There is a pervasive sense of unreality in Washington about the nature and scale of the economic crisis facing the United States and the world. The Obama Administration seems to be proceeding on the assumption that the problem in the US financial sector is still one of illiquidity rather than insolvency, and that the task is to prop up US banks for the next few months until markets value their toxic assets more fairly. The growing consensus of many economists, on the other hand, is that they are insolvent. The rapid downturn in the real economy, accelerated by the financial meltdown last fall, is feeding back into the banking sector as higher quality home mortgages (like Alt-As), commercial real estate loans, and credit card debt start to go bad. It is easy to see why the administration doesn’t want to admit to itself that the banks are insolvent, because this would mean going back to Congress for another trillion or so dollars for further bailouts. It is this political logic that kept Japan from dealing with its non-performing loan problem in the 1990s, and means we may be headed down the same road.
The Republicans, for their part, are in total denial of what befell the country under their watch. Having presided over the growth of a half-trillion dollar deficit during the boom years of the 2000s, they have suddenly re-discovered the virtues of fiscal austerity at the one moment in the business cycle when deficit spending is desperately needed. In their efforts to think through what went wrong in their electoral defeat last year, many are saying that the problem was that they strayed from Reaganism. Very few Republicans have come to terms with the fact that it was some of the key tenets of Reaganism—in particular, its hostility to regulation and belief that tax cuts would be self-financing—that lie at the root of the country’s current problems. It is true that the Democrats were complicit in much of this—Bob Rubin and Larry Summers were as much believers in financial sector de-regulation as any Republican, while Congressional Democrats did a lot to protect the train wreck that was Fannie Mae and Freddie Mac.
But the fundamental ideas regarding the self-regulating capacity of the market and the deadening hand of government are Republican ones. Former Senator Phil Gramm, author of the 1999 Gramm-Leach-Bliley Act that repealed the Depression-era Glass-Steagal Act and weakened the ability of the US to regulate derivatives, is, along with Alan Greenspan, one of the individuals most responsible for laying the intellectual groundwork of the crisis. This didn’t prevent him from writing an astonishing op-ed in the Wall Street Journallaying major blame for the meltdown on the Democrats and their support for Fannie and Freddie. Fannie and Freddie without question contributed to the crisis. But these institutions didn’t induce AIG to recklessly issue credit default swaps, or Washington Mutual to sign up borrowers with no due diligence, or Merrill Lynch to create securitized mortgages that are impossible to value, or Moody’s to give these securities Triple-A ratings. As long as Republicans don’t admit to themselves that this enormous crisis emerged as a result of factors intrinsic to Reaganism, they will never find their way out of the desert.
Both Democrats and Republicans seem to be operating under the assumption that the recession will bottom out some time later this year, and that we will see a gradual recovery starting in 2010. Certainly Obama’s medium-term budget is based on the assumption that we will be growing briskly again in a couple of years and in a position to tackle long-term problems like entitlements and the deficit. My own view is much more pessimistic, for reasons related to the global economy.
The long-term conditions for the current crisis were set in train as a result of Asian, and especially Chinese, responses to the 1997-98 Asian financial crisis. As Martin Wolf of theFinancial Times pointed out in his book Fixing Global Finance, countries in the region decided to protect themselves from skittish global liquidity by reversing its flow and building up reserves of US dollars. This meant that from 2001 to 2008, more than US$ 5 trillion of foreign savings poured into the world’s richest economy, the US, fueling a credit boom and the overleveraging of both households and corporations. The level of debt that was subsequently built up was extraordinary; in contrast to the recession of the early 1980s, when US private debt was 123 percent of GDP, it had reached 290 percent by 2008. Of that, household debt moved from 48 percent to 100 percent of GDP. This is why the Fed’s efforts to flood the US with liquidity will have limited effect; households and businesses will be deleveraging for a much longer period than in earlier recessions. Americans are re-learning how to become savers; they need to do that, but their prudence leads to Keynes’ famous paradox of thrift where aggregate demand turns anemic.
There are many problems on the supply side of the economy; we have lost a lot of our manufacturing base, and the service economy that was supposed to supplant it is a mirage.Gretchen Morgenstern points out that Merrill Lynch lost more money in the past two years than it earned in the previous ten, even as its executives took home billions of dollars in pay and bonuses. At the peak of the boom, financial sector earnings were 40 percent of total US corporate profits, but we see in retrospect that these numbers didn’t reflect real value being added to the economy. When you look not just at bank balance sheets but at the negative externalities the sector imposed on the rest of the economy, the real productivity gains for the past decade are likely to be far lower than they seemed to be when the boom was still on. We didn’t recognize this at the time because it was being masked by the willingness of foreigners to hold US dollar assets.
But an equally great problem for the future is on the demand side. For all the talk of decoupling, the spread of the recession via falling US imports shows the extent to which the whole global economy was dependent on the US, and particularly US consumers, for its growth. The sharpest declines in fourth quarter 2008 GDP among industrialized countries were in Japan and Korea, not because they were fiscally imprudent like the US, but because of their high dependence on exports. China is falling off of a similar cliff, though not quite as fast. US consumers will not and should not return to their debt-driven overconsumption anytime soon; but Asia’s economies still do not promote domestic consumption. US households have seen their net worth plunge by some $11.2 trillion, or 18%, through the end of 2008, with further losses in the first quarter of 2009. The baby boomers in particular, whose net worth has fallen more dramatically because they held more assets than the general population, need to rebuild their savings for their impending retirements, and will not be reopening their wallets even if easy credit becomes available again. Asian countries recovered relatively quickly from the crisis of the late 1990s because global demand was still strong; where is it going to come from now? The only hope is public spending, like the much-reviled US stimulus bill; but outside the US there have been relatively few countries willing and able to step up to the plate.
All of this suggests a rather prolonged recession, or perhaps a prolonged period of flat to very modest growth. We may in fact be lucky to duplicate Japan’s performance of about 0-1 percent per annum growth during the 1990s.
We need to look at the crisis in a longer term perspective. The baby boom generation—of which I am a member—went through its life over-consuming and under-saving, all the while exempting themselves from taxation (except for a brief period in the Clinton years, when we succeeded in running a budget surplus). Getting out of the crisis they created will require significantly increasing the already high levels of public debt they incurred; not only will they will then pass these liabilities down to their children, but they will start incurring health care costs that will eat up a significant chunk of future GDP if not constrained.
All of this does not amount to a failure of capitalism, but to a failure of American public policy. It is inevitable, however, that the credibility of things that Americans hold near and dear—i.e., liberal democracy and a market economy—will suffer greatly as a result of the crisis. People from Latvia to Korea to Mexico are suffering from a global recession that started in the United States. It started in large measure because of the faith that Americans placed in the ability of free markets to regulate themselves, a key aspect both of Reaganism and of the so-called “Anglo-Saxon” model of capitalism. Alan Greenspan admitted last fall that he was astonished that the self-interest of the financial community did not prevent it from making huge mistakes. Now that the public sector is cleaning up behind them, we need to move from astonishment to a different model of capitalism if we are to fix our own economy, and regain a shred of credibility on the world stage.