[As I promised yesterday, I wanted to elaborate on some of the points Ezra Klein raised in his WaPo article…and like I said, a kids soccer tournament slowed me down…the thing is, these kids stepped up their game like I never expected and won the tournament in the last minute of the second overtime! Go, UNITED!
Anyway, this is a loooong post…but that’s a tribute to Ez Klein for writing such a stimulating [sic] piece.]
Ezra Klein has penned a fascinating account of the process, politics, and policy reaction to the Great Recession. It’s a critical piece—given the current economy, how could it be otherwise? But the critique is crafted with insight into the factors that led the government to under-respond to the crisis, and in this regard, Klein makes what could and should be an invaluable contribution.
He’s written a cautionary tale. We should read this piece not just to look backwards about what we got wrong, but to figure out how to fix the process going forwards.
I’d like to add two points. First, though Klein tightly summarizes what it is, specifically, that makes a financial recession so difficult to get out of, I’d like to flesh that point out a bit more. If we learn nothing else from the economic pain we’re still going through, we should at least recognize the damage done by bubbles, especially debt bubbles, and ever more especially, housing debt bubbles.
Second, I’d like to think, from a former insider’s perspective, about Klein’s message (or at least, my reading of it): there’s a design flaw that causes our government to underreact to crises like the Great Recession. In fact, there are a number of such flaws, some of which, like basic checks of concentrated power, serve us well in normal times. But the flaw on which I focus below—the deep misunderstanding and irrational fear of budget deficits—is something that we can and should change.
Ezra starts from the insight that Rogoff and Reinhart warned anyone listening that recessions born of financial crises are particularly intractable to the usual counter-cyclical attack. Why is that?
Debt and Its Specific Discontents
It’s not just about the deleveraging cycle, where firms and households resist spending and fail to respond to low interest rates as they’re rebalancing their assets and liabilities. This is important, especially for households—we still have a 70% consumption economy, and when the household sector is more interested in paying off old debt than in current spending, we’re by definition stuck in an slog.
But I’ve come to view the deleveraging point as only one part of the problem, and one that’s actually hard to parcel out from the lousy jobs market, which is the main constraint on consumers. The Fed’s debt service ratio—the share of income households are spending to service their debt—is the lowest it’s been since the mid-90s (though the fact that it’s still falling suggest the deleveraging cycle isn’t over).
I think the bigger problem is in the banks, and it’s born of that extremely combustible combination: debt and psychology. When an equity (as opposed to a debt) bubble pops, markets move quickly to mark down the asset inflation born of speculation. A share of stock in some worthless fad that was worth $1,000 on Monday can be worth $1 by Friday.
Debt bubbles don’t work that way. Debt-based assets don’t get “marked-to-market” in the same way as stocks. De-nile ain’t just a river, and banks who hold such assets can engage in “extend and pretend” in a way they can’t when an equity bubble pops. This is especially the case in a housing bubble. Holders of non-performing mortgages that are deeply underwater—and more than half of the 11 million underwater mortgages are more than 25% below sea-level—convince themselves that these assets turned liabilities will resurface and sail again someday.
And in fact, some will. But many won’t and to admit that and mark them down means the bank needs to find more capital to keep its balance sheet in shape. Basically, a debt bubble injects human nature into the problem, and our nature is to cross our fingers and engage in magical thinking about zombie assets coming back life.
Is the Federal Government Capable of Reacting As Needed?
In the current context, the answer to the above question is clearly no, but this is not a situation diametrically opposed to where we were in 2009. It’s just a very extreme version of it.
Here’s how Ezra puts it, re the great recession:
“These crises have a sort of immune system. It is never possible for the political system to do enough to stop them at the outset, as it is never quite clear how bad they are. Even if it were, the system is ill-equipped to take action at that scale. The actors comfort themselves with the thought that if they need to do more, they can do it later. And, for now, the fact that this is the largest rescue package anyone has ever seen has to be worth something.
Perversely, the very size of the package is part of its problem. With something extraordinary that is nevertheless not enough, the economy deteriorates, and the government sees its solutions discredited and its political standing weakened by the worsening economic storm. That keeps it from doing more.”
