We Are at the Beginning of a Long, Profound, Painful Process of Change
by James K. Galbraith
Statement by James K. Galbraith, Lloyd M. Bentsen, jr., Chair in
Government/Business Relations, Lyndon B. Johnson School of Public
Affairs, The University of Texas at Austin and Senior Scholar, Levy
Economics Institute, before the Committee on Financial Services, U.S.
House of Representatives, Hearings on the Conduct of Monetary Policy,
February 26, 2009.
MR. CHAIRMAN and Members of the Committee, it is again a privilege to
appear today at these hearings, which as a member of the staff I
worked on from their inception in 1975. In 1930, John Maynard Keynes
wrote, "The world has been slow to realize that we are living this
year in the shadow of one of the greatest economic catastrophes of
modern history." That catastrophe was the Great Crash of 1929, the
collapse of money values, the destruction of the banking system. The
questions before us today are: is the crisis we are living through
similar? And if so, are we taking adequate steps to deal with it? I
believe the answers are substantially yes, and substantially no.
This statement covers six areas very briefly:
* Why the baseline forecast is too optimistic, and why the
recovery bill was too small.
* Why low interest rates will have limited effectiveness going forward.
* Why the banking plan will not work.
* Why Social Security and Medicare are not part of the problem,
but of the solution.
* How to keep people in their homes, and
* Why our long-term infrastructure and energy needs should be addressed now.
1. The Baseline Forecast Is Too Optimistic and the Recovery Bill Was Too Small
In early February the CBO baseline projected a "GDP gap" averaging
about six percent over the next three years (Table One). They also
expect a recovery beginning late this year and a return to normal by
2015. That was the baseline: the forecast even if the ARRA had not
The baseline rests on a mechanical assumption: that there is a
"natural rate of unemployment" of exactly 4.80 percent. The
assumption is that labor-market adjustments will return us to this
rate over time. By labor-market adjustment, economists usually mean a
fall in real wages, sufficient to make workers more attractive to
This assumption is unfounded. No fall of wages will restore
employment. Employment does not depend materially on wage rates, but
on the prospect for sales and profits. And these require credit.
Flow-of-funds data for December show that the fall-off in new
borrowing is the greatest in 40 years. The Levy Institute's
accounting-based macro model, based mainly on the rate at which
households are liquidating their debts, now suggests that the GDP gap
will be as much as 12 percent of GDP, with no recovery in sight. This
is shown in Figure One. This gap is compatible with unemployment
rates near ten percent, indefinitely.
The ARRA should add between 2 and 3 percent to total demand, per year
for two years. With normal multipliers (about 1.5 for spending) the
total boost to GDP might be between 3 and 5 percent. This would be
enough to turn a baseline recession averaging 6 percent into something
quite mild. But if the true collapse is twice as bad, the stimulus
was too small. And the multipliers are probably overstated, because
in a deep crisis liquidity preference grows stronger. A 12 percent
GDP gap might require a stimulus of, say, 10 percent including
automatic stabilizers to cope with it. The bill as enacted was far
short of that.
Chairman Bernanke, in his speech at London in January, said "the
global economy will recover." He did not say how he knows. And the
truth is, this is merely a statement of faith. In present conditions
the most dangerous position is that of the unfounded optimist. Those
who use this position to defend a program of inaction, or of little
action, or to defend a program of action that is geared to a forecast
of automatic recovery, might possibly turn out to be right. There
might be a deliverance. But to rely on that possibility in the design
of policy is surely unwise, for at least two reasons.
First, we know that bad news has been outrunning the forecasts for
months. Professional economists, working with the normal models,
failed to predict the crisis. In many important cases, including high
officials, they actively denied it could happen. Chairman Bernanke
was typical: through July of 2007, he argued that the Federal Reserve
Board's predominant concern was inflation; thus the Federal Reserve
was unable to give Congress a foretaste of a crisis that was to erupt
within days. And as the crisis has unfolded, events have repeatedly
come in worse than expected or caught us by surprise. This should
tell us something.
