No Return To Normal

Barack Obama's presidency began in hope and goodwill, but its test
will be its success or failure on the economics. Did the president and
his team correctly diagnose the problem? Did they act with sufficient
imagination and force? And did they prevail against the political
obstacles-and not only that, but also against the procedures and the
habits of thought to which official Washington is addicted?

The president has an economic program. But
there is, so far, no clear statement of the thinking behind that
program, and there may not be one, until the first report of the new
Council of Economic Advisers appears next year. We therefore resort to
what we know about the economists: the chair of the National Economic
Council, Lawrence Summers; the CEA chair, Christina Romer; the budget
director, Peter Orszag; and their titular head, Treasury Secretary
Timothy Geithner. This is plainly a capable, close-knit group, acting
with energy and commitment. Deficiencies of their program cannot,
therefore, be blamed on incompetence. Rather, if deficiencies exist,
they probably result from their shared background and creed-in short,
from the limitations of their ideas.

The
deepest belief of the modern economist is that the economy is a
self-stabilizing system. This means that, even if nothing is done,
normal rates of employment and production will someday return.
Practically all modern economists believe this, often without thinking
much about it. (Federal Reserve Chairman Ben Bernanke said it
reflexively in a major speech in London in January: "The global economy
will recover." He did not say how he knew.) The difference between
conservatives and liberals is over whether policy can usefully speed
things up. Conservatives say no, liberals say yes, and on this point
Obama's economists lean left. Hence the priority they gave, in their
first days, to the stimulus package.

But
did they get the scale right? Was the plan big enough? Policies are
based on models; in a slump, plans for spending depend on a forecast of
how deep and long the slump would otherwise be. The program will only
be correctly sized if the forecast is accurate. And the forecast
depends on the underlying belief. If recovery is not built into the
genes of the system, then the forecast will be too optimistic, and the
stimulus based on it will be too small.

Consider
the baseline economic forecast of the Congressional Budget Office, the
nonpartisan agency lawmakers rely on to evaluate the economy and their
budget plans. In its early-January forecast, the CBO measured and
projected the difference between actual economic performance and
"normal" economic performance-the so-called GDP gap. The forecast has
two astonishing features. First, the CBO did not expect the present
recession to be any worse than that of 1981-82, our deepest postwar
recession. Second, the CBO expected a turnaround beginning late this
year, with the economy returning to normal around 2015, even if
Congress had taken no action at all.

With
this projection in mind, the recovery bill pours a bit less than 2
percent of GDP into new spending per year, plus some tax cuts, for two
years, into a GDP gap estimated to average 6 percent for three years.
The stimulus does not need to fill the whole gap, because the CBO
expects a "multiplier effect," as first-round spending on bridges and
roads, for example, is followed by second-round spending by
steelworkers and road crews. The CBO estimates that because of the
multiplier effect, two dollars of new public spending produces about
three dollars of new output. (For tax cuts the numbers are lower, since
some of the cuts will be saved in the first round.) And with this help,
the recession becomes fairly mild. After two years, growth would be
solidly established and Congress's work would be done. In this way, the
duration as well as the scale of action was driven, behind the scenes,
by the CBO's baseline forecast.

Why
did the CBO reach this conclusion? On depth, CBO's model is based on
the postwar experience, and such models cannot predict outcomes more
serious than anything already seen. If we are facing a downturn worse
than 1982, our computers won't tell us; we will be surprised. And if
the slump is destined to drag on, the computers won't tell us that
either. Baked into the CBO model we find a "natural rate of
unemployment" of 4.8 percent; the model moves the economy back toward
that value no matter what. In the real world, however, there is no
reason to believe this will happen. Some alternative forecasts, freed
of the mystical return to "normal," now project a GDP gap twice as
large as the CBO model predicts, and with no near-term recovery at all.

Considerations
of timing also influenced the choice of line items. The bill tilted
toward "shovel-ready" projects like refurbishing schools and fixing
roads, and away from projects requiring planning and long construction
lead times, like urban mass transit. The push for speed also influenced
the bill in another way. Drafting new legislative authority takes time.
In an emergency, it was sensible for Chairman David Obey of the House
Appropriations Committee to mine the legislative docket for ideas
already commanding broad support (especially within the Democratic
caucus). In this way he produced a bill that was a triumph of fast
drafting, practical politics, and progressive principle-a good bill
which the Republicans hated. But the scale of action possible by such
means is unrelated, except by coincidence, to what the economy needs.

Three
further considerations limited the plan. There was, to begin with, the
desire for political consensus; President Obama chose to start his
administration with a bill that might win bipartisan support and pass
in Congress by wide margins. (He was, of course, spurned by the
Republicans.) Second, the new team also sought consensus of another
type. Christina Romer polled a bipartisan group of professional
economists, and Larry Summers told Meet the Press
that the final package reflected a "balance" of their views. This
procedure guarantees a result near the middle of the professional
mind-set. The method would be useful if the errors of economists were
unsystematic. But they are not. Economists are a cautious group, and in
any extreme situation the midpoint of professional opinion is bound to be wrong.

