A Stalled Counter-Revolution

There is no shortage of books attempting to sort out the dynamics of
the great financial collapse that began in the summer of 2007. Since we
are still in an early phase of the crisis and don't yet know whether it
will rival the Great Depression in its depth and duration, all verdicts
remain provisional. But rather in the spirit of the 1952 presidential
campaign's arguments over who lost China, the battle is already on to
define who lost the economy and what to do next.

It's clear that deregulation of finance played a leading role.
However, the right is already marketing a counter-story that the crash
is actually the fault of government regulation. You can read this
narrative daily in the editorial pages of The Wall Street Journal.
Surprisingly, one of the nation's leading conservative intellectuals is
not buying the story. Judge Richard Posner is among the most prolific
(and irritating) of the University of Chicago law-and-economics
scholars who helped entrench the markets-uber-alles paradigm in
American academic thought. But Posner has managed to write a compelling
book on the crash, A Failure of Capitalism, indicting the major
role played by financial deregulation -- though without ever
acknowledging that he was one of its intellectual fathers.

"A largely unregulated banking industry," he writes, "converged,
fatally as it has turned out, with falling interest rates in the early
2000s." The unregulated issuers of credit-default swaps, unlike
regulated insurance companies, "were not required to have reserves" to
pay claims. The financial industry is rife with conflicts of interest
and likewise, credit-rating agencies. "Libertarian economists," he
declares, "failed to grasp the dangers of deregulating the financial
markets and underestimated the risk and depth of the financial crisis."
And rather startlingly, he concludes: "The aggregate self-interested
decisions of these institutions produce the economic crisis by a kind
of domino effect that only government can prevent -- which it failed to
do." None of this is exactly breaking news. But coming from Posner, it
is a notable rejection of free-market economics; Adam Smith's core
teaching is precisely that individual self-interest aggregates to a
general good and that government should keep hands off.

But how did all this deregulation come to pass? Or, as a good
Chicagoan might ask, what is your theory of agency? Mostly, Posner
isn't saying. The book has numerous worthwhile insights, including a
surprisingly Keynesian analysis of the dynamics of depressions. But its
major weakness, so characteristic of the Chicago school, is to leave
out political power. He warns against "an orgy of recrimination against
Wall Street," though the political influence of financial elites goes a
long way to explaining the collapse of regulation. To read Posner, you
would think that an autonomous actor called government made regulatory
decisions in a hermetic realm beyond the vectors of power that operate
upon it.

Michael Kinsley is fond of observing that the right welcomes
converts while the left is suspicious of heretics. Kinsley has a point,
but conversions would be a little easier to take if the convert had the
decency to concede that his earlier mistaken theories had collided with
reality. Posner, however, doesn't look back. The author of a leading
textbook on law and economics, he was appointed to the federal
appellate bench by Ronald Reagan in 1981. In the intervening 28 years,
he has found time to write 53 books as well as to continue to teach
part-time at the University of Chicago. This superhuman pace leads to a
certain glibness, but one should welcome Posner's book even if it is a
reversal without a recantation.

For a more straightforward primer on the crash, the reader cannot do
better than Dean Baker's short volume, Plunder and Blunder. Baker
anchors the gross financial and regulatory abuses of recent years in
the fundamental shifts in the political economy that occurred in the
1970s. During that period, median wage growth adjusted for hours worked
largely ceased, and many of the instruments that created the more
balanced and managed economy of the postwar boom were either undercut
by events (inflation, the oil shock, technology) or deliberately
assaulted by shifts in political power (the attack on unions, the
weakening of economic regulation, and the creation of a trade regime
designed to serve business and undermine labor).

The stagnation of the incomes of most Americans, combined with the
globalization of production and finance, Baker explains, set the stage:
"More and more, the U.S. economy depended on something far less
virtuous than productivity gains and broad prosperity. In pursuit of
short-term growth, key institutions relied on risky bets and
unsustainable policies. In short, we got hooked on bubbles."

To understand the dynamics of the crash that finally hit in the fall
of 2008, it helps to comprehend the back story. Baker sorts out how
much of the improved economic growth of the 1990s was the result of a
more productive economy (some in the early years) and how much was the
illusory gain of a financial bubble (most of it by the late 1990s.) He
demolishes the Robert Rubin story that budget balance led to low
interest rates, which in turn led to increased investment and growth.
Rather, he explains, the low interest rates in a global economy had
little to do with domestic fiscal policy but instead were Federal
Reserve Chair Alan Greenspan's way of cleaning up after earlier bubbles
and stimulating new ones.

