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You Got Me Feelin Hella Good So I'm Gonna Keep on Dancing: Alan Blinder: "After the Music Stopped": Tuesday Book Reviews Extended Version Weblogging

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Alan Blinder is the latest economist out of the gate with an analytical account of the recent economic downturn. His 2013 After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: Penguin) is, I think, the best of accounts--at least the best for those without the substantial background and experience in finance needed to successfully crack the works of Gary Gorton. It is the best for four reasons:

  1. The narrative is very good--it is, from my perspective at least, clear and correct.
  2. Alan Blinder has a deep understanding of macroeconomics--thus he can place the events in context, and explain just how it was that the housing boom and its crash had such catastrophic effects on the American economy while, say, the dot-com boom and its crash did not (and was in fact a net plus for the U.S. economy as a whole: a lot of research and development got done, a lot of useful business-model experimentation took place, and a lot of very valuable twenty-first century virtual infrastructure got built--the housing boom brought us no analogous benefits).
  3. Alan Blinder has a very clear sense of the policy options, both in the past and now: what did work, what would have worked, what might have worked, and what would still work were we to try it to get us out of the current fix we are in.
  4. As noted, the book is very readable, even for those who have not been marinated in finance enough to grasp the technicalities and even for those who find topics like "the fall of the rupee" sensational and interesting. For those who do and have worked in or near Wall Street or it equivalent, I recommend Gary Gorton. For everybody else, I recommend Alan Blinder.The topic is certainly enormously important. The economy is today, still, four and a half years after the crash of 2008, six years after the emergence of the first signs of significant trouble in Wall Street, and seven years after the peak of the housing boom, deeply depressed.

Blinder writes that "policy makers are still nursing a frail economy back to health". I am not so sure that is right. It does not look, to me at least, "frail" and "being nursed back to health". To me, it still looks very sick. Blinder writes: "having the national unemployment rate near 8 percent is a lot better than having it near 10 percent, but it is far from good". Blinder is thinking in terms of an economy in which acceptable (although far from ideal or attainable) employment performance has an unemployment rate of 6 percent, and thus that we are halfway back to economic health.

I see an economy in which the share of American adults who were employed was 63% in the mid-2000s, fell to 58.5% in 2009, and is still 58.5% today. We would have expected the natural aging of America's population to have carried the share of adults at work from 63% down to 62% over the past seven years or so--not to 58.5%. And we would have expected the collapse of people's retirement savings either in housing or in stocks in 2008 to have led many Americans to postpone retirement. Given the collapse in the value of retirement savings and their impact on desired retirements, I see a healthy American economy today as one that would still have the same adult employment-to-population ratio of 63% as the economy of the mid-2000s.

From that perspective, we are not halfway back to health. We had a gap of 4.5% points between actual employment and full employment at the end of 2009. We have a gap of 4.5% points between actual employment and full employment today. We are flatlining. It is true that in late 2009 there were still real and rational fears that things might become worse very quickly, and that that possibility is no longer on the menu. But in my view our "recovery" has taken the form not of things getting better but of having successfully guarded against the possibility that things would get even worse. And that is a very feeble recovery indeed. And, in Europe, things are getting worse right now.

Most economists would say that there is a silver lining, in that this is not a Great Depression. I have been calling the current episode the "Lesser Depression". I now think that most economists are--and that I was--wrong in claiming this silver lining.

In the Great Depression that struck the U.S. in 1929, the subsequent twelve years before American mobilization for World War II erased the last shadows of the Great Depression, production averaged roughly 15% below the pre-Great Depression trend, for a total depression waste output shortfall of 180% of a year's production. Today, even if U.S. production returns to its stable-inflation potential by 2017--a huge if--we will as of 2017 have incurred a depression waste output shortfall of 60% of a year's production. The losses from what I have been calling the Lesser Depression will not be over in 2017. As best as I can foresee, there is no moral-equivalent-of-war on the horizon to pull us into a mighty boom to erase the shadow cast by the downturn, and when I take present and values and capitalize the lower trend growth of the American economy as a result of the shadow into the future, I cannot reckon the present value of the additional cost at less than a further 100% of a year's output today, for a total cost of 160% of a year's production. The damage is thus equal to that of the Great Depression, counting a 1% of production shortfall as equally destructive whenever it happens.

