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 Former Senator Phil Gramm, author of the 1999 Gramm-Leach-Bliley Act that repealed the Depression-era Glass-Steagal Act and weakened the ability of the US to regulate derivatives, is, along with Alan Greenspan, one of the individuals most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.
14 Comments »
It is surprising that the author did not mention mark-to-market as a key component of the meltdown. At no point in our financial history, long term illiquid assets were re-assessed in a similar fashion as tradable and marketable securities. Any casual observer could conclude that trying to rapidly sell an illiquid instrument, independently of its worth, will likely command a discount.
The author rightfully criticizes the Republican congress but fails to explain what the current denial of these congressmen fails to achieve. If congress is controlled by Democrats, why Republicans need to acknowledge that Reagonomics is a failure? Congress is currently run by Democrats in a similar expansive fashion that these Republican displayed. Restating history serves no purpose other than excusing the continued ineptitude of our public servants. It is that ineptitude of our regulators that created the biggest mess in our capitalist history. Deregulation has nothing to do with the miscarriage of duties.
To point at the Reaganomic tenets as the cause of the destruction is similar to blaming a composer for a poorly performed symphony. In fact, ample evidence supports the opposite: that tax reduction is self-financing. Reagonomics have been extensively debated with few arriving at the conclusions that the author intends to explain, but fails to support.
The author gravely fails to recognize that Greenspan, and the FED, are only able to manage the short end of the yield curve. It is the long end of the curve responsible for financing long term assets at prolongued low rates. Greenspan, or the FED, have not, and will never be, able to control anything other than short term interest rates.
In the end, I was still hoping to read what the author proposed as the new capitalism.
Comment by Eli Butnaru – March 18, 2009 @ 10:10 am
Concur with Mr. Butnaru, particularly with respect to the disparagement of Reagonomics. The evidence of GDP increase and, following a lag time, of greater tax revenue subsequent to tax cuts is demonstrable.
Mr. Fukuyama and many others also represent the linkage between current account surplus/deficit positions in too concrete a fashion with respect to observed economic and consumer conditions. Contrasted to other areas where economic multipliers can be reasonably measured, this area is less than certain in terms of resulting effects. $ 10 billion more of US bond purchases by China will not necessarily drive $ xx billion of US consumer activity, but it will of course help finance the US Governments’ budget and affairs.
Unrelated, going back a few months, the Fukuyama article of the commencement address he gave was an exceptionally good piece.
Comment by Jason Monroe – March 23, 2009 @ 5:13 pm
One major requirement of the new capitalism is, as the author noted but did not expand upon, a change in the timeline of incentives. Annual bonuses for speculative enterprises–as all financial venture are–do indeed privatize gains at the now obvious risk of socializing losses. Is it possible to develop a tax system, perhaps paying bonuses into escrow accounts, subject to recapture in the case of subsequent bailouts.
Comment by Lewis Beman – April 2, 2009 @ 11:39 am
The ‘new capitalism’ is going to be more cautious. It will be less unfettered and less laissez faire. It is going to be more mutual beneficial. That is not so hard to understand.
Reaganomics is at fault here, with its supply-side economics, producing and building way ahead of demand. (Look at Las Vegas and Dubai.) One contributing factor to the economic meltdown is the excesses of production and finance, which saturated the market until it couldn’t absorb any more. It will take time to mop up the excess and thus it will take time for a recovery to take hold.
Comment by David Airth – April 2, 2009 @ 4:35 pm
Mr Fukuyama is basically correct about the underlying reasons for what has happened although I think he is being unduly pessimistic about the chances of recovery. The US, and world economy for that matter, is incredibly resilient. Clearly we’re not going to return to the bubble rates of growth we saw over the last eight years but that doesn’t mean we’re going to remain in permanent recession either. Since, as he points out, conservatives are basically in denial about what’s happened I suppose it’s to be expected that some of the posters here are still defending the tenets of Reaganism but they need to get their facts right. Supply side tax cuts under Reagan and Bush NEVER generated enough revenue to pay for themselves. This is a matter of record. Even most respected conservative economists have now backed off that claim. During both administrations in addition to the tax cuts there were huge Keynesian expansions of public spending that were in aggregate a much more important contributor to economic expansion than tax cuts, but even then never produced enough tax revenue to match expenditures and hence created the subsequent record deficits both administrations left behind. In short, supply side tax theory except at it extremes doesn’t work. I’m afraid it’s one of those dogmas the Republicans are going to have to break free of as they navigate their way back to reality.
Comment by John – April 5, 2009 @ 9:08 am
I know this thread is pretty old but it’s nice to get some practice debating guys like Butnaru above.
First, as far as mark-to-market being the cause in the meltdown, that’s a complete falsehood. The assets we are talking about at this point are impaired. Even if they were classified as “held to maturity” and kept at their book value on the balance sheet, they’d still have to be written down, under “lower of cost or market.” Since these are illiquid assets, determining the market for them is tough (particularly because the banks are scared of getting real price discovery). But everyone knows that the market price for them is far lower than what the banks paid. In other words, we still get the same problem
Second, I think you misread the author’s point a little bit. At this time, because American’s are saving in an effort to deleverage, the federal government must pick up the slack in demand. In other words, austerity by the government is not a good thing, and Congress/the Administration must continue to be expansive. Republicans refinding their fiscal austerity will not work right now simply because of the collapse in demand.
