|Foreign Affairs, July-August 2013
Why the Economic Crisis Is Worse Than You Think
by J. Bradford Delong
After the Music Stopped: The Financial
Crisis, the Response, and the Work Ahead
BY ALAN S. BLINDER. Penguin Press,
2013, 476 pp. $29.95.
Alan Blinder is only the most recent in a series of prominent economists
who have produced analytic accounts of the U.S. economic downturn. His
crisp narrative lays out the policy options that were available at each
stage of the crisis, and his analysis is infused with a deep
understanding of macroeconomics. Overall, it is the best general volume
on the subject that has been published to date.
Despite its many virtues, however, the book paints an overly optimistic
portrait of the state of the U.S. economy. "More than four years after
Lehman Brothers went under," Blinder writes, "policy makers are still
nursing a frail economy back to health." But the U.S. economy is worse
than "frail," and there are few signs that it is being nursed "back to
health." Most economists claim at least one silver lining in the
economic downturn: that it was not as bad as the Great Depression. Up
until recently, I agreed; I even took to calling the episode "the Lesser
Depression." I now suspect that I was wrong. Compare the ongoing crisis
to the Great Depression, and there is hardly anything "lesser" about it.
The European economy today stands in a worse position compared to 2007
than it did in 1935 compared to 1929, when the Great Depression began.
And it looks as if the U.S. economy, when all is said and done, will
have faced certainly one lost decade, and perhaps even two.
The U.S. economy has enjoyed a recovery only in the sense that
conditions have not gotten worse. Blinder notes that the unemployment
rate jumped to ten percent at the height of the crisis and is now
hovering around eight percent, nearly halfway back to economic health.
But this assessment is misleading. In the middle of the last decade, the
percentage of American adults who were employed was roughly 63 percent.
That figure dropped to about 59 percent in 2009. It remains there today.
From the perspective of employment, the U.S. economy is not recovering
Look at the GDP figures: in the 12 years between the beginning of the
Great Depression and the United States' entry into World War II, the
U.S. economy saw its production drop by an amount equal to 180 percent
of the output of one average pre-crisis year. If one assumes, as the
Congressional Budget Office does, that U.S. production will return to
its pre-2008 form by 2017, the economy will have suffered a shortfall
equivalent to only 60 percent of one average pre-crisis year. But it is
unlikely that the economic downturn will be over by 2017: no war or
major innovation appears to be looming on the horizon that could propel
the country into an economic boom the way World War II did at the end of
the Great Depression. If the downturn drags on into a second lost
decade, the United States will incur further losses equal to the output
of a full average pre-crisis year, bringing the total cost of the crisis
to 160 percent of an average pre-crisis year and nearly equal to that of
the Great Depression.
Of course, the present downturn has caused far less human misery than
the Great Depression did. But that is because of political factors, not
economic ones. The great network of social insurance programs
established by President Franklin Roosevelt's New Deal, President Harry
Truman's Fair Deal, President John F. Kennedy's New Frontier, and
President Lyndon Johnson's Great Society, and defended by President Bill
Clinton, sharply limits the amount of poverty a downturn can cause.
And what of the future? Only ambitious political action of the kind that
created those programs can insure the country against suffering an equal
economic calamity down the line. 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 its lack of a road map out of the present impasse
that takes into account the political climate. Without a more dramatic
set of actions, the United States is likely to suffer another major
economic crisis in the years ahead.
SICK PATIENT, BAD DOCTORS
Some will argue that I am assuming the pose of Dr. Gloom. They are
likely to be wrong. For one, the U.S. bond market agrees with my
assessment. Since 1975, the yield on 30-year Treasury bonds has averaged
2.2 percentage points higher than that of short-term Treasury bills.
Given that the current 30-year Treasury bond yields 3.2 percent per
year, the typical financial market participant anticipates that
short-term Treasury bill rates will pay out interest at an average of
barely more than one percent per year over the next generation. The
Federal Reserve keeps the short-term Treasury bill rate at that low
level only when the economy is depressed -- when capacity is slack,
labor is idle, and the principal risk is deflation rather than
inflation. Since World War II, whenever the yield on the short-term
Treasury bill has been two percent or lower, the U.S. unemployment rate
has averaged eight percent. That is the future the bond market crystal
ball sees: a sluggish and depressed economy for perhaps the entire next
Meanwhile, barring a wholesale revolution in the thinking (or personnel)
of the U.S. Federal Reserve and the U.S. Congress, so-called activist
policies, such as multitrillion-dollar asset purchases or sustained
large-scale investments in infrastructure, are not going to be put in
place to rescue the economy. Policymakers are too concerned about rising
U.S. government debt. Their worries, of course, are misplaced right now,
as Blinder well understands. He shares the consensus of reality-based
economists that debt accumulation -- whether through the Federal
Reserve's buying government bonds or through the U.S. Treasury's issuing
them -- is not the U.S. economy's most serious problem as long as
interest rates remain low.
