Notes on the Financial Crisis, #3

By Tom Weisskopf | October 15th, 2008

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On receipt of my second set of notes on the financial crisis (dated October 5), one reader e-mailed back that it would surely not be the last. I’m afraid she was absolutely right. The crisis will not go away soon, and I’ll continue to send updates every now and then. Here is the third set of notes. —T.W.

26. The last 10 days have brought further news of economic disaster, highly volatile stock market movements (most of them sharply downward), and indisputable evidence that the crisis is world-wide in scope. It’s no longer just Hank Paulson and his associates trying to figure out what the U.S. Government should do to stem a collapse of the U.S. financial system; finance ministers in all the major nations around the globe—as well as the Director of the IMF—have been trying to coordinate governmental action to rescue the global banking system.

27. A major economic downturn in the U.S. (and consequently in most of the globalized world) has been inevitable for some time; the question has been whether it will be comparable in scope to the deep recession of the early 1980s or to the Great Depression of the 1930s. Before trying to answer that question, I’d like to step back and make some observations about the sources of the crisis.

28. In my first message (dated October 1), I focused blame on the de-regulation and non-regulation of significant parts of the U.S. financial sector—linked to the free-market ideology that started to inform U.S. Government economic policy in the late 1970s and gained ever greater strength in succeeding decades. Two other long-term trends, over the same period, also played important roles: growing economic inequality, and rising debt.

29. It is well documented that the distributions of both income and wealth in the United States have become much more unequal over the past 30 years; they have now reached peaks not seen since the late 1920s, just before the Great Depression.

30. It is also well documented that there has been an explosion of debt in the United States over the past few decades. The savings rate of the American household sector as a whole has dropped to virtually zero, and a substantial fraction of the American population has incurred debts well in excess of the value of their assets.

31. One would ordinarily expect higher degrees of income inequality to boost savings rates, since it is much easier for the rich than the poor to save some of their income; so it is somewhat paradoxical that, in an era of growing income inequality, private sector savings rates have been falling. The paradox may be partly attributable to an increasing propensity to consume on the part of the rich. But it is also due to the fact that borrowing has been made a good deal easier for the middle and lower middle income classes, many of whom have found borrowing and going into debt to be the only way to maintain their standard of living—since their stagnating incomes are no longer sufficient to do so.

32. Greater household borrowing was facilitated not only by increasingly energetic solicitation of consumers by credit card companies and of homeowners by banks pushing home equity loans. It was also facilitated by a Federal Reserve Board policy (under Alan Greenspan for most of the relevant time period) that leaned heavily in the direction of low interest rates and that encouraged lenders to find more ways to enable consumers and homeowners to borrow. These policies did—for a while—help to sustain aggregate consumption and thus help to avoid major economic downturns. But the fact that much of the borrowing was done for consumption, rather than for investment (with the prospect of future earnings in return), meant that borrowers would find it increasingly difficult to meet their payment obligations and to liquidate their debt burden.

33. The subprime mortgage crisis that developed over the past 5 years is a prime example—and indeed the culmination—of how the Fed, by encouraging excessive private sector borrowing in an effort to maintain economic dynamism, contributed to a burgeoning debt problem that was ultimately bound to become unsustainable. With less and less effective government regulation, the housing boom turned into a bubble and financial institutions found all kinds of opportunities to handle the escalating lending and borrowing in ways that were less and less transparent and accountable (and that were often unscrupulous). Thus growing economic inequality, burgeoning debt, and inadequate regulation are all bound up in the financial crisis that threatens the world today.

34. So what can be done now to limit the inevitable damage that is now underway all around us? There can be little doubt that doing nothing would invite a catastrophe on the order of the Great Depression. Much has been learned since then about economic stabilization policies. As I stressed in my first message, governmental authorities must take action to turn things around, and the action must be on a very large scale; it is now evident that it must also be a coordinated effort by all of the major players around the world.

35. The action needs to achieve the following objectives—the first four in order to overcome the current crisis, and the last two to prevent a recurrence of this kind of crisis in the future:

  • (f) it must stimulate financial institutions to start lending again—to one another and to business customers—rather than freezing their lending out of fear that borrowers may go belly-up and default on the loans;
  • (g) it must provide cash support to financial institutions in such a way that taxpayers can reasonably expect to recoup ultimately a substantial portion of the money dispensed from government treasuries to financial institutions;
  • (h) it must provide a way to help U.S. homeowners threatened by foreclosure to restructure their mortgage loans in such a way as to be able to stay on in their homes, and indeed it should help those who have already suffered from foreclosure to recover their bearings;
  • (i) it must include a major new fiscal stimulus, principally (but not necessarily exclusively) to the U.S. economy, based not primarily on tax cuts but on transfers to those who most need cash to spend—in particular state governments, the unemployed, and those who have lost or are otherwise likely to lose their homes or apartments;
  • (j) it must involve the development of new and effective regulations to increase the transparency of operations on the part of financial institutions, reduce excessive leverage, eliminate unaccountable risky instruments, and provide greater safeguards and securities for ordinary borrowers and investors;
  • (k) it must bring about a significant reduction in the degree of economic inequality in the United States, which has taken on dimensions far greater than in any other wealthy capitalist economy.

36. The bailout (or “rescue”) package passed by Congress earlier this month is obviously not sufficient to accomplish all these objectives, and it contains some elements that will do nothing to alleviate the crisis. I am thankful, however, that it was passed in a form much superior to the original Paulson proposal. For it has committed the U.S. Government to take major action to deal with objectives (a) and (b), and it has enabled the U.S. Government to do so in ways that most economists now believe are better than originally envisaged by Paulson—for example, by using stock injections (in exchange for equity shares) rather than simply purchasing toxic assets. Indeed, Gordon Brown—by committing the British Government to pursue precisely the kind of stock injection plan recommended by Joe Stiglitz, Warren Buffett and others, has pressured the U.S. Government to do more of the same.

37. The fact that the U.S. Government cannot now act alone, but has to act in coordination with European governments—less infatuated with free market ideology—in the context of a globalized financial crisis, means that U.S. actions are already being pushed in a more desirable direction. There is no guarantee that even a new U.S. Government will act to achieve all six objectives I have listed above; but there is no doubt that the prospects for such thoroughgoing reform would be significantly greater under an Obama than a McCain administration. At the very least, it has become clear that the era of free market fundamentalism has now come to an end.

Tom Weisskopf is a professor of economics at the University of Michigan.

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