Now it is certainly true that this downturn has caused less human misery than the Great Depression caused. But that is because of political and sociological factors, not economic ones. The great construction of social insurance programs by Franklin Roosevelt's New Deal, Harry Truman's Fair Deal, John F. Kennedy's New Frontier, and Lyndon B. Johnson's Great Society--and their successful defense by Bill Clinton--does not appear to have imposed any significant drag on America's long-run economic growth and does mean that income support programs sharply limit the amount of mass poverty that a severe economic downturn will cause.

Nevertheless, my conclusion is that I should stop calling this downturn the "Lesser Depression" because there is little if anything "lesser" about it. The current downturn has a different shape than the Great Depression did. But, so far at least, there is no reason to take the current Lesser Depression to be any smaller in the hierarchy of macroeconomic disasters than the Great Depression was.

As Oscar Wilde's Lady Bracknell, in "The Importance of Being Earnest", admonishes the orphaned Jack Worthing: "To lose one parent, Mr. Worthing, may be regarded as a misfortune. To lose both looks like carelessness." To undergo one Great Depression-sized disaster may indeed by regarded as a misfortune. To undergo two does indeed smack like carelessness. There is something deeply wrong here--something that we thought we had fixed after the 1930s, and yet it turned out that we had not in fact done so.

And what of the future? Only ambitious political action like that of a Roosevelt could insure the country from suffering an equal economic calamity once again. Yet the U.S. political system is dysfunctional. Congress will not support the kind of financial regulation the country sorely needs. Blinder concludes his narrative with a number of smart forward-looking recommendations, but his book’s biggest weakness is that it lacks a roadmap out of the present impasse, without which the United States is likely to suffer another major economic crisis in the years ahead.

Still Waiting for the Real Recovery

Is it possible that I am assuming the pose of a "Dr. Gloom" here? I do not believe so. For one thing, the U.S. bond market agrees with me. Since 1975 the term premium on the 30-year nominal Treasury bond has averaged 2.2% points: on average the 30-year nominal Treasury yields 2.2% points more than the expected average of future short-term nominal Treasury bill rates over its lifespan. The current nominal 30-year Treasury yields 3.2%/year. That means that, unless the marginal bond buyer today is unusually attracted to holding the 30-year Treasury, the marginal financial market participant anticipates that short-term nominal Treasury bill rates will average 1.0%/year over the next generation. The Federal Reserve keeps the short-term nominal Treasury bill rate near 1.0%/year only when the economy is depressed, when capacity is slack, when labor is idle, and when the principal risks are of deflation rather than of rising inflation. Since World War II, the U.S. unemployment rate has averaged 8% when the nominal Treasury bill rate is 2.0%/year or lower. That is the future that the bond market crystal ball--and the stock market crystal ball and the foreign exchange market crystal ball--all see for the United States and the world: a slack and depressed economy, if not for the entire next generation, at least for the bulk of it.

Barring a wholesale revolution in the thinking and personnel of the Federal Reserve, the U.S. Congress, and their counterparts elsewhere, activist policies are not going to rescue us.

Alan Blinder shares the consensus of reality-based economists that debt accumulation--whether the Federal Reserve buying or the U.S. Treasury issuing--is not our most serious problem right now. Yes, there is a possibility that someday--perhaps tomorrow--those who are presently buying the $1.1 trillion/year of new Treasury issues and holding the $1.0 trillion/year of new reserve deposits at the Federal Reserve will decide that they would rather do other things with their income than buy the flow of Treasuries and absorb the flow of reserve deposits. But when they switch to buying other things, they buy either property abroad--in which their counterparties then must spend their dollars and so boost U.S. exports--or buy corporate bonds which fund business investment--in which their counterparties boost spending on capital goods--or they buy goods and services directly--which boosts spending on consumption goods. The switch of the flow of expenditure away from soaking up Treasury bond issues and reserve deposit creation is the same thing as the economic recovery which boosts employment, production, and tax revenue, and so eliminates the deficit. The question of how the U.S. will finance its deficit after savers decide to switch away from accumulating more Treasuries and reserve deposits is a question that fails to understand how the circular flow of purchasing power and economic activity works. There are definite real problems associated with managing an economy near full employment in order to make the most of opportunities to sustain long-run economic growth. But it is much more pleasant to have those economic problems than to have our current economic problems.