Second, we know that the origins of the crisis lie in a breakdown of
the banking and financial system, following a breakdown in the
regulation of mortgage originations, in underwriting, and in credit
default swaps. This is something we have not seen in our lifetimes.
We know that the actions already taken in response -- the TARP, the
nationalization of the commercial paper market and the swap agreements
with the ECB and other central banks -- are unprecedented. We know
that these measures have, at best, only averted a deeper catastrophe.
And we know that the baseline forecast, which is a mechanical
procedure based on statistical relationships between non-financial
variables, for the most part, takes none of this into account.
We therefore have no basis for confidence in the baseline forecasts,
and we should prepare ourselves, as Churchill said to Parliament at
the time of Dunkirk, "for hard and heavy tidings."
2. Monetary Policy Alone Cannot Restore Growth and Employment
Chairman Bernanke deserves respect for his forceful interventions
since the crisis broke. A failure, last October, to nationalize the
commercial paper market would have been disastrous. Increasing
deposit insurance limits warded off a run on the banks. The extension
of currency swap agreements to Europe and elsewhere helped stabilize
global markets temporarily, though there is a grave question, as to
whether those swaps can be unwound.
I also supported this Committee's version of the TARP, despite its
limitations. At that time, a collapse of the payments system in the
last months of a dying presidency was to be avoided at all costs. And
the most unworkable idea in TARP, the outright repurchase of bad
assets at inflated prices, was abandoned in favor of a step -- the
purchase of preferred equity in banks -- that was possibly unnecessary
but not the worst that might have happened.
Despite the fact that these steps were able to ward off complete
disaster, monetary policy today has little power to restore growth.
In the Depression they called it "pushing on a string." With interest
rates already at zero, there is little more the Federal Reserve can
do. Chairman Bernanke's London speech grasps at a number of straws,
including "policy communication" and the reduction of long-term
interest rates. But the former is a weak reed and the latter is of
very doubtful effect in a liquidity trap. If rate cuts do not lead to
new borrowing -- as they have not -- then their effect is actually
counterproductive, since they reduce the interest income flowing to
the elderly and others who hold the national debt, or (what is the
same thing, economically) cash and cash-equivalents in the banks.
The phrase "quantitative easing" -- or in Chairman Bernanke's
formulation, "credit easing" -- is often heard these days. What does
it mean? Not much, in my view. Can it be relied on to produce a
return to economic growth? No. Credit easing, at its heart is about
liquidity -- a problem monetary policy can deal with. But the
problems of the economy go far beyond liquidity. Chairman Bernanke's
discussion of "heterogeneous effects" -- the supposed differences
between lending to banks, to the commercial paper market or elsewhere,
strikes me as a keen example of wishful thinking. It is unlikely that
the Federal Reserve can, merely by making judicious distinctions,
materially reduce the perception of risk in these markets and
therefore the credit spreads that are strangling them today.
The deeper problem obviously lies in the lack of demand for output, in
the collapse of confidence, in the grim prospects for profit, and in
the absence of collateral to support new loans. These problems will
require much more work -- work to persuade the public and the business
community that effective, long-range, sustained, visible action is
underway. The Federal Reserve is not the agency that can persuade the
world of this.
Thus, in this situation the main responsibility for pulling the ox
from the ditch is not Chairman Bernanke's. Let me turn next to the
question of whether Secretary Geithner's plan to restart the "flow of
credit" can take up the slack.
3. The Bank Plan Will Not Work
The scale of the ARRA was predicated on the baseline and also on the
idea that lending by the banking sector can be made to return to
normal. That is, it assumed, implicitly, that Secretary Geithner's
plan for the banks will succeed. So we must ask, will it?
The bank plan appears to turn on a metaphor. Credit is "blocked" or
"frozen." It must be made to "flow again." Take a plunger to the
toxic assets, a blowtorch to the pipes, it's said, and credit will
flow. This will make the recession essentially normal, validating the
baseline forecast. Add the stimulus to a normalization of credit, and
the crisis will end. That's the thinking, so far as I can tell, of
the Treasury department in this new administration.
But common sense begins by noting that the metaphor is wrong. Credit
is not a flow. It is not something that can be forced downstream by
clearing a pipe. Credit is a contract. It requires a borrower as
well as a lender, a customer as well as a bank.