Baker is a particularly good guide to the logic of the housing
bubble. He disentangles the roles of the several culprits, including
President George W. Bush, whose "ownership society" goals led the White
House to induce Fannie Mae and Freddie Mac to begin large-scale
purchases of badly underwritten loans. It was this policy shift coupled
with serial regulatory lapses by Greenspan and others, and not the
Community Reinvestment Act demonized by the right, that caused
sub-prime mortgages to spin out of control. Baker has also been an
astute critic of efforts by former Treasury Secretary Henry Paulson and
his successor Timothy Geithner to prop up, rather than clean out, toxic
securities, and he includes a useful summary of the kind of regulation
that we need going forward.

The crash of the stock market in 2008 was also the crash of a
reigning political ideology and its economic paradigm. While a leftist
economist such as Baker never accepted the dominant view, the
revisionism of a Posner attests to the breadth of that intellectual
collapse. Also instructive is the new thinking of more mainstream
academic economists.

For the subtitle of their new book, Animal Spirits, George Akerlof and Robert Shiller use the line: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.
"Animal spirits" is a famous phrase of John Maynard Keynes' to
characterize the impulsivity of much economic behavior. Though the new
discipline of behavioral economics has added fascinating details about
how this irrationality operates, thanks to the ingenious experimental
work at the boundary of economics and psychology by such scholars as
Daniel Kahneman, Amos Tversky, and Richard Thaler, it turns out that a
lot of the fundamentals are right there in Keynes.

As the financial collapse has demonstrated yet again, markets are
not self-correcting. If they were, Wall Street would not be lined up
for trillions of dollars in government handouts. In saluting Keynes'
quip, Akerlof and Schiller argue that much of the story is in the
unreliability and incompleteness of supposedly rational behavior -- the
micro-foundation of the free-market model. They contend that modern
economics, even self-described Keynesian economics, has given short
shrift to this core behavioral insight. They embellish the idea by
exploring the importance of "norms" of fairness in setting wages and
prices, and the key role of confidence in sustaining both normal
economic price setting and also periodic euphoria. Episodes of systemic
corruption, they suggest, are just another reflection of human
fickleness. "The business cycle," they write, "is connected to
fluctuations in personal commitment to principles of good behavior."
And people's failure to fully calibrate the costs of inflation --
"money illusion" as Keynes called it -- is yet another dimension of
nonrationality.

Yet, almost in spite of their effort to hang a whole new
macroeconomics on the idea of nonrational micro-behavior, their book
also follows Keynes' other insights about the instability of a purely
free market economy. For Keynes, even if everyone were perfectly
rational, there could be failures of the economy to reach its
production potential at equilibrium, and there could be politically
generated failures to pursue sensible financial regulation. My one
quibble is that Akerlof and Shiller overstate the connection between
less-than-perfect rationality and systemic instability.

Their best chapter is on the limited capacity of central banks to
prevent or cure calamities. As they note, the Fed cannot push
short-term interest rates below zero. Shadow banks are outside the
Fed's purview. And, in an observation that has been frighteningly
overtaken by events, they write that "the Fed usually trades only in
safe, short-term bonds." No longer. Lately, as a desperate response to
a crisis partly of the Fed's own making, the Fed has been buying all
manner of junk assets. As Dean Baker points out, the Fed itself can be
part of the problem when it combines low interest rates with feeble
regulation. This is less a matter of animal spirits than the political
capture of what is supposed to be a public-spirited entity. And who
rescues the system when the Fed's own balance sheet starts coming
apart?

The failure of central bankers is the subject of one of the most
compelling works of economic and political history to appear in many
years, Liaquat Ahamed's Lords of Finance. His subtitle says it all: The Bankers Who Broke the World.
Ahamed, an investment manager and financial historian, writes about the
fateful three decades between August 1914 and World War II. He combines
biography of the four most influential central bankers of the era with
riveting narrative history and lucid economic analysis. This is a story
whose broad outlines most educated people vaguely know, but Ahamed
magnificently fills in the details and extracts the larger
significance. As a mirror of our own times, the history is chilling.

