Financial Crisis, Stimulus and Regulation: Next Time Won't Be Different

In spite of the smack down from Rick Santelli (CNBC's "freaked out white man") Ezra Klein, a financial columnist for the Washington Post, recently wrote an excellent piece (here) on the Late 2000 Financial Crisis (also known as the Subprime Mortgage Crisis). Klein's article argues that there is never the political will to either (1) impose strong enough regulation to prevent financial crises or, (2) once the crisis has started, provide enough stimulus to bring the economy back to full employment.

One particular quote from the article caught my attention:

It is never possible for the political system to do enough to stop them [financial crises] at the outset, as it is never quite clear how bad they are. Even if it were, the system is ill-equipped to take action at that scale [once the crisis has started].

If Klein is accurate, the theories of Keynesian intervention and of central bank control of the economy are fundamentally wrong--something to think deeply about at a possible libertarian moment in US politics.

Causes of The Deficit: Republicans Acting Responsibly

I am fortunate enough to have Ron Johnson, R-WI, as my US Senator. He is one of the freshman class aligned with the Tea Party movement. I have been tweeting Senator Johnson suggesting that he seriously consider raising the US Debt Ceiling. My basic argument is that the current deficit was causally related to actions taken during the Bush II administration. Being a Republican, Senator Johnson should be willing to take responsibility for these actions.

In the event that Senator Johnson would be interested in a more detailed explication of my causal argument, I've provided the following path diagram (click to enlarge) developed from Chapter 10 of the book This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff.

Reinhart and Rogoff's own explanation is pretty straight forward (p. 172-173):

When a country experiences an adverse shock--due, say, to a sudden drop in productivity, war, or political or social upheaval--naturally banks suffer. The rate of loan default goes up dramatically. Banks become vulnerable to large losses of confidence and withdrawals, and the rates of bank failure rise. Bank failures, in turn, lead to a decrease in credit creation. Healthy banks cannot easily cover the loan portfolios of failed banks, because lending, especially, to small and medium-sized businesses, often involves specialized knowledge and relationships. Bank failures and loan pullbacks, in turn, deepen the recession, causing more loan defaults and bank failures, and so on.

Earlier in Chapter 10, Reinhart and Rogoff explain that recessions, bailouts and foreign wars (Iran, Afghanistan and the War on Terror) all lead to increases in the deficit. All these causes of increasing US debt are the direct result of actions taken during the Bush II administration, to include the lax attitude toward regulation of the financial sector that led to the Subprime mortgage crisis itself (the shock in the path diagram).

Notably missing from this causal explanation are entitlement programs, Obama care, public sector unions, high taxes (taxes were cut during the Bush II administration) and other right wing fixations. Senator Johnson will certainly see the sense of my air-tight causal argument. The rational policy response, which he will also certainly appreciate, would be to end foreign wars and the war on terror in addition to increased regulation of the financial sector. And, since the wealthy do not seem to know how to spend tax reductions on anything other than speculation, a tax increase on ill-gotten gains would also help reduce the deficit.

Technical Note: The upper part of the path diagram above is a positive feedback loop (negative signs multiplied together become positive as in basic algebra). The positive feedback effect explains why financial crises last so long and are so resistant to policy interventions.

Rewriting History

Over the last decade, there has been a concerted effort to rewrite the history of the Great Depression (here, here, and here). Historian Robert McElvaine (here) and economist Paul Krugman (here) have both attempted to challenge the revisionists.

Basically, the revisionists have argued that the policies of the New Deal were either ineffective or actually caused the Great Depression. Revisionists point to the 1937 Recession as proof of their assertions.

The challengers argue that the 1937 Recession was caused precisely by contractionary spending policies the Roosevelt administration mistakenly pursued after Roosevelt's 1936 re-election. They argue that, like the Obama administration during the late-2000s Great Recession, the Roosevelt administration failed to stimulate the economy enough until the spending spigot was opened during World War II.

After reading both side of the debate, it still seems an open question whether anything short of putting the entire economy on a war footing (that is, conventional deficit spending, tax cuts, monetary manipulations, etc.) would be an effective policy response. Part of the problem is defining what a "return to normalcy" would actually mean when the period before the collapse was being driven by an economic bubble.

One definition would be a return to full employment but "normal" employment was itself distorted by the bubble: people who would normally not be in the labor market were drawn in during the bubble and people were pushed out who should not have been as a result of the crash.

