May 2009


Dean Baker

The Rudd essay & the global financial crisis (Part IV)

Prime Minister Kevin Rudd has in his essay given us a bold statement about the nature of the current economic crisis, and laid out an ambitious agenda in response to the crisis. Unfortunately, the diagnosis of the problem is not entirely on target and therefore the response is not fully adequate to the enormity of the problem.

In analysing the nature of the problem, it is important to understand that the villains in this story were not free-market ideologues. While many of them may have espoused free-market ideology, this ideology did not correspond to the policies they pursued. In fact, in a variety of circumstances they have been very happy for the government to intervene in the market, though always when income is thereby redistributed upward.

In the case of the financial sector, this intervention has taken the form of government policies that act to protect large and wealthy financial institutions from the consequences of their own actions. In the US, respect for the free market did not prevent Alan Greenspan using the Federal Reserve's power to support the stock market during the crash of 1987. Nor did it prevent him intervening, a decade later, in the collapse of the Long-Term Capital Management hedge fund to ensure that no major financial institutions were brought down in its wake.

In the current crisis, government intervention has taken the form of an insurance policy dubbed "too big to fail". Under this policy, the government insures the creditors of major financial institutions, such as Bear Stearns, AIG, Citigroup and the Bank of America. This government protection allows the financial behemoths to make riskier investments, because their creditors know that the government will protect them against losses if things turn out badly.

The demand for "deregulation" in this context does not constitute free-market ideology; rather, it reflects a desire to receive such government insurance without restrictions, and without paying for it. It is both inaccurate and overly generous to call it "market fundamentalism". The same one-sided approach to deregulation that Kevin Rudd accurately describes as "hypocritical" can be found in most areas of public policy when we look beyond the rhetoric.

The second key point in understanding the crisis is that the failed policies were not just promulgated by a small clique of ideologues. Almost the entire economics establishment, in the US and around the world, somehow failed to see the largest financial bubble in history. In his brief reference to the American housing market, Kevin Rudd understates the case for a bubble. From 1895 to 1995, real house prices nationwide just kept even with the overall rate of inflation. From 1995 to the bubble's peak, in 2006, house prices outpaced inflation by more than 70 percentage points, creating US$8 trillion in housing-bubble wealth. Other countries saw housing bubbles that were even larger, relative to the size of their economies.

This unprecedented run-up came with no obvious changes in the fundamentals of supply or demand in the housing market. Nor was there any remotely comparable increase in rental prices, which in this decade actually lagged slightly behind the overall rate of inflation. The explosion of sub-prime and other risky mortgages, involving millions of families, should have been another clear warning sign. In short, there was overwhelming evidence that the economy was being driven by a gigantic asset bubble, yet nationally and internationally those in policy positions ignored this evidence.

This is an indictment of both the economics profession and our institutions of government. Is it really the case that no one at the Treasury or the Federal Reserve in the US - or, internationally, the IMF or the OECD - saw the danger on the horizon? Or, worse, did analysts at these institutions recognise the imminent crisis but find themselves forced to keep their analysis private, to avoid offending powerful interests? The public needs to know why these institutions failed so completely, and the institutions need to be restructured so that they do not perform so dismally in the future.

At least part of this restructuring must involve greater transparency and openness in all areas of finance and its regulation. The idea that monetary and financial policy can be determined by a priesthood of central bankers, away from the rough and tumble of politics, is badly misguided. We may not want politicians to set interest rates, but we do want the people who set interest rates to be accountable to our democratically elected officials. The effort to shield central banks from political influence has left the banks under the sway of the financial industry. This is neither good policy nor good politics.

More generally, we must understand the current crisis as a massive shortfall in aggregate demand. This is the Keynesian problem of the Great Depression, not the comparatively modest recessions of the postwar era. For this reason, the size of the required stimulus, both in the US and around the world, is far larger than that which has been put on the table thus far. Simple arithmetic shows that the shortfall in annual demand created by the collapse of America's housing and commercial-real-estate bubbles, and the fall-off in consumption due to the negative wealth effect, is close to US$1.3 trillion - more than 8% of GDP. The recently approved stimulus package, which amounted to just over 2% of GDP, is nowhere near large enough to bring the economy back to full employment.

The need to spend creates unprecedented opportunities. In the US, this money could be used to improve infrastructure and promote energy efficiency, as is already being done with the first round of stimulus. A second dose could be used to extend universal health-care insurance and reform the health-care system. Money could also be used to finance paid sick days and family leave, or shorter working weeks and longer vacations, to bring employment conditions in the US more in line with those of other wealthy countries.

The most important point that the public must recognise is that this is a crisis of inadequate demand. For the moment, at least, the world of scarcity is nowhere on the horizon. In this world, we can and should throw money at our problems; but we should do so in a way that promotes benefits for the long term, in addition to reducing unemployment in the short term.

There are some fears that we should confront more directly. We need a working financial system, but that should not make us hostage to the banks. Until 14 September 2008, America's top economic policymakers believed the system could withstand the failure of a major bank. They were wrong about the impact of the Lehman Brothers bankruptcy, but this ought not mean that every cent of every bank's obligations must be honoured. We do not have to saddle our children and grandchildren with the cost of honouring all of AIG's credit-default swaps or Citigroup's bonds. Those who are concerned about deficits in the present environment would be best to direct their energies to containing unnecessary payments in the financial sector, rather than restricting the stimulus necessary to restart the economy.

Finally, the world must recognise that the American dollar was and is overvalued, and that this overvaluation was at the core of the imbalances that led to the crisis. The overvaluation was the cause of America's massive and unsustainable trade deficit. There is no reason for concern about a crisis of confidence in the dollar: it will come, and it will be a good thing.

Currency values equilibrate trade. The dollar must fall back to a level that is consistent with a sustainable trade deficit. The financial crisis has led to a flight to dollars as a haven - a flight which has reversed much of the decline in the dollar that occurred over the preceding six years. The earlier drop in the value of the dollar had begun to reduce the trade deficit, but with the recent increases this progress is now likely to be reversed.

Yet at some point the financial situation will stabilise, and the dollar will resume its decline. This decline is a necessary step towards restoring financial stability. It should not be cause for panic.

Kevin Rudd should be commended for recognising the opportunities created by the crisis. However, I believe that these opportunities are even more impressive than he indicates - if we have the courage to be creative and push the limits of the possible.

© Dean Baker 2009.

Cover: May 2009
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