I had always thought that policy makers well understood the basic principle of macroeconomic management. It was that the government's proper role was to adjust the circular flow in order to make Say's Law that (potential) supply creates its own (effective) demand true in practice, even though it was not true in theory. The government's job was to tweak asset supplies so that there were sufficient liquid assets, sufficient safe assets, and sufficient financial savings vehicles that the economy as a whole did not feel under pressure to deleverage, and so push production below potential output. This principle has gone out the window. The working majority of the Federal Reserve believes it has extended its aggressive expansionary policies to if not beyond the bounds of prudence. As Blinder writes: "The epic hawk-dove battle within the Federal Open Market Committee still rages. The Fed’s hawks seem more worried about the inflation we might get than about the high unemployment we still have. I’m rooting for the doves." But even the doves fear that their policies are already imprudent.

Worse is the attitude of the U.S. Congress. As Alan Blinder writes:

America’s budget mess is starting to look Kafkaesque because the outline of a solution is so clear: We need modest fiscal stimulus today coupled with massive deficit reduction for the future. Some of that will take the form of higher taxes—sorry, Republicans. Most of it will be lower spending—sorry, Democrats. If you view the world through sufficiently rose-colored glasses, you can perhaps see the two parties inching in that direction. But 'inching' isn’t good enough. There is plenty of room for partisan bickering over the details, but we need to adopt the Nike solution—Just do it!—as soon as possible. The Simpson-Bowles plan points the way, and I imagine that some distant cousin of Simpson-Bowles will be adopted someday. Someday. But not today.

He is preaching the right message, but he is preaching it to an audience of ravens and vultures. The working majority in the U.S. Congress is taking its cues from the Saturday Night Live character "Theodoric of York, Medieval Barber". It believes that what the economic patient needs is another good bleeding of rigorous austerity, and that is putting further downward pressure on employment and production. And policymakers elsewhere are more enthusiastic advocates of what used to be called "prolonged liquidation".

Alan Blinder also shares the consensus of reality-based economists that we are not going to get appropriate policies to restore effective demand to potential supply. He calls for an

unemployment rate more like 5 percent to 5.5 percent should be our goal; anything higher is unwarranted defeatism…

Nothing has changed since the 1990s or the mid-2000s to make such an unemployment goal incompatible with stable inflation. And, as Blinder notes, "the Federal Reserve seems to agree, having posted an official target range of 5.2 percent to 6 percent unemployment." But "we are not getting there quickly".

What Should Economists Do?

As U.S. policymakers cling stubbornly to wrongheaded policies, what can economists do? In such an environment, they can no longer realistically expect to push policy toward an appropriate posture. So what else should occupy their time? What, then, should economists who seek to better the world do? We can no longer realistically expect to push policy toward an appropriate posture. So what else should occupy our time?

At this point in the Great Depression John Maynard Keynes turned away from focusing on influencing policy to attempt to reconstruct macroeconomic thought by writing the General Theory so that the next time the crisis came economists would think about the economy in a different and more productive way than they had over 1929-1933. Up until 2009, I would have said that he had succeeded and been correct when he wrote to George Bernard Shaw at the start of 1935 that:

I believe myself to be writing a book on economic theory which will largely revolutionize--not I suppose, at once but in the course of the next ten years--the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say--in my own mind, I'm quite sure…

But today it is clear that the task was only half-done, if that. The same ritual incantations to summon the Confidence Fairy to appear and shower the blessings of prosperity on the economy that were made by the Herbert Hoovers and Andrew Mellons and Ramsay MacDonalds and Stanley Baldwins of the 1930s are now being made repeatedly and ever-more frantically.

At the London School of Economic on March 25, 2013 Lawrence Summers called for the twin reconstructions of macroeconomic thought on the one hand and of the institutions and orientation of central banking on the other--of macroeconomics so that economists could understand and advise and turn policy makers away from their incantations to the Confidence Fairy to more useful tasks, and of central banking so that never again would central bankers find themselves without the confidence to use the necessary tools to maintain prosperity.