Finally, it’s just not true that the short end of the yield curve has no effect on the financing of long-term assets. Muni bonds for construction using variable rate debt use things like 1 month LIBOR as their index. Adjustable rate mortgages were indexed to 12 month T-bills and LIBOR, among other indices. If the FED starts buying up 12 month T-bills then they lower the yield- that’s as basic as it gets.
Overall, I thought the article was well done, although like everyone else I would have liked to see it more forward looking. I think the poster David Airth got it right, capitalism with a more watchful eye
Comment by Antonio Rodriguez – April 5, 2009 @ 9:32 am
Excellent article.
This blind devotion to Reaganomics and unfettered free markets has not worked and will never work–it’s like leaving children unsupervised in a candy store.
As someone wrote, the invisible hand remained invisible…
Comment by Abby – April 5, 2009 @ 10:10 am
Mark to Market was not part of the problem. Derivatives were not illiquid assets. Derivatives were sold on the market on a daily basis until it was discovered that they were worthless.
Why is it that Conservatives lament about the need to value assets higher than their actual worth? To do so only makes an insolvent institution viable, but only on paper.
If their wish came true and accepted accounting practices were ignored to allow the value of those worthless assets to be overvalued. Those assets would be used as collateral to further leverage the company. Which would only make that company more insolvent.
This would be like a person paying cash to buy a house. Only to see the house burn to the ground. Should that person be able to then borrow money based on the purchase price of that nonexistent house?
Comment by Paul French – April 5, 2009 @ 11:15 am
In reply to Buthnaru and Monroe regarding Reaganism…
You must admit that at some point tax cuts don’t work anymore. If the government could levy no taxes then there would be no roads, regulation, infrastructure, military defense and the country’s economy would quickly collapse one way or the other.
This disproves your idea that cutting taxes always results in long-term growth. At some point, clearly, cutting taxes is no longer optimal.
Remember that Reagan lowered the tax rate to 42% and Clinton got it down to 39%. Bush lowered it to about 36% and the whole stack of cards fell apart…
I posit that Bush’s tax cuts finally crossed the line to a point where it was no longer optimal to lower taxes.
Comment by Hector Maquieira – April 5, 2009 @ 11:33 am
The first commenter conveniently leaves out the fact that for 6 years the Bush Administration had the luxury of a GOP controlled Congress to rumber stamp his every move.
Even when allowing for the Congressional Democrats willingness to play dead for those 6 years, how is the current debacle the sole fault of the Democrats?
Based on the proposals coming from the Obama Administration we’re supposed to believe the that people who layed the foundation for the current debacle will be the ones to lay groundwork for our future economic recovery.
This is what happens when you have a politics and an economy built on lies and snake-oil.
Comment by T.G. – April 5, 2009 @ 2:38 pm
You shouldn’t lay all the blame for this at the feet of Americans. Irrational exuberance, believing you could get rich via cute ways (house flipping, mortgage backed securities, etc) and an unrealistic view of long term market fluctuations (Dow 36,000 anyone?) were not purely American traits; they are emblematic of modern societies worldwide.
Being stuck in gridlock for three hours a day, sipping lattes, watching American Idol – these are the ‘benefits’ of a society without moorings dependent on ever decreasing resources (oil, American consumer market share) and ever expanding competition for those resources.
You once wrote a book call ‘The End of History and The Last Man’ bout how people in modern, wealthy societies could lose their ‘elan’ to fight modern problems. You were right, except the problems are in people’s souls as much as in the world at large. Changing habits of consumption and adjusted ‘mark to market’ values of happiness and personal fulfillment should be considered as part of any long term solution.
Comment by Nathan – April 5, 2009 @ 2:41 pm
The evidence of GDP increase and, following a lag time, of greater tax revenue subsequent to tax cuts is demonstrable.
No, it is not. The rise in GDP is illusionary, fueled by the Keynesian stimulus of deficit spending. The malinvestment of the debt issued to cover the deficits cripples the economy in the long term. Technically the malinvestment is not the fault of Reagnomics but a failure of Reagan/Bush public policy. An implementation error not a failure in the theory. But then again, according to some, so was the Soviet Union.
Reaganomics is not cutting taxes and spending, it is cutting taxes without cutting spending and running up huge deficits. Cutting taxes and spending so that there are no deficits but government was smaller might work, or not. It is based on the assumption that the ‘free market’ will make better decisions about capital spending than government bureaucrat would. Of course we now know that to be ridiculous. Not that the government is good, just that industry is just as bad.
Comment by Lighthouse – April 5, 2009 @ 4:15 pm
Tax cuts – to what? 95% is patently bad, and Reaganomics works there, but where do you stop? 0% income tax?
“Tax cuts!” makes for a great bumper sticker, but it’s hollow without serious contextualization.
Comment by Julie Charles – April 6, 2009 @ 12:29 pm
It should be possible to let banks go bankrupt and it should not be bankers to decide which industries are worth developing. The way bankers have made industrial development dependent on credit has led to a guided economy, guided not by vision but by short term profit chance for bankers. If wages and economic profits with all money transfers is taken out of the hands of bankers and banks offer their clients services for their money they do not directly need, banks may go bankrupt like any other business. Money transfer should be a nonprofit service, since it does not create anything and can nowadays be handled at very low costs electronically.
Comment by J.F.Besseling – July 15, 2009 @ 4:06 pm
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