I don't think we really appreciate the distortionary effects of bubbles and the importance of preventing bubbles from expanding in the first place.

The Financial Crisis Could Reduce U.S. Income Inequality

The role of income inequality in the Financial Crisis of 2007-2010 will be analyzed and debated for many years in the future. The time series above plots the percent of income being received by the top 99-100% of income earners in the US (the data are from Emmanuel Saez, here, and are controversial--read both sides here). What is very interesting is that income inequality peaked right before the Great Depression and right before the Great Recession. The coincidence (?) suggests a number of hypothesis about income inequality and financial speculation (here).

In this post, I'm going to beg the obvious question "If there is too much income inequality in the U.S., how much income should the upper 1% of income earners be making?" One approach to answering this question is to assume that the earnings of the top 1%, like the earnings of every other worker, should be tied to growth in the U.S. economy. If the economy grows by 4%, however, how much of that 4% growth premium should be captured by the upper 1%? All of it? Some of it? None of it?
What turns out to be a better model and one that fits the data better is that, regardless of growth in the U.S. economy, the share of income to the upper 1% should remain at about 13%, about where it is right now in 2010 after the Financial Crisis. Interestingly, from 1950 to about 1990, the upper 1% weren't getting their share! Something changed after 1990 (a nice topic for analysis and speculation) and that innovation, whatever it was, created a huge inequality bubble--a bubble that was popped by the Subprime Mortgage Crisis.
For the future, the model predicts that we will return to the level of income inequality that marked the U.S. economy from WWI to the 1990s. What new innovation might come along to create the next inequality bubble? We can't know the future but the model predicts that without shocks, the income of the top 1% would stabilized around 13%--something I probably won't see in my lifetime.

The Drunkard's Walk and the Moment of Truth

The National Commission on Fiscal Responsibility and Reform has finally issued their report on the U.S. Deficit, "The Moment of Truth". They are not the only ones trying to seize the moment. The Economic Policy Institute has issued its report "Investing in America's Economy: A Budget Blueprint for Economic Recovery and Fiscal Responsibility." And, the Bipartisan Policy Center has released its report "Restoring America's Future." There are enough recommendations in and questions raised by these reports to keep many policy analysts busy blogging for many years in the future. Before jumping into the issues, I'd like to put a stake in the ground.

What do we expect to see when we look at a historical time plot of the U.S. Deficit? If the deficit hawks are right, we should see the deficit increasing uncontrollably over time when, in fact, the deficit should always be zero. The Keynesian viewpoint is that we should see periods of deficits during recessions followed by periods of surplus during recoveries. In other words the deficit should be a drunkard's walk, randomly moving from surplus to deficit based on shocks to the economy. The only issue is the range of movement: conservatives think there should be very little, if not zero movement and liberals say it depends on economic conditions.

The first figure above, using data from the CBO, fits a random walk model to the U.S. deficit. Although the fit is not bad, it looks like the model is always "catching up" and missing the turning points. What is striking about the graphic is that the deficit "excursions" are increasing in amplitude: economic shocks getting worse, spending responses ("bailouts") and attempts to "stabilize an unstable economy" getting more desperate.

Both the conservative and Keynesian views miss seeing that the U.S. deficit is part of a system. During an economic downturn, there is a flight to quality. Investors want to unload their higher-risk investments for the safety of U.S. debt which is covered by the "full faith and credit" of the U.S. government. During normal times, purchasing U.S. debt allows country's with trade imbalances (e.g. China) to do something safe with their dollars.

When we add debt held by the public into the random walk model, the predicted fit is much better (second graphic above). For the U.S. deficit to exist, there has to be a counter-cyclical market for U.S. debt. The market is somewhat self-correcting. If investors don't want to purchase U.S. debt, the only other way to create a deficit (as is the case in many "debt crisis" countries) is to print money.

What does this all have to do with the common explanations for the U.S. deficit being repeated in the policy echo chamber? Is it those mandatory entitlement expenditures such as Social Security, Medicare and Medicaid that must be eliminated to eliminate the deficit? Is this a reasonable conclusion from the graphics and discussion above? Is it the entitlement programs or the shocks to an "unstable economy" that are driving the deficit? It all depends on the time path of the entitlement programs compared to the time path of the deficit, a topic I'l talk about in future posts.

Unemployment Insurance and Employment

Yesterday, the U.S. Senate rejected the Unemployment Insurance Stabilization Act of 2010 that would have continued unemployment benefits until January 2012. Evidently, Republicans first want the Bush era tax cuts extended for their wealthy constituents.

