The Economic Crisis vs. the Crisis in the Economy, Part I

By Simon Johnson

The Economic Crisis

The global financial crisis of fall 2008 was unexpected. A few people had been predicting that serious problems were looming, and even fewer had placed bets accordingly, but even they were astounded by what happened in mid-September.

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis. (See http://BaselineScenario.com for more on what came before, how events unfolded during fall 2008, and where matters now stand).

1. On the weekend of September 13-14, 2008, the U.S. government declined to bail out Lehman. The firm subsequently failed, i.e., did not open for business on Monday, September 15. Creditors suffered major losses, and these had a particularly negative effect on the markets given that through the end of the previous week the Federal Reserve had been encouraging people to continue to do business with Lehman.
2. On Tuesday, September 16, the government agreed to provide an emergency loan to the major insurance company, AIG (AIG). This loan was structured so as to become the company’s most senior debt and, in this fashion, implied losses for AIG’s previously senior creditors; the value of their investments in this AAA bastion of capitalism dropped 40% overnight.
3. By Wednesday, September 17, it was clear that the world’s financial markets - not just the US markets, but particularly US money market funds - were in cardiac arrest. The Secretary of the Treasury immediately approached Congress for an emergency budgetary appropriation of $700bn (about 5% of GDP), to be used to buy up distressed assets and thus relieve pressure on the financial system. A rancorous political debate ensued, culminating in the passing of the so-called Troubled Asset Relief Program (TARP), but the financial and economic situation continued to deteriorate both in the US and around the world.

Thus began a financial and economic crisis of the first order, on a magnitude not seen at least since the 1930s and - arguably - with the potential to become bigger than anything seen in the 200 years of modern capitalism. We do not yet know if the economic consequences are “merely” a severe recession or if there will be a prolonged global slump or worse.

The Crisis in Economics

Does this economic crisis constitute or imply a crisis for economics? There are obviously two answers to this question: no, and yes.

Let me discuss the “no crisis” view first. There are actually several variants on this view. The first is that the post-Keynesian consensus comes through the crisis just fine. In fact, the current emphasis on fiscal stimulus in the US (and the debate about fiscal stimulus elsewhere) supports the position that we are back to Keynesian fundamentals. There is a decline in private spending underway, and governments around the world are seeking to replace that with public spending (or, if you prefer, the private sector suddenly wants to save more, so the public sector better rush to save less.)

A more nuanced version of this view adds some financial accelerators, or perhaps we should now call them decelerators. We obviously had a series of bank runs in mid-September, but not just by small depositors and not just on banks. We also had a situation where falling values for collateral triggered more asset sales (either for accounting reasons or due to market pressure of various kinds), and this led to further lowering of collateral.

More broadly, there was also some kind of bad expectations trap, in which everyone expected everyone else to default and that kind of fear of counterparty risk is obviously self-fulfilling.

In other words, this view is that we can retrofit our favorite mainstream models to accommodate what happened, at least at a fairly high level of abstraction. There is no crisis for macroeconomic thinking, let alone for economics.

An alternative interpretation is that mainstream macroeconomics is in big trouble. You can think about this in terms of whether standard thinking provides plausible answers to four current policy issues. (Daron Acemoglu of MIT has an important essay in preparation, arguing that there are deeper problems for economics, including for the most fundamental microeconomics - such as how we think about firms and reputations - in the light of the crisis.)

First, let’s begin with whether macroeconomics can answer definitively or even informatively the most important question of the day. Are we in danger of falling into another Great Depression, with a prolonged, worldwide fall in output and employment?

The mainstream answer to this question is: no, because we’ve learned a lot about economics since the Great Depression and because we also learned a great deal about policy both during and after the 1930s.

I’m not so convinced. For example we know that a key policy mistake in the early 1930s was to allow banks to fail. This will not happen again, at least not for “systemic institutions” - as the G7 made clear in October. But bank failure was a problem because it contributed to a big contraction in credit - this has been well established in the work of Ben Bernanke and others. Unfortunately, we know relatively little about how to stop today’s process of falling credit around the world, known as “global deleveraging.”

Second, consider the current consensus on saving the day in the US and around the world through a large US fiscal stimulus - probably $800bn over several years, which would constitute the largest peacetime boost ever for the US economy. Is this really the right approach?

We know that allowing the price level to decline was an essential error of the early 1930s, as this increased the real debt burden for everyone with fixed nominal obligations. We think we know how central banks can prevent this kind of deflation, and Mr. Bernanke’s now famous November 2002 speech laid out a clear road map for appropriate policies - even to the extent of “quantitative easing,” i.e., extending more credit without sterilization through selling Treasuries, thus increasing the monetary base.

Still, I am struck by the fact that while the opinion leaders among US-based macroeconomists eventually called for some version of “credible irresponsibility” (to counter deflation or even produce inflation) in Japan during the 1990s, we have still not reached the point where such terms have joined the acceptable lexicon for most of the mainstream on the US economy today. (Some leading economists, I find, are willing to talk in these terms in private, but not yet in public.)

I would stress that nothing in the Fed policy or the Obama Plan has yet turned the corner on this issue. In fact, inflation expectations have not risen significantly since it became clear Mr. Obama would win the election and introduce a major fiscal stimulus.

Think about that in terms of monthly payments on your (or my) house. Let’s say the interest rate on your mortgage is 6%, which is roughly the average for the U.S. When inflation runs around 2% (as is typical), the real, inflation-adjusted rate you pay is lower - actually only 4%. But the price level is now expected by the financial market to be flat on average for each of the next 5 years. So in this case the real interest rate will be 6%. In other words, the advent of deflation implies a massive unexpected transfer of income from borrowers to lenders. With the face value of outstanding mortgages over $10trn, this will likely depress spending by more than can be compensated for by any reasonable fiscal stimulus.

The appeal of recreating positive inflation expectations is that it would put downward pressure on the dollar and thus push our major trading partners to cut interest rates and engage in their own forms of monetary expansion - or face appreciation of their currencies and a fall in exports. The result will be higher global inflation, to be sure, but this is the only realistic way to persuade European Union members to take the measures necessary to stimulate their stronger economies or even save their own weaker economies from default.

President Obama can ask our allies to provide stimulus until he is blue in the face, but the fact of the matter is that the very size of our own fiscal expansion gives the Germans and others the incentive to free ride - they are hoping to recover on the back of exports to our infrastructure projects. It is only more expansionary monetary policy in the US that will force their hands in the right direction, for us and for them.

Continued in Part II >>