The borrower must meet two conditions. One is creditworthiness,
meaning a secure income and, usually in the case of a private
individual, a house with equity in it. Asset prices therefore matter.
With a chronic oversupply of houses, prices fall. Collateral
disappears, and even if borrowers were willing many of them would not
qualify for loans.
The other condition is a willingness to borrow, motivated by the
"animal spirits" of business enthusiasm or just the desire for more
worldly goods. In a slump such optimism is scarce. Even if people
have collateral, they want cash. And it is precisely because they
want cash that they will not deplete their reserves by plunking down,
say, a down-payment on a new car.
The "credit-flow" metaphor implies that people came flocking to the
auto showrooms last November and were turned away because there were
no loans to be had. This is not true. What happened was that people
stopped coming in. And they stopped coming in because, suddenly, they
felt poor, uncertain and afraid.
In this situation, stuffing the banks with money will not change their
behavior. Banks are not money-lenders. Banks are money-creators.
They do that by making loans. And the bank chiefs have made it very
clear, in testimony here and elsewhere: they will not return to
ordinary commercial, industrial and residential lending until they can
see a reasonable way to make money at it. If given the chance, they
may go off on another bender in commodities or some other quick way to
repair losses. More likely, they will hunker down, invest in
Treasuries and prime corporate bonds, and rebuild capital for the
long-term, as they did from 1989 to 1994. Only this time, with the
yield curve as flat as it is and the insolvencies as deep as they are,
it could take a decade or longer.
Seen in this light, the latest version of the plan to remove bad
assets from the banks' balance sheets is a costly exercise in
futility. It will protect incumbent management, for a time. It will
keep the equity values above zero, for the benefit of those who did
not sell their shares when they were high and those who now speculate
on a public rescue. It will do this at the expense of driving public
debt, as a share of GDP, to very high levels. But there is no reason
to believe that the "flow of lending" will be restored, nor that banks
which long ago abandoned prudent and ordinary lending practices will
now somehow return to them, chastened by events. Why should they
change behavior, if their losses are in effect guaranteed by the
The Treasury plan, if put in place as described, would have a perverse
effect on the distribution of wealth. To guarantee bad assets at
rates above their market value is simply a transfer to those who hold
those assets. It would enable them to convert those assets, sooner or
later, to cash. The plan would thus preserve the wealth of bank
insiders and financial investors, while failing to prevent the
collapse of the wealth of almost everyone else. I cannot believe that
the American public will tolerate this, for very long.
There is an argument, made by those who would suspend mark-to-market
accounting, that the true value of the mortgage-backed securities has
been depressed by fire-sale conditions, and that a guarantee would
help to restore confidence and would be validated, in changing
economic conditions, by improved performance of the loans. This is
something that does, in fact, sometimes happen: good loans go bad in
bad times, but become good again when conditions improve. But it is
not an appropriate argument for the current case.
Why not? Because the sub-prime securities that are at the bottom of
this problem were, and are, in very large measure, corrupt, abusive
and even fraudulent from the very beginning. They should never have
been issued, and they should never have been securitized, and the
ratings agencies engaged in fraud, on the face of it, by giving them
AAA ratings in certain configurations, without actually inspecting the
loans. No private buyer, with responsibility to do due diligence on
these loans, will ever purchase them simply because due diligence is
going to reveal the truth. So far as we know, the loans, almost
uniformly, lack documentation or show prima facie evidence of fraud or
misrepresentation. The ratings agency Fitch so determined, when it
reviewed just a small sample of loan files in 2007: there was fraud or
misrepresentation in practically every file. The default rates on
these loans will be very high no matter what happens. It is only a
matter of time. Therefore, there is no reason to think that the
Treasury's guarantees, at any price above the market price, are likely
ever to be made into a profitable investment by changing economic
Finally, one has to worry about the long-term consequences of issuing
new public debt just to wash away the sins of the banks. Those in the
larger world who have, in the past, trusted the transparency,
efficiency and accountability of the U.S. financial system -- and have
therefore been willing to treat the US as a haven of financial safety
and stability -- are bound to take note. It can't be good for the
long-term reputation of the government, and therefore for the
long-term stability of the dollar. Moreover, while there is no reason
to treat these asset exchanges as new public spending, it is certain
that adding ten or twenty percent of GDP to the public debt
(fruitlessly) will complicate the political problems associated with
the effective fiscal expansion measures that getting out of the crisis
may require. In short, the Treasury plan will not achieve its stated
goals, and meanwhile risks both triggering inflation and obstructing
If we are in a true collapse of finance, our models will not serve and
our big banks will not serve either. You will have to replace them
both. Since several very big banks are deeply troubled, there is in
my view no viable alternative to placing them in receivership,
insuring their deposits, replacing their management, doing a clean
audit, isolating the bad assets. Since these banks were clearly too
large, in my view they should be broken up, and either sold in parts
or relaunched as multiple mid-sized institutions with fresh
capitalization and leadership.
