Robert Samuelson

Is This Downturn a Crisis of Confidence or a Fundamental Error?

Prefacing my thoughts on economics, as always, with the warning that I am not an economist, but only an amateur…

My non-professional observation is that when a disproportionate amount of money is controlled by the financial sector, a crash soon follows. This observation isn’t original. As Paul Krugman observed a few days ago in the New York Times:

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies — giants like A.I.G., Citigroup and Bank of America.

Krugman concludes that this structural issue is at the root of the problem – rather than a liquidity issue with the banks:

I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

Simon Johnson, an economist formerly with the IMF, agrees with Krugman in a long piece in The Atlantic Monthly, and he echoes another point I’ve been making:

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail.

Reading both of these men, I find myself hoping they are wrong while sensing that they are at least partially right. Evan Thomas of Newsweek captured this balance nicely in his cover piece from the current issue:

If you are of the establishment persuasion (and I am), reading Krugman makes you uneasy. You hope he’s wrong, and you sense he’s being a little harsh (especially about Geithner), but you have a creeping feeling that he knows something that others cannot, or will not, see. By definition, establishments believe in propping up the existing order. Members of the ruling class have a vested interest in keeping things pretty much the way they are. Safeguarding the status quo, protecting traditional institutions, can be healthy and useful, stabilizing and reassuring. But sometimes, beneath the pleasant murmur and tinkle of cocktails, the old guard cannot hear the sound of ice cracking.

At the same time as Establishment defenders such as Robert Samuelson are uneasy about the scope of what Obama is proposing, other members of the Establishment are uneasy that he may not be doing enough. We don’t know who is right.

To some extent we can discount Krugman’s opposition due to his personal fantasy of how his life might work out:

Krugman says he found himself in the science fiction of Isaac Asimov, especially the “Foundation” series—”It was nerds saving civilization, quants who had a theory of society, people writing equations on a blackboard, saying, ‘See, unless you follow this formula, the empire will fail and be followed by a thousand years of barbarism’.”

His critique of Obama’s plans seems to follow this model – as his warnings take on more prophetic tones.

But there is real intellectual weight to this theory of the financial crisis as something more than a liquidity or confidence crisis. Krugman outright rejects this explanation:

[T]he banks [are] really, truly messed up: they bet heavily on unrealistic beliefs about housing and consumer debt, and lost those bets. Confidence is low because people have become realistic. [my emphasis]

In other venues, Krugman describes the problems as extending far further than this – as above when he discusses the trend towards increasing the influence of American finance and increasing income disparity. This stands on contrast to the approach of both Hank Paulson and Tim Geithner who believe that the crisis is primarily one of confidence. They are treating the crisis as a more technical and esoteric version of a bank panic solved by a show of strength, as for example, the Panic of 1907:

Shipments of gold were on the way from London to New York, and confidence had returned to the French Bourse, “owing,” reported one paper, “to the belief that the strong men in American finance would succeed in their efforts to check the spirit of the panic.” During a panic, confidence is almost as good as gold.

Today, the government has taken the role of “the strong men in American finance” who are seeking a show of strength to boost confidence.

On the one side, you have economists – from Simon Johnson to Paul Krugman to Nouriel Roubini – who have been predicting doom for some time claiming that there are fundamental problems with our finance industry – and as a result of the size and influence of our finance industry – our entire economy. On the other you have men and women with power – in both finance and government – who are acting as if the problem is mainly one of a lack of confidence and a broken mechanism.

My bet – based in no small part on my innate optimism as well as a respect for people on both sides of this debate – is that in the short term, the Geithner plans will work to restart the “old” economy. In this moment before that happens though, pressure from Europe and internal critics as well as a desire to avoid a repeat of this fiasco will enable enough forward-looking, gradualist regulation and legislation to correct the long-term problems with high finance. Already, there are some signs that this is what is happening.

What’s Wrong With the Stimulus Plan

[digg-reddit-me]Aside from the partisan power play that seems to be motivating most of the Republican opposition to the stimulus plan, there are a number of fair-minded criticisms.

First, the plan lacks the Obama touch – the deft promise to cut those programs that don’t work and to make sure the ones that are around still do work, the libertarian paternalistic designs of Cass Sunstein, the nimble government program that does not coerce but merely offers opportunity. Of course, there is a sensible reason for this. The stimulus is needed right now – and it will take time to design new programs with this balancing between libertarian principles and liberal ends in mind. So, Obama has decided that this stimulus package must work within existing programs – which Republicans have used as an excuse to attack those programs.

Second, there is not a clear exit strategy. Many of these spending measures and tax breaks are supposed to be emergency measures that the government will only maintain during this crisis – but new spending and cuts in taxes both are hard to roll back. The idea that taxes are hard to raise is, of course, the basis of the “Starve the Beast” strategy that conservatives adopted (as described by George Will):

For years, many conservatives advocated a “starve the beast” approach to limiting government. They supported any tax cut, of any size, at any time, for any purpose, assuming that, deprived of revenue, government spending would stop growing.

But they found out that spending was also hard to cut:

But spending continued, and government borrowing encouraged government’s growth by making big government cheap: People were given $1 worth of government but were charged less than that, the balance being shifted, through debt, to future generations.

Obama’s stimulus plan involves both increasing spending and cutting taxes. The question is – can we then raise taxes and cut spending after this is over? Obama has clearly indicated he intends to – and to shore up America’s long-term fiscal solvency by dealing with entitlement spending too. If he is able to pull off this Grand Bargain, then he will belong in the rank of the best presidents. If he is not, then this temporary increase could have disasterous effects.

Third, by trying to act so quickly, there will inevitably be unintended consequences. To avoid as many of these as possible, the bill should be cleaner and its provisions should work faster.

Fourth, as Robert Samuelson wrote in the Washington Post:

As it turns out, President Obama didn’t make the tough choices on the stimulus package. He could have either used the program mainly (a) to bolster the economy or (b) to advance a larger political agenda, from energy efficiency to school renovation…There were tough choices to be made – and Obama ducked them.

This bill is something of a muddle so far, in part because of the need for speed, and in part because Obama has let the House and Senate Democrats craft the bill, waiting to give his input until the conference in which the bills passed by the House and Senate will be reconciled.

Fifth, the bill offers both short term stimulus measures and downpayments on longer term (and worthy) projects. A stimulus bill should only include spending in the short term. The 75% goal Obama has set is too low. Every dime in the stimulus package should be out by the end of 2010. Kay Bailey Hutchinson ably stuck to this point in her Meet the Press appearance this past Sunday. Her confident demeanor and obvious grasp of policy made me wonder what had led John McCain to bypass her in choosing his Vice Presidential nominee.

In short, most of the bills problems seem to come from the speed with which it is being forced out. This is a tradeoff Obama seems to be willing to make – as this bill is intended primarily to demonstrate that stimulus is coming and the problem is being taken seriously.