James Galbraith: No Return to Normal

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James Gal­braith has writ­ten a very good analy­sis of the cri­sis and why the poli­cies being fol­lowed in the USA (and, by impli­ca­tion, here) will not work.

I repro­duce some extracts here to give you a flavour of the arti­cle, but I rec­om­mend a read of the full paper in the Wash­ing­ton Monthly–thanks to blog mem­ber War­ren Raft­shol for bring­ing it to my atten­tion. The empha­sis added to some points is mine.

No Return to Normal. Why the economic crisis, and its solution, are bigger than you think.

The deep­est belief of the mod­ern econ­o­mist is that the econ­o­my is a self-sta­bi­liz­ing sys­tem. This means that, even if noth­ing is done, nor­mal rates of employ­ment and pro­duc­tion will some­day return. Prac­ti­cal­ly all mod­ern econ­o­mists believe this, often with­out think­ing much about it. (Fed­er­al Reserve Chair­man Ben Bernanke said it reflex­ive­ly in a major speech in Lon­don in Jan­u­ary: “The glob­al econ­o­my will recov­er.” He did not say how he knew.) The dif­fer­ence between con­ser­v­a­tives and lib­er­als is over whether pol­i­cy can use­ful­ly speed things up. Con­ser­v­a­tives say no, lib­er­als say yes, and on this point Obama’s econ­o­mists lean left. Hence the pri­or­i­ty they gave, in their first days, to the stim­u­lus pack­age.

But did they get the scale right? Was the plan big enough? Poli­cies are based on mod­els; in a slump, plans for spend­ing depend on a fore­cast of how deep and long the slump would oth­er­wise be. The pro­gram will only be cor­rect­ly sized if the fore­cast is accu­rate. And the fore­cast depends on the under­ly­ing belief. If recov­ery is not built into the genes of the sys­tem, then the fore­cast will be too opti­mistic, and the stim­u­lus based on it will be too small…

Why did the CBO reach this con­clu­sion? On depth, CBO’s mod­el is based on the post­war expe­ri­ence, and such mod­els can­not pre­dict out­comes more seri­ous than any­thing already seen. If we are fac­ing a down­turn worse than 1982, our com­put­ers won’t tell us; we will be sur­prised. And if the slump is des­tined to drag on, the com­put­ers won’t tell us that either. Baked into the CBO mod­el we find a “nat­ur­al rate of unem­ploy­ment” of 4.8 per­cent; the mod­el moves the econ­o­my back toward that val­ue no mat­ter what. In the real world, how­ev­er, there is no rea­son to believe this will hap­pen. Some alter­na­tive fore­casts, freed of the mys­ti­cal return to “nor­mal,” now project a GDP gap twice as large as the CBO mod­el pre­dicts, and with no near-term recov­ery at all…

Three fur­ther con­sid­er­a­tions lim­it­ed the plan. There was, to begin with, the desire for polit­i­cal con­sen­sus; Pres­i­dent Oba­ma chose to start his admin­is­tra­tion with a bill that might win bipar­ti­san sup­port and pass in Con­gress by wide mar­gins. (He was, of course, spurned by the Repub­li­cans.) Sec­ond, the new team also sought con­sen­sus of anoth­er type. Christi­na Romer polled a bipar­ti­san group of pro­fes­sion­al econ­o­mists, and Lar­ry Sum­mers told Meet the Press that the final pack­age reflect­ed a “bal­ance” of their views. This pro­ce­dure guar­an­tees a result near the mid­dle of the pro­fes­sion­al mind-set. The method would be use­ful if the errors of econ­o­mists were unsys­tem­at­ic. But they are not. Econ­o­mists are a cau­tious group, and in any extreme sit­u­a­tion the mid­point of pro­fes­sion­al opin­ion is bound to be wrong.

The most like­ly sce­nario, should the Gei­th­n­er plan go through, is a com­bi­na­tion of loot­ing, fraud, and a renewed spec­u­la­tion in volatile com­mod­i­ty mar­kets such as oil. Ulti­mate­ly the loss­es fall on the pub­lic any­way, since deposits are large­ly insured. There is no chance that the banks will sim­ply resume nor­mal long-term lend­ing. To whom would they lend? For what? Against what col­lat­er­al? And if banks are recap­i­tal­ized with­out chang­ing their man­age­ment, why should we expect them to change the behav­ior that caused the insol­ven­cy in the first place?…

In oth­er words, Roo­sevelt employed Amer­i­cans on a vast scale, bring­ing the unem­ploy­ment rates down to lev­els that were tol­er­a­ble, even before the war—from 25 per­cent in 1933 to below 10 per­cent in 1936, if you count those employed by the gov­ern­ment as employed, which they sure­ly were. In 1937, Roo­sevelt tried to bal­ance the bud­get, the econ­o­my relapsed again, and in 1938 the New Deal was relaunched. This again brought unem­ploy­ment down to about 10 per­cent, still before the war…

The New Deal rebuilt Amer­i­ca phys­i­cal­ly, pro­vid­ing a foun­da­tion (the TVA’s pow­er plants, for exam­ple) from which the mobi­liza­tion of World War II could be launched. But it also saved the coun­try polit­i­cal­ly and moral­ly, pro­vid­ing jobs, hope, and con­fi­dence that in the end democ­ra­cy was worth pre­serv­ing. There were many, in the 1930s, who did not think so.

What did not recov­er, under Roo­sevelt, was the pri­vate bank­ing sys­tem. Bor­row­ing and lending—mortgages and home construction—contributed far less to the growth of out­put in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had sav­ings at all, peo­ple stayed in Trea­suries, and despite huge deficits inter­est rates for fed­er­al debt remained near zero. The liq­uid­i­ty trap wasn’t over­come until the war end­ed.

It was the war, and only the war, that restored (or, more accu­rate­ly, cre­at­ed for the first time) the finan­cial wealth of the Amer­i­can mid­dle class. Dur­ing the 1930s pub­lic spend­ing was large, but the incomes earned were spent. And while that spend­ing increased con­sump­tion, it did not jump­start a cycle of invest­ment and growth, because the idle fac­to­ries left over from the 1920s were quite suf­fi­cient to meet the demand for new out­put. Only after 1940 did total demand out­strip the economy’s capac­i­ty to pro­duce civil­ian pri­vate goods—in part because pri­vate incomes soared, in part because the gov­ern­ment ordered the pro­duc­tion of some prod­ucts, like cars, to halt…

Third, in the debt defla­tion, liq­uid­i­ty trap, and glob­al cri­sis we are in, there is no risk of even a mas­sive pro­gram gen­er­at­ing infla­tion or high­er long-term inter­est rates. That much is obvi­ous from cur­rent finan­cial con­di­tions: inter­est rates on long-matu­ri­ty Trea­sury bonds are amaz­ing­ly low. Those rates also tell you that the mar­kets are not wor­ried about financ­ing Social Secu­ri­ty or Medicare. They are more wor­ried, as I am, that the larg­er eco­nom­ic out­look will remain very bleak for a long time

A para­dox of the long view is that the time to embrace it is right now. We need to start down that path before dis­as­trous pol­i­cy errors, includ­ing fatal banker bailouts and cuts in Social Secu­ri­ty and Medicare, are put into effect. It is there­fore espe­cial­ly impor­tant that thought and learn­ing move quick­ly. Does the Gei­th­n­er team, forged and trained in nor­mal times, have the range and the flex­i­bil­i­ty required? If not, every­thing final­ly will depend, as it did with Roo­sevelt, on the imag­i­na­tion and char­ac­ter of Pres­i­dent Oba­ma.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.