The deficit hawks seem to have forgotten the basic principle of
macro-economic management: that the government's job is to ensure that
there are sufficient quantities of liquid assets, safe assets, and
financial savings vehicles. Over the past several years, this principle
has gone out the window. A majority of the voting members of the Federal
Open Market Committee, which oversees the Federal Reserve's buying and
selling of government bonds, believe that the Fed has already extended
its aggressive expansionary policies beyond the bounds of prudence.
Blinder rightly disagrees: "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."
Worse still is the attitude of the U.S. Congress. "America's budget mess
is starting to look Kafkaesque," Blinder writes, "because the outline of
a solution is so clear: we need modest fiscal stimulus today coupled
with massive deficit reduction for the future." Republicans must accept
that tax rates will be higher a decade from now, he argues, and
Democrats must accept lower government spending than is currently
projected. A deficit-reduction package, perhaps in the mold of the
Simpson-Bowles plan (a proposal by Erskine Bowles and Alan Simpson,
co-chairs of the president's deficit commission, that combines spending
cuts and tax increases), should be adopted in the future, Blinder
argues, but not yet. Blinder is preaching the right message, but he is
preaching it to an audience of ravens and vultures. Congress is taking
its cues from Steve Martin's Saturday Night Live character Theodoric of
York, Medieval Barber: no matter what the ailment, all the patient needs
is another good bleeding. In this case, the tool of bloodletting is
rigorous austerity, which only puts further downward pressure on
employment and production.
A BROKEN SYSTEM
As U.S. policymakers cling stubbornly to wrong-headed 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 economists' time?
At the juncture in the Great Depression most similar to today's point in
the current crisis, John Maynard Keynes turned away from policy to
attempt to reconstruct macroeconomic thought from the ground up. By
writing The General Theory, Keynes intended to force economists to think
differently when the next crisis struck. Up until 2009, it looked like
Keynes had succeeded. But today, it is clear that his task was only half
finished, if that. The same ritual incantations that were made during
the 1930s -- summoning the "confidence fairy," through the magic of
austerity, to shower the blessings of prosperity on the economy -- are
now recited repeatedly and ever more frantically. This is worrisome, to
say the least.
Speaking at the London School of Economics in March, the economist
Lawrence Summers called for the reconstruction of macroeconomic thought,
on the one hand, and the reconstruction of the institutions and
orientation of central banking, on the other. But no living economist is
smart, bold, or arrogant enough to try to be Keynes, and Blinder wisely
takes a more modest approach. He frames his recommendations for reform
in ten commandments: three that are addressed to the government and
seven that are addressed to financiers. The first set urges policymakers
to remember that the cycle of profit, speculation, exuberance, crash,
bankruptcy, panic, and depression has been a constant feature 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 walk up to the edge of defrauding the public. The
second set of commandments exhorts financiers to remember that their
shareholders are their real bosses, that managing and limiting risk are
essential, that excessive borrowing is dangerous, that complex financial
instruments are equally dangerous, that trading should be carried out
using standardized securities in public markets, that the balance sheet
is a picture of a firm's position and not a toy, and, finally, that
perverse compensation systems must be fixed.
It is clear that the U.S. government ought to obey Blinder's first three
commandments and strictly regulate finance. It should hold Wall Street
liable for its past misrepresentations and omissions to encourage better
behavior in the future. But Blinder does not emphasize enough just how
difficult that task has proved to be and how little political will
exists to face it. Some economists assume that this job will be easier
for future generations because even people who are currently in their
20s will never forget the orgies of fraud that were committed in the
housing, mortgage, securities, and derivatives markets. Others,
meanwhile, think that the political will to rein in financial excess
will only continue to wane. According to this camp, Wall Street finds it
easy to buy influence on Capitol Hill. Although financial firms have a
collective long-term interest in being regulated, financiers are too
stupid to recognize this -- or they simply expect to make their pile and
then say, "Après moi, le déluge." If this argument is indeed correct,
the United States is in awful trouble.
Sound regulation of Wall Street will depend on a different, less
money-dominated form of politics -- like the kind that was generated by
the more egalitarian income distribution of the post-World War II years.
But how to get to such an income distribution today? After World War II,
the United States made a successful commitment to mass education, which
sharply increased the number of those competing for high-salary jobs and
thus reduced their income edge over the working class. Such a renewed
commitment to education, coupled with a severe strengthening of the
progressivity of the U.S. tax system, could create the type of politics
and Capitol Hill that would support the kind of financial regulation
that 2008-9 revealed was desperately needed.