Third,
the initial package was affected by the new team's desire to get past
this crisis and to return to the familiar problems of their past lives.
For these proteges of Robert Rubin, veterans in several cases of
Rubin's Hamilton Project, a key preconception has always been the
budget deficit and what they call the "entitlement problem." This is
D.C.-speak for rolling back Social Security and Medicare, opening new
markets for fund managers and private insurers, behind a wave of budget
babble about "long-term deficits" and "unfunded liabilities." To this
our new president is not immune. Even before the inauguration Obama was
moved to commit to "entitlement reform," and on February 23 he convened
what he called a "fiscal responsibility summit." The idea took hold
that after two years or so of big spending, the return to normal would
be under way, and the costs of fiscal relief and infrastructure
improvement might be recouped, in part by taking a pound of flesh from
the incomes and health care of the old.

The
chance of a return to normal depends, in turn, on the banking strategy.
To Obama's economists a "normal" economy is led and guided by private
banks. When domestic credit booms are under way, they tend to generate
high employment and low inflation; this makes the public budget look
good, and spares the president and Congress many hard decisions. For
this reason the new team instinctively seeks to return the bankers to
their normal position at the top of the economic hill. Secretary
Geithner told CNBC, "We have a financial system that is run by private
shareholders, managed by private institutions, and we'd like to do our
best to preserve that system."

But,
is this a realistic hope? Is it even a possibility? The normal
mechanics of a credit cycle do involve interludes when asset values
crash and credit relations collapse. In 1981, Paul Volcker's campaign
against inflation caused such a crash. But, though they came close, the
big banks did not fail then. (I learned recently from William Isaac,
Ronald Reagan's chair of the FDIC, that the government had contingency
plans to nationalize the large banks in 1982, had Mexico, Argentina, or
Brazil defaulted outright on their debts.) When monetary policy relaxed
and the delayed tax cuts of 1981 kicked in, there was both pent-up
demand for credit and the capacity to supply it. The final result was
that the economy recovered quickly. Again in 1994, after a long period
of credit crunch, banks and households were strong enough, even without
a stimulus, to support a vast renewal of lending which propelled the
economy forward for six years.

The
Bush-era disasters guarantee that these happy patterns will not be
repeated. For the first time since the 1930s, millions of American
households are financially ruined. Families that two years ago enjoyed
wealth in stocks and in their homes now have neither. Their 401(k)s
have fallen by half, their mortgages are a burden, and their homes are
an albatross. For many the best strategy is to mail the keys to the
bank. This practically assures that excess supply and collapsed prices
in housing will continue for years. Apart from cash-protected by
deposit insurance and now desperately being conserved-the American
middle class finds today that its major source of wealth is the
implicit value of Social Security and Medicare-illiquid and intangible
but real and inalienable in a way that home and equity values are not.
And so it will remain, as long as future benefits are not cut.

In
addition, some of the biggest banks are bust, almost for certain.
Having abandoned prudent risk management in a climate of regulatory
negligence and complicity under Bush, these banks participated
gleefully in a poisonous game of abusive mortgage originations followed
by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not
pass them all. And when in August 2007 the music stopped, banks
discovered that the markets for their toxic-mortgage-backed securities
had collapsed, and found themselves insolvent. Only a dogged political
refusal to admit this has since kept the banks from being taken into
receivership by the Federal Deposit Insurance Corporation-something the
FDIC has the power to do, and has done as recently as last year with
IndyMac in California.

Geithner's
banking plan would prolong the state of denial. It involves government
guarantees of the bad assets, keeping current management in place and
attempting to attract new private capital. (Conversion of preferred
shares to equity, which may happen with Citigroup, conveys no powers
that the government, as regulator, does not already have.) The idea is
that one can fix the banks from the top down, by reestablishing markets
for their bad securities. If the idea seems familiar, it is: Henry
Paulson also pressed for this, to the point of winning congressional
approval. But then he abandoned the idea. Why? He learned it could not
work.

Paulson
faced two insuperable problems. One was quantity: there were too many
bad assets. The project of buying them back could be likened to
"filling the Pacific Ocean with basketballs," as one observer said to
me at the time. (When I tried to find out where the original request
for $700 billion in the Troubled Asset Relief Program came from, a
senior Senate aide replied, "Well, it's a number between five hundred
billion and one trillion.")

The
other problem was price. The only price at which the assets could be
disposed of, protecting the taxpayer, was of course the market price.
In the collapse of the market for mortgage-backed securities and their
associated credit default swaps, this price was too low to save the
banks. But any higher price would have amounted to a gift of public
funds, justifiable only if there was a good chance that the assets
might recover value when "normal" conditions return.