Aside from the naked class-based motivation for not also extending unemployment insurance (UI), what are the likely consequences of the Senate's action?

The graphic on the right summarizes the arguments (read more here, here, here, here, here, and here). The Great Recession created our current unemployment problem by reducing GDP growth. UI, enacted during the Great Depression, is one of the built-in stabilizers in the economy that allows employees to ride out brief economic downturns. UI also provides an immediate boost to consumption since the unemployed immediately spend what they receive in benefits.

The right-wing criticism of UI is that it reduces job search. Granting that there might be some small reduction in search activity due to UI (the data, however, show that UI actually increases job search), if the jobs are not there, it doesn't matter how hard one searches. Until the Great Recession is over, employment will continue to be depressed. And, the failure by the Senate to extend UI will only serve to prolong the Great Recession through a reduction in consumption.

Supply Side vs. Demand Side

This Sunday on CNN's Fareed Zakaria GPS, Fareed interviewed Paul Krugman (Princeton University Department of Economics) and Raghuram Rajan (University of Chicago School of Business). It was as clear an exposition as I've heard of supply-side vs. demand-side economics and worth watching (here and for more Rajan, here, more Krugman, here, and more Zakaria on this topic, here).

Rajan argued for supply-side measures to return US competitiveness (increased business confidence, improved labor force skill levels, tax cuts to stimulate investment, etc.) while Krugman made the Keynesian argument (the subprime mortgage crisis has reduced consumer demand, business have excess capacity and won't invest or expand until there is more demand, and therefore government has to step in with economic stimulus).

It's hard not to agree with both positions since each is right, in theory. As a practical matter, however, the supply-side solutions only work in the long-term (how long will it take to retrain the US workforce?) and the demand-side solutions may not work at all (the US political system is unable to act quickly enough and with enough unity of purpose to enact a stimulus that would be large enough to have any impact).

Eventually, the economy will heal itself or at least find a new equilibrium. There's just no guarantee that the new equilibrium will be at a high level of either growth or employment.

The President's New Plan

It's getting close to the mid-term elections in the US and President Obama has a new plan for business tax breaks. Robert Reich gave a great commentary on NPR's Market Place and the commentary seemed to be based (with some embellishment) on the causal model above (click on the graphic for an enlarged view).

The president is proposing corporate tax cuts for R&D. Tax cuts will lead to the development of labor-saving technology that reduces jobs. Profits might also generate some investment (if there is demand). Otherwise, profits will be expended on CEO pay and Shareholder dividends which fuel the Stock Market casino (didn't that all start the Great Recession in the first place, that is, too much easy money sloshing around).

The problem we're having right now is inadequate demand created by the Great Recession (you can see the vicious circle in the graph: lack of demand leads to lack of sales leads to lack of production which leads to unemployment which decreases demand, etc.). Interest rates could be lowered by the Federal Reserve but they are almost at zero (the zero-bound) right now. Exports could be increased but the rest of the world is also in recession. Imports could be reduced (e.g., automobiles) but that requires demand for US products.

What remains is the Keynesian economic prescription: government spending. There is only one problem with increased government spending: it is being blocked by deficit hawks, fiscal conservatives, sound money evangelists, and bond vigilantes. The same dynamic played out during the Great Depression until WWII intervened.

So, the President's New Plan will be counterproductive (R&D tax cuts could decrease jobs), the Fed is at the zero-bound, and government expenditure will not increase unless we have another World War. What's going to happen?

Eventually, the markets will have their way and, in the words of Andrew Mellon (Herbert Hoover's Treasury Secretary), the markets will:

...liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

For people that believe in markets and for people that do not, Mellon makes an important point. All markets will eventually adjust to bubbles created in other markets (e.g., housing and the stock market). The adjustments are brutal and painful if not necessarily swift. Subdivided ghost towns will be bulldozed or left to decay, jobs will be shipped to low-wage countries, companies will fail, people will drop out of the work force or take jobs below their skill level, and eventually there will be a new equilibrium.

The politics of all this are a little infantile: The US father figure (the president) is expected to fix the mess yet, at the same time that he is expected get out of the economy by reducing expenditure and regulation. I just heard another great Catch-22 in NPR Marketplace tonight: all the stimulus funds have not been spent because there are not enough federal workers to manage the contracts.