And meanwhile, how do we keep the economy running? There should be a
public bank to provide the loans to businesses -- small, medium and
large -- sufficient to keep them running through the crisis. This was
the function, in the Depression, of the Reconstruction Finance
Corporation. While the need for this today is very clear in the
automotive sector, as time goes on a much larger part of American
industry and commerce will face similar problems and similar needs.
The resulting forced liquidation of the productive sector is a
distinct possibility, and is not in our national interest.
4. Social Security and Medicare Are Not the Problem
A repeated theme from certain quarters holds that the financial
meltdown is only a side-show, that the real "super sub-prime crisis"
is in the federal budget, and that the most urgent need today is
"entitlement reform," which is code for cutting Social Security and
Medicare, in the guise of saving those programs. Some of this was
heard earlier this week at the White House meeting on "fiscal
These arguments are both mistaken and dangerous.
By long-standing political convention Social Security and Medicare are
attached to designated funding streams -- portions of the payroll tax.
It was the original intent that Social Security benefits would be
largely matched by these taxes, but this was never true for Medicare,
and as the aging population grows and lives longer it has become
contentious for Social Security as well. Thus we have frightening
estimates of "unfunded liabilities" running to the scores of trillions
of dollars over long or infinite time horizons, with dire warnings
that these will drive the entire government of the United States into
bankruptcy, whatever that means.
These arguments are testimony to the power of accounting to cloud
men's minds, and not much else. Let me make some obvious points.
First, a transfer program reassigns claims to output. It neither
creates nor destroys production. What comes from somewhere, goes
somewhere else. Thus Social Security liabilities to the government
are matched by assets in the hands of the aged and those who will
become aged -- that is to say, in the hands of citizens of the
country. From the standpoint of the country, the two sides of the
balance sheet necessarily balance. Talk about "unfunded liabilities"
without discussing the corresponding assets is intrinsically
misleading: the liabilities in question are owed to citizens of the
United States, and represent to them a very modest degree of income
security and as well as access to medical care in old age.
There is no operational reason why the country cannot transfer income
to its elderly, as a group, as much or as little as it wishes. The
supposed inter-temporal aspect of this transfer is meaningless, for
two reasons. First, the goods and services actually provided to the
elderly at any point in time are always produced only shortly before
they are used. Second, the workers on whom the liabilities supposedly
fall today, are the same people who accrue the assets that they will
enjoy later. It is true that Social Security's real burden will rise
as the population ages: from about 4.5 percent to about 6.5 percent of
GDP over the century ahead. There is no reason to be afraid of this,
it is simply the mechanical consequence of the fact that there will be
more old people to care for. Those people would exist, and would be
cared for to some degree, without Social Security. But the process
would be much more erratic, much less fair, and subject to the neglect
and petty cruelties of private financial relations.
The only issue posed by a deficiency of payroll taxes, now or later,
is whether the funds devoted to Social Security and Medicare might be
described as coming, in part, from other sources: from the wealthy, or
from bondholders. So what if they are? There is no reason in
principle why income or estate taxes (as the late Commissioner Robert
Ball suggested), or a financial transfer tax, could not be assigned to
cover Social Security and Medicare costs. The Social Security
compromise of 1983, which raised payroll taxes on my generation,
plainly envisaged that the obligations to cover my generation's
retirement would come, in due course, from somewhere else. That is
what "paying back the Trust Fund" is all about.