In World War I, the great nations of Europe spent about half of
their total national output slaughtering each other. To finance this
bloody orgy, they borrowed. In the aftermath, they drowned in war
debts. All owed massive sums to the United States, which entered the
war late, profited handsomely, and emerged with its productive powers
enhanced. France and Britain had the insane idea that they could find
the money to pay off the war debts by squeezing Germany "until the pips
squeak," as the contemporary phrase had it. They were not bothered by
the fact that this was plainly impossible. Lord Cunliffe, a former head
of the Bank of England and a leader of the British delegation to the
Paris Peace Conference, recommended that Germany pay $100 billion in
reparations. "It was an astounding figure," Ahamed writes. "Germany's
annual GDP before the war had been around $12 billion."

The central bankers of the war's victors, Montagu Norman of the Bank
of England, Benjamin Strong of the New York Federal Reserve, and Emile
Moreau of the Banque de France, had one overarching goal -- to restore
the prewar gold standard. Their German counterpart, Hjalmar Schacht of
the Reichsbank, appointed in the aftermath of Germany's ruinous
hyperinflation, had a different goal -- to lift the crushing burden of
war reparations that was sandbagging the German economy and by
extension the economies of the rest of Europe.

Had these central bankers not been so utterly orthodox in their
thinking, they might have grasped that their historic role was not to
restore the gold standard but to relieve Europe of the downdraft of war
debts so that normal production and commerce might resume. In the end,
they managed neither to restore the gold standard nor to get commerce
flowing. And when the Great Depression struck, partly as the logical
consequence of their folly, the central bankers failed yet again, bound
by the orthodoxy of fiscal and monetary restraint.

In 1931, the final collapse of the debt-ravaged German economy
ensued. That spring, the central bankers made one last effort to
resolve the debt crisis. They failed, despite pleas and threats from
Schacht, who had stepped down as head of the Reichsbank. By early 1932,
German production had fallen 40 percent and a third of the work force
was idle. Hjalmar Schacht went over to the Nazis, subsequently becoming
Hitler's minister of the economy, directing public works and
rearmament.

Once again, a familiar figure makes a fleeting appearance in this
story -- John Maynard Keynes. It was Keynes, as a young adviser to the
British Treasury at the Paris Peace Conference, who warned about the
catastrophic consequences of the policy of extracting crushing war
reparations. Subsequently, in one of the most prescient tracts of the
era, "The Economic Consequences of the Peace," Keynes explained that if
Germany were to pay reparations at all, its economy had to recover. "If
Germany is to be milked," Keynes wrote, "she must not first of all be
ruined." Despite a brief flirtation with Keynes by Prime Minister David
Lloyd George, his warnings were ignored.

Keynes would get his chance, 25 years later, when as the leader of
the British delegation at Bretton Woods, he helped construct a postwar
financial and monetary system that used public institutions to restore
credit and economic growth, rejecting the deflationary tendencies of
private finance. As always, his enemies were the barons of banking,
backed by their allies in government, who wanted to rely entirely on
private financial flows and a system biased toward the interests of
creditors.

"There is no greater testament of his legacy," Ahamed writes, than
the fact that the world avoided a repeat of the Great Depression for
six decades. But the Keynesian moment at Bretton Woods was very much
the exception to a century-old pattern. Ordinarily, the forces of
orthodoxy rule-as they do today, notwithstanding Wall Street's
disgrace. It takes extraordinary circumstances for the top financial
officials of leading governments to be as radical as Keynes.

The malfeasance of today's central bankers has different particulars
but a common element -- orthodoxy. However, orthodoxy has a different
meaning today, one that seems almost opposite to the rigor of the
keepers of the gold standard but in its own way, just as unreal and
dangerous. The parallels between the 1920s and the 2000s begin with a
common element. Alan Greenspan and Ben Strong both pumped up a stock
market bubble with cheap money and feeble regulation. The relative
economic weakness of Europe allowed Strong to reconcile his penchant
for a gold standard globally with support for cheap money at home. When
Strong died in 1928 and the stock bubble seemed increasingly dangerous,
his successors excessively tightened credit.

Today, however, orthodoxy has come to mean doing whatever it takes
to revive the Wall Street casino. The plan recently announced by
Treasury Secretary Geithner and Fed Chair Ben Bernanke is intended not
to drive the money changers from the temple but to lend them public
funds so that they can double down on their bets. The Fed's own balance
sheet will quadruple. The one common thread that links the failed
central bankers of Ahamed's tale with the folly of Geithner and
Bernanke is that all were working hand in glove with private financial
elites.

The economic ideology of laissez-faire has been shattered, but the
political power of Wall Street is oddly intact. Keynes may be honored
again in unlikely places, but as far as public policy is concerned, he
is honored in the breach.