What comprises this “immune system?” Part of it is good, old-fashioned checks and balances, envisioned by the framers to avoid concentration of power (the Senate alone can stop any idea, good or bad, in its tracks). In terms of getting ample stimulus into the system quickly, I vividly recall how this came down in China, as their central planners just turned the stimulus dials to wherever they wanted, without any oversight.
It’s true that the framers didn’t envision the filibuster abuse now mastered by the Senate, nor the deep aversion to fact-based analysis that pervades our current dysfuntionality. But I don’t think this fundamental structure is the root of the problem.
The deeper problem was the difficulty of the system to react to the depth of the Great Recession.
Now, I’m operating with a sample of one here—I’ve only witnessed such moments from the inside once, but I’ve seen them from the outside enough to have an informed opinion.
First, the fact that we failed to recognize the depth of the recession was not at the heart of the problem. Other trusted voices—Klein mentions Krugman and Stiglitz (I’d add Dean Baker and Larry Mishel)—were warning that things were going to be worse than our forecast, and we heard them. I myself, as quoted in Ezra’s piece, told the NYT in December of 2008: “We’ll be lucky if the unemployment rate is below double digits by the end of next year.” (And see footnote 1 in Romer/Bernstein, e.g.)
We wanted to have the largest package we could get and that was arguably what we ended up with. Moreover, the damn thing worked pretty much like we thought it would. Our mistake was failing to follow up on the initial success.
As Carmen Reinhart herself says in the piece, the Recovery Act prevented recession from morphing into depression. The engine was racing in reverse, and our actions and those of the Fed shifted it into neutral, where we’ve been stuck ever since, and stuck at an unacceptably high level of under-capacity.
What kept us from doing more? In fact, we did do more, but again, not enough. We extended unemployment benefits, the first time homebuyers credit, the Hire Act, the payroll tax holiday, a small business lending bill, and more.
Yet, we’re still stuck, and at this point even the tiniest policy lift is terribly heavy.
Obviously, there’s a lot of politics in there. Some of the opposition doesn’t want to give the President anything that might help him, and they’re willing to throw the economy under the bus. Others, however, look at 9% unemployment and conclude nothing worked. To tell them we would be stuck at 11% and rising does not persuade. And they’re unwilling to throw more good money after bad.
So part of our problem is that nobody does counterfactuals—what would have occurred absent the intervention. That’s understandable, and we should have tried harder to communicate that issue to the public. Still, I’m not sure if we could have made a difference. I do know that talking about green shoots didn’t help (I remember some critic at the time suggesting that we must be smoking green shoots).
But I actually think the “green shoots” mistake is an important hint. One reason to go there is because if you believe things are truly getting better—if you really think that soon the private sector can pick up the growth baton—then you can pivot away from spending toward deficit reduction. And the internal desire to do that is always strong in the White House—at times like this, too strong.
This isn’t just an Obama issue. FDR did the same thing.
One little wiggle up in Treasury rates or one bad T-bills auction, and the economic policy makers start worrying about the revenge of the bond vigilantes. The political advisors were deeply attuned to the public’s preference for less government spending, especially after the midterms. And unlike job creation, which is often indirect and dependent on a chain of events (you spend, not save, your tax cut, and you spend it on domestic goods, not imports), the government does hold the purse strings and can cut spending—just look at the (deeply misguided) austerity programs showing up across the globe. (Note: embedded in that last sentence is the recognition that direct job creation measures are a lot more effective than indirect ones; that’s a different, though related, post.)
In other words, one of the reasons we historically under-react to economic downturns is an irrational fear of temporary deficit spending. The main question we want to ask both back then and right now is not “is the deficit getting too large” but “is it large enough?” As long as the economy is operating under capacity and the spending is temporary—think Recovery Act, not Bush tax cuts—to do too little in the name of deficits, bond vigilantes, and Treasury rates (which are now at historic lows), is to condemn millions to unnecessary unemployment, declining living standards, and even, in the case of the young, permanent scarring.
I’ll have a lot more to say about this in an article coming out soon in the journal Democracy, and it’s but one of many dynamics that contributes to the immunity that Klein discusses. And, yes, for many in Congress it’s a tactic—they don’t care about the deficit other than its use a cudgel against doing something to help someone other than their funders. But as long as we fail to understand the dynamics of deficits—their need to expand as much as necessary in bad times and contract in good ones—we will never be able to meet the market failures we face now or in the future.