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

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

By Simon Johnson

Third, what is the deeper cause of this crisis? A supersized financial system - the obesity of banks and shadow banks - helped create the vulnerabilities that made the September crisis possible. This financial system captured its regulators and took on far more risk than it could manage (or even understand). And this is a statement not just about US banks, but also about most parts of the global financial system.

The answer lies with the political economy of the US financial system, including the power politics of large financial firms. These grew large relative to the institutions that support and constrain them. In effect, we created an emerging market-type of structure. There is nothing in the mainstream textbooks or working papers about this - the general working assumption has been that institutions in the US were significantly better than in emerging markets. The time has obviously come to question in what sense this is really true.

The US banks have received generous bailouts, at least after the Lehman-AIG events, with no change in management. Have they become stronger or weaker? After the crisis we will have probably no more than 6 major banks in the US, with little threat from new entrants and small hope of controlling their actions indefinitely through effective regulation.

The problems are even more pressing if it is the case that these banks need to be recapitalized fully. They oppose this policy, for obvious reasons. The fiscal stimulus may well prove ineffective in the face of this political opposition, which is still well represented at the heart of the new administration’s economic strategy. Again, however, I find leading economists to be surprisingly quiet on this key issue.

The fourth question is: What are the implications for the eurozone? Again, there is a huge divergence of opinions among economists on this point. Personally, I’m struck by the growing pressure on some of the weaker sovereigns that belong to the euro currency union. Greece faces the most immediate problems, as demonstrated both by widening credit default swap spreads and - over the past few weeks - increasing spreads of Greek bonds over German government bonds. The cost of servicing Greek government debt is thus rising at the same time as Greece has to roll over debt worth around 20 percent of GDP in the coming year.

Greece has a debt-to-GDP ratio over 90 percent, and the perceived risk of default is significant. In our baseline view, Greece receives a fairly generous bailout from other eurozone countries (and probably from the EU). This, however, does not come early enough to prevent problems from spreading to Ireland and other smaller countries (which then also need to implement fiscal austerity or to receive support). Italy is also likely to come under pressure, due to its high debt levels, and here there will be no way other than austerity. With or without a bailout, Greece and other weaker euro sovereigns will need to implement fiscal austerity.

The net result - in my opinion - is less fiscal stimulus than would otherwise be possible, and in fact there is a move to austerity among stronger euro sovereigns as a signal. Governments will therefore struggle to dissave enough to offset the increase in private sector savings. But the global mainstream economics approach still seems to be emphasis on fiscal policy coordination.

In any case, monetary policy in Europe will be slow to respond. The European Central Bank decision-making process seeks consensus and some key members are still more worried about inflation down the road than deflation today. Eventually the ECB will catch up, but not before there has been considerable further slowing in the eurozone.

Probably existing macroeconomic thinking can accommodate this kind of analysis. It’s a blend of financial market analysis with political economy. But I don’t know any models, let alone much empirical work, that bears directly on - or comes close to testing - any dimensions of this issue. Economics is in thin air.

My guess is that, among other things, we need to change dramatically our ways of thinking about fiscal policy. This needs to prepare for irregular but large crises, which implies being more countercyclical - and that implies less growth in boom times. Monetary policy will not stop bubbles and regulators will always fall behind; responsibility for making sure we can handle major financial crises rests with fiscal policy.

Rethinking the Structure of the Global Economy

If economics is in so much trouble, what does this imply for thinking about economic policy - both in terms of sensible crisis management and more medium-term attempts to rebuild a reasonable global system?

In order to create the conditions for long-term economic health, we need to identify the real structural problem that created the current situation and likely means the global economy has entered a new phase of instability. It wasn’t a particular set of payments imbalances (read: US-China), as these can and will change (which does not excuse policymakers who refused to address this issue). It wasn’t the failure of a particular set of domestic regulators, as regulatory challenges and responses change over time (which doesn’t excuse the specific regulators).

Let me suggest a way to think about these economic issues, although I know this will not sit well with many macroeconomists (although it may go down better with those who focus on longer run growth issues). The underlying problem was that, after the 1980s, the “Great Moderation” of volatility in industrialized countries created the conditions under which finance became larger relative to GDP and credit could grow rapidly in any boom. In addition, globalization allowed banks to become big relative to the countries in which they are based (with Iceland as an extreme example). Financial development, while often beneficial, brings risks as well. (None of these points would have sat well with mainstream finance or economics two years ago, but perhaps the consensus around some of these points has shifted recently.)

The global economic growth of the last several years was in reality a global, debt-financed boom, with self-fulfilling characteristics - i.e., it could have gone on for many years or it could have collapsed earlier. The US housing bubble was inflated by global capital flows, but bubbles can occur in a closed economy (as shown by experiments). The European financial bubble, including massive lending to Eastern Europe and Latin America, occurred with zero net capital flows (the eurozone had a current account roughly in balance). China’s export-driven manufacturing sector had a bubble of its own, in its case with net capital outflow (a current account surplus).

But these regional bubbles were amplified and connected by a global financial system that allowed capital to flow easily around the world. We are not saying that global capital flows are a bad thing; ordinarily, by delivering capital to the places where it is most useful, they promote economic growth, in particular in the developing world. But the global system also allows bubbles to feed on money raised from anywhere in the world, exacerbating global systemic risks. When billions of dollars are flowing from the richest countries in the world to Iceland, a country of 320,000 people, chasing high rates of interest, the risks of a downturn are magnified, for the people of Iceland in particular.