Part of the worry about "entitlements" relates to borrowing, and thus
to future deficits. Are these "unfunded liabilities" so large as to
threaten the creditworthiness of the government? Clearly this is not
the case. Despite immense efforts by the gloom-and-doom chorus on
this question, the government of the United States is today funding
itself, long term, for less than it did in the 1950s. Solvency was
not a question then and is not a question now. This also suggests
that the long-term deficit projections for the government as a whole,
though much discussed at the fiscal responsibility summit, are not a
worry for the financial markets, either.
The preoccupation with Social-Security-and-Medicare is actively
dangerous to the prospects for economic recovery. Why? Because it
raises concern and anxieties among today's working population, who
have been told repeatedly that these programs will not be present for
them when they will need them. The rational individual response, in
that case, is to save more and spend less. I don't think this effect
is very large, right now, but it is a risk. There are cases in the
world (notably in China) of distressed populations over-saving
obsessively, to try to provide for security that could be provided
much more cheaply by social insurance.
More immediately, our elderly population is under a tremendous
squeeze, from the stock market collapse, from falling house prices and
from falling interest rates. It has already lost, through these
channels, a major part of its wealth. The economist Mark Zandi told
the House Democratic Caucus in December that this alone could subtract
around $200 billion per year from total spending, and the situation is
worse now than it was then.
Talk about the supposed need to cut back on Social Security and
Medicare thus gets in the way of the discussion we should be having.
This is over how to use these programs to get us out of the hole we
are in. Each them could be powerful and useful. To wit:
* a permanent increase in Social Security benefits would help
offset the losses that the elderly population, as a group, is
suffering on its equity investments and its cash holdings. A thirty
percent increase in Social Security benefits would not repair
individual losses, but it would keep the elderly out of poverty as a
group, and relieve severe difficulties in many individual cases.
* a payroll tax holiday would powerfully ease the financial
situation of America's working families, giving them roughly an 8.3
percent pay increase and their employers a comparable reduction in the
cost of keeping them on the job. Many mortgages would be paid, and
many cars purchased, that otherwise would default or go unsold.
* a reduction in the age of eligibility for Medicare would be a
powerful response to the industrial crisis, permitting many older
workers who would like to retire but who cannot afford to lose health
insurance to do so. This would relieve health burdens from private
industry, while not infringing on the employer-insurance systems still
in effect for the prime-age workforce. Note that transferring workers
from private health care to Medicare in this age bracket has no real
economic cost: the same health care is provided to the same people.
In fact, the reduction in private insurance claims and bookkeeping
constitutes a real saving.
These measures are among the most promising available at this moment.
Congress should be prepared to use them if and when it becomes clear
that the present policies are insufficient. And the historical
linkage between Social Security and Medicare benefits and the payroll
tax should then be broken. Social Security and Medicare obligations
should be treated, henceforward, as simply the bonded obligations of
the government -- like net interest, backed by the full faith and
credit -- thus making explicit what is obvious to any careful
observer, which is that these programs cannot go "bankrupt" anymore
than the government of the United States can go bankrupt, which it
And of course the United States Government has not gone bankrupt, in
more than two centuries of continuous operations and through much
bigger deficits and greater trials than we are experiencing just now.
5. Keep People in Their Homes
The housing crisis is at the root of our difficulties, for since the
Tax Reform Act of 1986 our economy has been strongly biased toward
collateralizing lending with homes. This model, which built up a
structure of debt over a very long period of time, has now collapsed.
It has collapsed, moreover, in ways that not only have destroyed the
market for sub-prime securities, but that also have compromised
secondary markets for prime mortgages.
