the Depression because he did too little rather than too much. He points out that overall government spending did not increase as much as is commonly understood:

The effects of federal public works spending were largely offset by other factors, notably a large tax increase, enacted by Herbert Hoover, whose full effects weren’t felt until his successor took office. Also, expansionary policy at the federal level was undercut by spending cuts and tax increases at the state and local level.

Which leads Krugman to the conclusion that:

The economic lesson is the importance of doing enough. F.D.R. thought he was being prudent by reining in his spending plans; in reality, he was taking big risks with the economy and with his legacy. My advice to the Obama people is to figure out how much help they think the economy needs, then add 50 percent. It’s much better, in a depressed economy, to err on the side of too much stimulus than on the side of too little.

Krugman has me convinced of his thesis for now. It certainly makes more sense than the alternative explanations I have heard about the New Deal and the Great Depression. But the last word – and the final prescription – should come from Franklin Delano Roosevelt himself:

It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.

This is my hope for an Obama presidency – one that I saw as far back as December when I posted this quote – and one that his campaign has born out.