The prevalence of debt in the global boom was also a major contributing factor to today’s recession (although major disruptions could also arise from the busting of pure equity-financed booms). Debt introduces discontinuities on the downside: instead of simply becoming losing money, companies with high debt levels go bankrupt in hard times. Lehman, AIG, and now GM all created systemic risks to the US and global economies because one default can trigger a series of defaults among other companies - and simply the fear of those dominos falling can have systemic effects. Similarly, emerging market defaults can have systemic effects by spreading fear and causing investors to pull out of unrelated but similarly situated countries (and causing speculators to bet against their currencies and stock markets).

Ideally, global economic growth requires a rebalancing away from the financial sector and toward non-financial industries such as manufacturing, retail, and health care (for an expansion of this argument, see our opinion piece on this topic, available through http://baselinescenario.com/2008/11/11/obama-economic-strateg/). Especially in advanced economies such as the US and the UK, the financial sector has accounted for an unsustainable share of corporate profits and profit growth. However, the financial sector, despite the experiences of the last year, is still powerful enough to resist significant structural reform. While this will not prevent a return to economic growth, it will maintain all of the risks that led to the current situation - in particular, the risk of synchronized booms and busts around the world.

Understanding how to prevent stability from creating future vulnerability will require us to rethink a great deal about economics and how economies operate. Political economy is probably the place to begin, but a lot more needs to be done on fundamentals. Whether or not our economies manage to avoid a major global depression, economics is in crisis.

Revised version of text prepared for delivery as Presidential Address to the Association for Comparative Economics, San Francisco, January 4, 2009. Comments from members of the Association are gratefully acknowledged. Conversations with Daron Acemoglu and Adam Davidson helped to shape these remarks and this essay draws freely on joint work with Peter Boone and James Kwak (see http://BaselineScenario.com for details), but the views expressed here are solely those of the author.

Comments

[Lin:]

Re

Great article ! I concur with all ideas expressed .

Jan 06 06:52 PM

[MarvinMBA:]

The author is right on with the comments about the International Political Economic Model now becoming important. Coordination with our trading and investment partners on a world wide basis is exactly what is needed to help contain the volatility we are going thru now and in the future...MarvinMBA

Jan 06 08:03 PM

[User 265729:]

The so-called global economy is a fake. No common currency. Can you freely move from country to country to compete for jobs?

It's never been a global economy. At best it could be deemd something that some nations used to exploit other nations and that some corporations used to destroy the workforce in their own countries -- all for profit.

Global economy? Really now.

Jan 06 08:49 PM

[Ricard:]

In industrial societies, the economy is the base from which one can achieve political objectives...i.e., war without war.


On Jan 06 08:49 PM curbs-in wrote:

> The so-called global economy is a fake. No common currency. Can
> you freely move from country to country to compete for jobs?
>
> It's never been a global economy. At best it could be deemd something
> that some nations used to exploit other nations and that some corporations
> used to destroy the workforce in their own countries -- all for profit.

>
>
> Global economy? Really now.

Jan 06 11:01 PM

[You're Kidding:]

"However, the financial sector, despite the experiences of the last year, is still powerful enough to resist significant structural reform."

This will be our downfall if it does not change.

Obviously, the reason the banking system got hundreds of billions in the bailout, and the auto industry had to fight to get far, far less, is because politicians are frightened to death of money because they just don't understand what it is and how it functions. One reason for this is because human beings are so attracted to the idea of money because of their emotional greed for it, while at the same time they know this lust can be a "bad" thing and can lead to utterly bazaar and inexplicable behavior: murder and suicide to mention two.

So, if the people (bankers) who work with and control this stuff (money) say things are really bad and they need a bunch more of it, well, we better give it to them, by golly!

De-privatizing (nationalizing) the banking system and wrestling control of it from the few hundred that really control it (Fed+) would be the greatest thing to help ourselves we could ever do. However, at that point, who is going to be in charge of it? And how do we make sure that they act in accordance with what's best for us, our country, and the world, so we avoid the kind of situation we are in today?

Good question....

Jan 07 05:02 AM

[investor88:]

According to author Simon its too early to call for the all clear as many professionals are now saying. Prof Simon has expressed the risks quite well, and all is not well yet. Tread with caution.

Jan 07 08:45 AM

[John Lounsbury:]

Simon - - -

I am reading between the lines:

1. Concentration of wealth in too few hands freezes all others out of capital access. When the concentrated wealth becomes highly leveraged, the forced declining resources of the rest of the world leads to collapse and massive wealth destruction. (My view is that corporations, individuals or governments are suspect as accumulators of too much wealth, especially when highly leveraged. Government example: the Soviet Union. I hope the U.S. avoids becoming another example.)

2. Fiscal stimulus has been practiced repeatedly since 1960. Fiscal restraint in good times has been ignored. (Except, possibly, in the late '90s. I say "possibly" because the vast capital gains in that time period may have provided cover for what might be called fiscal restraint, but really was just being lucky.) Keynsian economic theory has been cherry picked by policy makers (both parties) to give the carrots when the rabbits are starving but not taking the carrots away when the rabbits are well fed. I agree that economics is in crisis, but it is more in how it has been abused by policy makers and market opportunists than on the basic merits of economic theories.

3. We are still being victimized by the Golden Rule: "Those that have the gold make the rules." I would add that there is an algorithm: "Even when the gold is illusory, the same still make the rules." If we could tear everything down and start over from basic foundations we might do better. I don't think that tearing everything down would work because the foundations of society could be buried or destroyed. Without the foundations, life would be returned to prehistoric structures and building anew would then take centuries.

4. This is not actually between the lines (and related to algorithm 1, above) because you state: "Ideally, global economic growth requires a rebalancing away from the financial sector and toward non-financial industries such as manufacturing, retail, and health care..."

You have been presenting excellent fundamental economic commentary in understandable language in your recent articles. Thanks.

Jan 07 12:27 PM