There is no way for public policy to stabilize housing prices as such
in the near term. House prices are private contracts for
idiosyncratic goods, and cannot be controlled. Therefore, policy must
focus on the proximate problem, which is chronic excess supply. The
only way to do that, short of buying up surplus homes and knocking
them down, is to find a means to stop the wave of evictions,
vacancies, trash-outs and forced sales that is overwhelming the
In economic terms the problem is simple: how to align, in a way that
is fair and sustainable, the payments people are required to make on
their houses with their actual capacity to pay? But there is a
corollary which is not so simple: how to do so in ways that do not
encourage irresponsible behavior on the part of homeowners who are not
The administration's plan of action in the housing sphere is a bright
spot on the policy horizon. It meets, so far as I can tell, the tests
of fairness and sustainability reasonably well. But it does so only
for a limited class of borrowers, who are not too deeply underwater
already on their homes. It will provide a measure of relief, but it
will not, so far as I can tell, either stop the wave of foreclosures
or prevent a continued decline in prices.
There are, I think, two basic alternatives that might work. One would
be to declare a comprehensive moratorium on new foreclosures, and then
to turn over the entire portfolio of troubled mortgages to an entity
like the depression-era Home Owners Loan Corporation for triage and
renegotiation on a case-by-case basis. The advantage of this approach
is that, if done on a large enough scale, it would work. An HOLC
could distinguish honest from fraudulent borrowers, fit legitimate
homeowners into appropriate work-out categories, and manage or dispose
of the properties of the rest. Meanwhile people would enjoy a
presumptive right to stay in their homes. The difficulty is that this
would take a long time and a lot of money and manpower, and the system
would still be prone to manipulation, at least to some degree.
An alternative, suggested by Warren Mosler, is to allow the ordinary
foreclosure process to work. But, after foreclosure, owner-occupied
properties would be bought at the lower of the appraisal price or
mortgage balance by a new federal entity, and the previous owner
allowed to stay in the house for a fair market rent, with the option
of repurchasing the home at a fair appraisal value later on. This
would have the advantage of protecting against moral hazard, while at
the same time preserving occupancy, to the maximum extent possible.
6. The Long Term Starts Now: Infrastructure, Energy and the Dollar
Finally, though these remarks depart from the realm of monetary policy
in a strict sense, it is important to make them briefly.
First, no recovery program will work unless crude oil imports in the
upswing are effectively curtailed. Failure to do this simply leaves
the power to set oil prices in the hands of speculative markets and
the swing producers -- Saudi Arabia and possibly Russia. This is the
channel that poses the most serious inflation risks going forward.
Second, a growing economy down the road will need new focal points for
public and private investment. Infrastructure and energy are clearly
the great challenges ahead: infrastructure because this vital
contributor to efficiency and competitiveness has been severely
neglected for decades, and energy because of the danger of climate
change. The correct approach to infrastructure remains a National
Infrastructure Fund -- a permanent facility that can provide funds to
state and local governments and to regional authorities independently
of market conditions, while serving as a source of standards and
providing a measure of oversight.
Third, energy conservation and the production of sustainable energy
are areas with potential for great gains; since the United States is
the world's greatest per capita greenhouse gas emitter we have the
capacity to make the largest improvements. But there is also the
potential here for economic gains: if we do this job right, we can
develop new industries which will set standards for efficient and
sustainable energy production and use, and reduce our trade deficits,
over time, both by curbing imports and by exporting these new products
to the world. These new industries will help sustain the
international position of the dollar in the long run.
For the time being, the world crisis has revealed the relative
strength of the dollar and the structural weakness of the euro and of
other major currencies. This situation, which has surprised many,
removes the concern that the dollar will lose its reserve status -- at
least for the moment. But it awakens an equally serious danger, which
is that instability between world currencies could produce a
cumulative spiral of global economic collapse. This is an important
danger, for which we are ill-prepared. There needs to be a new
attention to the financial architecture, both to achieve a coordinated
fiscal expansion and to admit the serious possibility of an even
larger crisis, preparing for the moment when major reforms may be
The time to start work on all of these issues is now. Let's face it.
We are not in a temporary economic lull, an ordinary recession, from
which we will emerge to return to business-as-usual. We are at the
beginning of a long, profound, painful process of change. Of
irreversible change. For better or for worse. We need to start
thinking and acting accordingly.
Thank you very much for your time and attention.