But none of us are smart or bold or arrogant enough to try be a Keynes. Alan Blinder, however, seeks to do the second half of his task: to write a book that is both a popular history of the financial crisis and the downturn for those who cannot crack the books of Gary Gorton and his ilk, and to lay out prescriptions for how to keep us from having, in a generation, to once again suffer the pain of having our knuckles rapped by the fan of Lady Bracknell.

What Should Politicians and Voters Do?

What does Alan Blinder recommend for financial reform? He frames his recommendation in ten commandments, ten "thou shalts". He has three that are addressed to the government and the citizenry. They are that we should remember that the cycle of profit, speculation, exuberance, crash, bankruptcy, panic, and depression has been a constant of industrial market economies since at least 1825; that self-regulation by financiers is a disaster; and that financiers should have very strong incentives not to try to walk up to the edge of defrauding the investing public. Then Blinder addresses seven commandments to the financiers, who, he says, should remember that: their shareholders are their real bosses, managing and limiting risk is essential, leverage is dangerous, complexity in finance is just as dangerous, trading should be carried out using standardized securities in public markets so that people can see what is going on, the balance sheet is a picture of a firm's position and not a toy, and "Thou Shalt Fix Perverse Compensation Systems".

That the United States at least ought to obey Blinder's three commandments to the government and strictly regulate finance, in the interest of avoiding excessive leverage and hold financiers strictly--albeit civilly, for burden-of-proof reasons--liable for misrepresentations and omissions, seems clear. However, accomplishing it is a political task. One point of view is that this political task will be easy for at least the next generation: even people who are twenty today remember the orgies of near-fraud and outright fraud committed in the housing, mortgage, mortgage-backed securities, and derivatives markets; not until they retire in 2060 will it be possible to pull the same type of tricks again on the same scale. The second point of view is that this political task will be impossible. According to this point of view, times like these in which income inequality are high are times in which finance finds it easy to buy Capitol Hill, and that although finance has a collective long-run interest in being regulated so that it does not overspeculate again financiers are too stupid to recognize this collective interest--or expect to make their financial pile, and take an apres moi le deluge. Certainly the root-and-branch Republican opposition in the Congress to the very existence and functioning of the relatively innocuous Consumer Financial Protection Board is a strong piece of evidence for the second point of view. And if that point of view is indeed correct, we are in awful trouble: only a successful commitment to an extraordinary educational effort to boost the numbers of the hypernumerate and so sharply reduce the education salary premium coupled with a severe strengthening of the progressively of the tax system could then create a politics and a Capitol Hill that would support the kind of financial regulation that 1929 taught us that we needed, and that 2008 taught us that we needed again.

Blinder's seven commandments addressed to financiers seem to me to be less useful. Perverse compensation systems--systems that provide financiers with enormous incentives to run very large risks in the belief that you can make your pile and, before the time the crash comes, have moved on to philanthropy or politics or art collecting exist for a reason. And it is these perverse compensation systems that provide financiers with the incentives to forget that shareholders are their real bosses, to deliberately un-manage risks, to assume excessive leverage, and to treat the balance sheet as a toy. Moreover, there are three ways to make money in finance. The first is to have better information, and so buy low and sell high: this is nearly impossible. The second is to match risks that need to be born with people for whom it makes sense to bear extra risk: this is difficult. The third is to match risks that need to be born with people with money who do not understand what the risks really are: this turns out to be easy. And this is especially easy when there is less information in the financial market--when securities are complex, when trading is proprietary and secret, when bespoke rather than standardized is the order of the day, and when balance sheets are toys rather than accurate representations of firm positions.

Fixing perverse compensation systems would fix all these problems. But with perverse compensation systems, all these problems are intractable. The right organization of finance is one in which financial professionals lead middle-class lives but get to be rich at 60 if, when they reach 60, people look back and see that their judgment has been very good and their clients have received good value for their fees. Shareholders of financial corporations could impose such a compensation system if they organized themselves and so wished. They aren't organized. They do not so wish.

Blinder's ten commandments for governments, citizens, and financiers thus face extraordinary problems of implementation.

