Econ 115: The Great Divergence (November 3, 2009)
On Track for Another 6% Productivity Growth Quarter in the Fourth...

What Would Have Happened If World Governments Had Washed Their Hands of the Financial Crisis?

For Project Syndicate:

Slouching Toward Sanity: In America today – and in the rest of the world – economic-policy centrists are being squeezed.

The Economic Policy Institute reports a poll showing that Americans overwhelmingly believe that the economic policies of the past year have greatly enriched the bankers of Midtown Manhattan and London’s Canary Wharf (they really aren’t concentrated on Wall Street or in the City of London anymore). In America, the Republican congressional caucus is just saying no:

  • no to short-term deficit spending to put people to work,
  • no to supporting the banking system,
  • and no to increased government oversight or ownership of financial entities.

And the banks themselves are back to business-as-usual: anxious to block any financial-sector reform and trusting congressmen eager for campaign contributions to delay and disrupt the legislative process.

I do not claim that policy in recent years has been anything close to ideal.

If I had been running things 13 months ago, the United States Treasury and Federal Reserve would have let Lehman and AIG fail – but would have taken the obligations of those entities for cash at face value provided that the obligations also came with sufficient equity warrants to give the government a proper share of the upside. That would have preserved the functioning of the system. That would have punished--severely--the banking and shadow-banking systems’ equity holders who had not performed sufficent due diligence. That would have kept any bankers today from claiming that their risk management practices were adequate and did not need reform.

If I had been running things 19 months ago, I would have nationalized Fannie Mae and Freddie Mac. For the duration of the crisis shifted monetary and financial policy from targeting the Federal Funds rate to targeting the price of mortgages. Ever since 1825, the purpose of monetary policy in a crisis has been to support asset prices to prevent the financial markets from sending to the real economy the price signal that it is time for mass unemployment. Nationalizing Fannie and Freddie, and using them to peg the price of mortgages, would have been the cleanest and easiest way to accomplish that.

Nevertheless, policy over the past two and a half years has been good.

A fundamental shock bigger than the one in 1929-1930 hit a financial system that was much more vulnerable to shocks than was the case back then. Despite this, unemployment will peak at around 10%, rather than at 24%, as it did in the US during the Great Depression. Nonfarm unemployment will peak at 10.5%, rather than at 30%. Nor will we in the end have a lost decade of economic stagnation, as Japan did in the 1990’s.

Admittedly, this comparison bar is low.

But our policymakers have cleared it. They might have well not have.

Thus it is worth stepping back and asking: What would the economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program (TARP) program had won the day? What would the economy have looked like today had Senators Nelson, Snowe, and company done to Obama's discretionary deficit-spending plan what their predecessors did to Clinton's in 1993 and blocked it?

The only point of reference is the Great Depression itself. That is the only time in more than a century when (a) a financial crisis caused a widespread, lengthy, and prolonged reinforcing chain of bank failures, and (b) the government by and large washed its hands--neither intervened on a large scale itself nor passed the baton to a consortium of private banks (usually, in the U.S., headed by Morgan) to support the system as a whole.

It is now 19 months after Bear Stearns failed and was taken over by JP MorganChase, with the assistance of up to $30 billion of Federal Reserve money on March 16, 2008. Industrial production now stands 14% below its peak in 2007.

By contrast, 19 months after the Bank of United States, with 450,000 depositors, failed on December 11, 1930 – the first major bank collapse in New York since the Knickerbocker Trust failure during the panic and depression of 1907 – industrial production, according to the Federal Reserve index, was 54% below its 1929 peak.

Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient webs that offer the best possible incentives to people to make deals and use resources productively. A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it?

If so, then the unavoidable conclusion must be that things would not have been so bad if the government had refused to implement an expansionary fiscal policy, recapitalize banks, nationalize troubled institutions, and buy financial assets in non-standard ways.

The problem, though, is that all the theoretical arguments that depressions as deep as the Great Depression simply do not happen to modern market economies – well they applied just as well to the 1930s as they do to today.

But the Great Depression did happen. And it could have happened again. All that had to happen then was for the logic of the financial crisis to roll through to its conclusion, in the absence of extraordinary government intervention to stem it.