A Dialogue on the Resolution of the Financial Crisis of 1989 and the Non-Resolution of the Financial Crisis of 2007: Tuesday Focus: March 25, 2014
Sokrates: Production is currently mired some 8% below the growth trend that back in 2008 we confidently thought of as normal and highly unlikely to be disturbed.
Glaukon: It is indeed.
Thrasymakhos: And employment is currently mired some 7% below the proportion of the population that back in 2008 we confidently thought of as normal and highly likely to be quickly reattained after macroeconomic shocks.
Khremistokles: What will you say next, Thrasymakhos? That the sky is blue?
Aristokles: Nobody now expects a return to the “old normal”…
Glaukon: Indeed.
Thrasymakhos: Actually, the sky is grey here in Berkeley, California where we exist, and the morning fog has not yet burned off…
Khremistokles: But why doesn’t anyone expect a return to the “old normal”?
Sokrates: If you can say that we “exist” at all, being simply of figments of Brad DeLong’s imagination, as he sits at Espresso Roma, drinking coffee, trying to wake up, writing this dialogue, intermittently watching lectures from the “Reason and Persuasion” MOOC of John Holbo, and waiting for Nicholas Lemann…
Aristokles: Such a large and persistent disturbance to the macroeconomy must have had a very great and terrible cause…
Thrasymakhos: So you are objecting to my word “here”?
Sokrates: Yes…
Thrasymakhos: But if “here” for us does not mean “Berkeley, California”, what does it mean?
Aristokles: And what is the color of the sky here?
Kephalos: Ahem!
Aristokles: I am sorry. I meant: And what is the color of the sky “here”?
Khremistokles: I’m sorry I said anything. It was a metaphor.
Kephalos: So, Aristokles, in your view what was this great and terrible Oz–sorry, cause–of our current deep and persistent macroeconomic distress?
Khremistokles: To the contrary, Aristokles: I maintain that the cause was not great and terrible, but small and meek…
Aristokles: How so?
Khremistokles: We had a housing boom here in the United States in the 2000s…
Glaukon: Indeed you speak truly, Khremistokles…
Khremistokles: And for a five-year period we spent an average of 1%-point of GDP more than normal on housing construction here in the United States in the 2000s, and about half of that excess was financed by mortgages that were unsoundly financed and not going to be repaid…
Platon: So what you are saying, Khremistokles, is that there was a bad debt of 5 years x 1%-point of GDP x $15 trillion/year x 1/2 = $375 billion that was not going to be repaid?
Khremistokles: Exactly…
Platon: And double that $375 billion to $750 billion: there were an equivalent amount of home equity loans–people using their houses as giant ATMs, in Doug Henwood’s memorable phrase–that had equally unsound finance in their underpinnings…
Sokrates: And that this $750 billion of fictitious debt that was inevitably going to be defaulted on was the source of our distress?
Glaukon: Indeed you speak truly, Sokrates…
Khremistokles: I am sorry, in a $15 trillion/year production economy–in an economy with $50 trillion of wealth–in a global economy of more than $80 trillion of financial assets, $750 billion of bad debt losses that have to be recognized does not seem to me to be a very large disturbing factor…
Sokrates: But Paul Krugman writes:
What It Would Have Taken: What would it have taken — what would it take now — to have maintained or restored full employment? My argument is that it would have required more radical, aggressive policies than anyone close to the levers of power has been willing to contemplate, at any point along the way. So the fact that the Fed was wrongly obsessed with inflation for most of 2008, the original subject of my post, was just a contributing factor; things would have been a bit better, but nowhere near OK, if the Fed had stayed focused on underlying inflation and ignored the effects of the commodity-price blip…
“More radical, more aggressive policies than anyone close to the levers of power has been willing to contemplate…”–that is what Paul Krugman says.
Khremistokles: But between 1989 and 1995 the Resolution Trust Corporation undertook to “resolve” 747 bankrupt Savings and Loans with assets of $500 billion. And that was in a $6 trillion/year rather than a $15 trillion/year economy. Our policymakers back in 1989 had no problem with nationalizing and then resolving bad debt on a scale of what would now be $1.25 trillion, comfortably larger than the fundamental bad debts produced by the 2000s housing bubble…
Thrasymakhos: And they did it without a major downturn, and in spite of everything Charles Keating, his peers, and their five tame senators– Alan Cranston, Dennis DeConcini, John Glenn, John McCain, and Donald W. Riegle–did to run interference for the S&L industry and try to get the government to top off and let the S&L gunslingers keep their fortunes…
Khremistokles: Setting up a Housing Mortgage Resolution Corporation to take over bad mortgages, extract some of the money from malefactors who had constructed, issued, and sold them, and finance the rest via a tax on high finance would not have been an especially radical or aggressive policy to deal with an episode of overlending…
Aristokles: And it would avoided the episodes of panic, revulsion, and discredit which have mired us in our current mess…
Glaukon: You speak truly, Aristokles…
Thrasymakhos: You think that taxing high finance for any purpose, or “resolving” any financial institution that is not a 100% commercial bank, is not “aggressive”? You think it is not “radical”? Do you live in this country? Do you understand its political economy?
Sokrates: But how about now? Paul Krugman writes:
: What It Would Have Taken: “Think of it this way: what would a really effective set of policies be right now? First… aggressively reverse the fiscal austerity of the last few years…. Monetary policy should accommodate that boost; interest rates should not go up even if inflation goes somewhat above 2 percent. In fact, there’s an overwhelming prudential case for raising the inflation target…. Say for the sake of argument that the right policy is two years of fiscal expansion amounting to 3 percent of GDP each year, plus a permanent rise in the inflation target to 4 percent. These wouldn’t be radical moves in terms of Econ 101 — they are in fact pretty much what textbook models would suggest make sense given what we have learned about macroeconomic vulnerabilities. But they are completely outside the bounds of respectable discussion. That’s the sense in which we are “doomed” to long-term stagnation. We have met the enemy, and it’s not the economic fundamentals, it’s us.
Thrasymakhos: Oh, Krugman’s 100% right about today…
Khremistokles: He is indeed. We are totally tracked…
Thrasymakhos: Very few members of congress or FOMC participants seem to spend any significant time talking to anybody who is not a plutocrat…
Khremistokles: But he is wrong about how aggressive and radical the needed policies back in 2007 were. As a share of GDP, the bad shopping-mall and office-tour debts of Houston, etc, in 1989 were as large as the bad mortgages of 2007…
Thrasymakhos: But back in 1989 the political power of the princes of finance was much less than in 2007…
Aristokles: And Sunbelt S&L operators are different animals than those who run the too-big-to-fail banks…
Khremistokles: All it needed in 2007 was a congress willing to get out the RTC playbook, or a Fed and a Treasury willing to use their administrative and regulatory authority to construct a pickup RTC of their own in advance of Lehman Brothers…
Sokrates: But they did not do so. Why not?
Thrasymakhos: Hank Paulson’s book certainly did not tell us. I’m hoping that Tim Geithner’s book will tell us, but I am really not holding my breath…