Blinder has seven steps for policy makers who find themselves enmeshed in a crisis to undertake. I could boil them down to three: focus, communicate, and make a fair distribution of the pain your highest priority. Policy makers should never promise that there will be less pain: if there was a bigger disaster for public understanding of the overall situation and for President Obama's standing and credibility than the Obama administration's August 2, 2010 "Welcome to the Recovery" op-ed in the New York Times--well, I don't know what it could be, save possibly the Obama administration's off-the-record comment to Edward Andrews in April 2009 that he already saw the "green shoots" of economic recovery.

Policy makers must impose distributions of pain that are both fair and are seen to be fair. Executives and directors who failed in oversight as their banks' derivatives books got out of control should have lost their jobs, their stock options, and their past years' bonuses--and that would have made their juniors happy. Shareholders who voted for such executives and directors should have lost their equity--and the Treasury could then have made some money when it privatized them. When Warren Buffett was lending to big investment banks at 10%/year with substantial equity kickers attached, Hank Paulson's U.S. Treasury should not have been lending to his former firm and its peers at 5%/year. The Obama administration should not have spread its efforts so wide as it tried to do so many different things. And the Obama administration should have talked to the people--over and over again, in language the average voter could grasp, understanding where people were starting from and how to bring them along.

In short, Blinder says: anchor yourself to reality, mark your beliefs to market rapidly, and do your job.


Despite the U.S. economy’s feeble recovery, it is difficult to evaluate the Obama administration’s handling of the fallout from the financial crisis. On the one hand, the president and his team made enormous errors--believing that recovery would take hold rapidly, that banker opposition to financial reform could be neutralized and overridden, and that housing needed neither cramdown nor large-scale foreclosure relief, to list three. Enormous mistakes were made, and mistakes that I could clearly see at the time were big mistakes.

On the other hand, in a financial crisis I think that Karl von Clausewitz's famous dictum applies: "Everything… is very simple, but the simplest thing is difficult… things do not turn out as we expect. Nearby they do not appear as they did from a distance". Actually doing successful policy in real time is a lot harder than it looks. And as my colleagues in the Obama administration point out, Congressional obstacles to successful management of the crisis have been extraordinarily burdensome, and each day reinforces the message that even though the crisis had an origin in the United States--and so should have logically had the bulk of its impact on the United States--Europe is doing far, far worse than America. It could have been much worse, and is worse right now across the Atlantic.

Still, it is undeniable that crisis management has not been successful at achieving recovery, that institutional rebuilding has stalled, and the proper lessons of the financial crisis have not penetrated the United States’ money-dominated politics.

But that crisis management has not been anything that could be called fully successful by any means, and institutional rebuilding has stalled before it has barely started, and that the proper lessons have not penetrated our money-dominated politics--these do not mean that we can give up. When we look beyond our efforts to fix things, what we need to see is ourselves, again, undertaking more. As Blinder closes:

There’s still work ahead. Bubbles will be back. So will high leverage, sloppy risk management, shady business practices, and lax regulation. We need to put in place durable institutional changes that will at least make financial disruptions less damaging the next time the music stops. History really does rhyme. We need to pick up the meter.

In the short run, little can be done except to take down the names of those—policymakers and economists--who were predicting inflation and national bankruptcy from monetary and fiscal stimulus and growth and recovery from austerity, and remind voters and journalists alike of who was right and who was wrong. In the medium term, policies will shift. By 1935, six years after 1929, all major economies had adopted New Deals of one sort or another save for France whose continued attachment to the gold standard served as a horrible warning. Should Britain’s Cameron-Osborne-Clegg Tory-Salad government survive and double-down on its austerity policies, it may serve a similar role as a horrible warning of prioritizing spending cuts over economic recovery when demand is missing—of the consequences of, as British Depression-era economist R.G. Hawtrey put it, “Crying: ‘Fire! Fire!’ in Noah’s Flood.” The political moment to prioritize recovery and full employment may yet come, if those who understand can recognize and seize the moment.

And in the long run, the task remains to educate shareholders that it is unwise to offer the traders and managers who supposedly work for them fortunes based on short-run mark-to-market accounting, and to educate politicians that such systems create risks too large to be acceptable. It ought to be possible to carry out that task.

Someday. Maybe.

A Review of Alan Blinder's After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: Penguin Press)

J. BRADFORD DELONG is Professor of Economics at the University of California at Berkeley

Properly edited shorter version in Foreign Affairs, July/August 2013

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