Blinder's next seven commandments, addressed to financiers, are less
useful than the first three. Blinder is right to identify perverse
compensation systems as a major problem. They give financiers incentives
to take large risks in the belief that they can make a killing and then
get out before the crash. The truth is that there are three ways to make
money in finance, and only one of them is simple. The first is to
possess better information than other market participants and use that
information to buy low and sell high: this is nearly impossible to do on
a regular basis. The second is to match necessary risks with investors
for whom it makes sense to bear extra risk: this is very difficult. The
third, and simplest, is to match necessary risks with investors who do
not understand what those risks really are. This is especially easy when
information in the financial markets is scant -- when securities are
complex, when trading is proprietary and secret, and when balance sheets
do not accurately represent firms' performance.
As long as perverse compensation systems for financial executives exist,
the United States' financial problems will remain nearly, if not
completely, intractable. Reforming such systems would fix many, if not
all, of these problems. In an ideal world, financial professionals would
earn amounts similar to other professionals -- such as doctors, lawyers,
architects, and engineers -- until near retirement, at which point they
would be amply rewarded if their judgment had been superb and their
clients had received good value. In a past generation, this was
accomplished via their late-career ascension to lucrative partnerships
at private investment banks. Today, shareholders of financial
corporations could impose such a compensation system if they so wished.
But they are not organized, and they do not so wish. Financiers,
therefore, have no pocketbook reasons to obey any of Blinder's
commandments, only their regard for the public interest.
Mindful that his prescriptions might not take hold and that another
calamity could well befall the economy, Blinder concludes his book by
suggesting how policymakers ought to act during the next crisis: they
must focus on heading off risks before they materialize, communicate
their policies clearly, make sure to distribute the pain fairly, and
never promise that there will be less pain than there will be. (It is
difficult to imagine a bigger disaster for the public's understanding
and the Obama administration's credibility than then Treasury Secretary
Timothy Geithner's August 2010 New York Times op-ed, "Welcome to the
Recovery" -- save, perhaps, for President Barack Obama's premature
sighting of "glimmers of hope.")
Policymakers must impose distributions of pain that not only are fair
but also are seen to be fair. Bank executives and directors who fail to
properly oversee their firms' investments should lose their jobs, their
stock options, and their past years' bonuses -- and if shareholders will
not impose such penalties, the government needs to do so. Shareholders
who voted for such executives and directors should lose their equity.
And the president needs to speak to the people, explaining the crisis
and the government's response, over and over again, in language the
average voter can grasp.
WHAT IS TO BE DONE?
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 the recovery would take hold rapidly, that banker
opposition to financial reform could be neutralized and overridden, and
that the housing sector needed neither reorganization nor large-scale
foreclosure relief, to list just three. On the other hand, it is
important to remember that reacting to a crisis is a lot harder than it
looks. Moreover, as economists in the Obama administration are quick to
point out, Congress has placed extraordinary obstacles in Obama's path.
It is also worth nothing that even though the crisis originated in the
United States, Europe is suffering more. In other words, it could have
been much worse, as it is right now across the Atlantic. Still, it is
undeniable that Obama's management of the crisis has not produced a real
recovery, that institutional rebuilding has stalled, and that the proper
lessons of the financial crisis have not penetrated the United States'
But this does not mean that policymakers and economists can give up. In
the short run, little can be done except to take down the names of those
policymakers and economists who have been predicting inflation and
national bankruptcy from monetary and fiscal stimulus and growth from
austerity -- and remind voters and journalists of who was right and who
was wrong. In the medium term, policies will shift. By 1935, six years
after the outbreak of the Great Depression, all the major economies had
adopted programs along the lines of the New Deal, except for France,
whose continued attachment to the gold standard served as a horrible
warning. Should its coalition government survive and double down on its
austerity policies, the United Kingdom may serve a similar role as a
warning against prioritizing spending cuts over economic recovery when
demand is missing -- a warning of the consequences of, as the British
Depression-era economist Sir Ralph Hawtrey put it, "cry[ing], 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
In the long run, however, the task remains to educate shareholders that
it is unwise to provide the traders and managers who supposedly work for
them with fortunes based on short-term accounting, and to educate
politicians that such compensation systems create risks too large to be
acceptable. It ought to be possible to carry out that task. Someday. Maybe.
J. BRADFORD DeLong is Professor of Economics at the University of
California, Berkeley, a Research Associate at the National Bureau of
Economic Research, and a Visiting Fellow at the Kauffman Foundation.
Follow him on Twitter @delong.