That
chance can be assessed, of course, only by doing what any reasonable
private investor would do: due diligence, meaning a close inspection of
the loan tapes. On the face of it, such inspections will reveal a very
high proportion of missing documentation, inflated appraisals, and
other evidence of fraud. (In late 2007 the ratings agency Fitch
conducted this exercise on a small sample of loan files, and found
indications of misrepresentation or fraud present in practically every
one.) The reasonable inference would be that many more of the loans
will default. Geithner's plan to guarantee these so-called assets,
therefore, is almost sure to overstate their value; it is only a way of
delaying the ultimate public recognition of loss, while keeping the
perpetrators afloat.

Delay
is not innocuous. When a bank's insolvency is ignored, the incentives
for normal prudent banking collapse. Management has nothing to lose. It
may take big new risks, in volatile markets like commodities, in the
hope of salvation before the regulators close in. Or it may loot the
institution-nomenklatura privatization, as the Russians would
say-through unjustified bonuses, dividends, and options. It will never
fully disclose the extent of insolvency on its own.

The
most likely scenario, should the Geithner plan go through, is a
combination of looting, fraud, and a renewed speculation in volatile
commodity markets such as oil. Ultimately the losses fall on the public
anyway, since deposits are largely insured. There is no chance that the
banks will simply resume normal long-term lending. To whom would they
lend? For what? Against what collateral? And if banks are recapitalized
without changing their management, why should we expect them to change
the behavior that caused the insolvency in the first place?

The
oddest thing about the Geithner program is its failure to act as though
the financial crisis is a true crisis-an integrated, long-term economic
threat-rather than merely a couple of related but temporary problems,
one in banking and the other in jobs. In banking, the dominant metaphor
is of plumbing: there is a blockage to be cleared. Take a plunger to
the toxic assets, it is said, and credit conditions will return to
normal. This, then, will make the recession essentially normal,
validating the stimulus package. Solve these two problems, and the
crisis will end. That's the thinking.

But
the plumbing metaphor is misleading. 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. And the borrower must meet two conditions. One is
creditworthiness, meaning a secure income and, usually, a house with
equity in it. Asset prices therefore matter. With a chronic oversupply
of houses, prices fall, collateral disappears, and even if borrowers
are willing they can't qualify for loans. The other requirement is a
willingness to borrow, motivated by what Keynes called the "animal
spirits" of entrepreneurial enthusiasm. In a slump, such optimism is
scarce. Even if people have collateral, they want the security of cash.
And it is precisely because they want cash that they will not deplete
their reserves by plunking down a payment on a new car.

The
credit flow metaphor implies that people came flocking to the new-car
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.

Strapped
and afraid, people want to be in cash. This is what economists call the
liquidity trap. And it gets worse: in these conditions, the normal
estimates for multipliers-the bang for the buck-may be too high.
Government spending on goods and services always increases total
spending directly; a dollar of public spending is a dollar of GDP. But
if the workers simply save their extra income, or use it to pay debt,
that's the end of the line: there is no further effect. For tax cuts
(especially for the middle class and up), the new funds are mostly
saved or used to pay down debt. Debt reduction may help lay a
foundation for better times later on, but it doesn't help now. With
smaller multipliers, the public spending package would need to be even
larger, in order to fill in all the holes in total demand. Thus
financial crisis makes the real crisis worse, and the failure of the
bank plan practically assures that the stimulus also will be too small.

In short, if we are in a true collapse of finance, our models will not
serve. It is then appropriate to reach back, past the postwar years, to
the experience of the Great Depression. And this can only be done by
qualitative and historical analysis. Our modern numerical models just
don't capture the key feature of that crisis-which is, precisely, the
collapse of the financial system.

If
the banking system is crippled, then to be effective the public sector
must do much, much more. How much more? By how much can spending be
raised in a real depression? And does this remedy work? Recent months
have seen much debate over the economic effects of the New Deal, and
much repetition of the commonplace that the effort was too small to end
the Great Depression, something achieved, it is said, only by World War
II. A new paper by the economist Marshall Auerback has usefully
corrected this record. Auerback plainly illustrates by how much
Roosevelt's ambition exceeded anything yet seen in this crisis:

[Roosevelt's]
government hired about 60 per cent of the unemployed in public works
and conservation projects that planted a billion trees, saved the
whooping crane, modernized rural America, and built such diverse
projects as the Cathedral of Learning in Pittsburgh, the Montana state
capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and
Triborough Bridge complex, the Tennessee Valley Authority and the
aircraft carriers Enterprise and Yorktown. It also built or renovated
2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800
bridges, 700,000 miles of roads, and a thousand airfields. And it
employed 50,000 teachers, rebuilt the country's entire rural school
system, and hired 3,000 writers, musicians, sculptors and painters,
including Willem de Kooning and Jackson Pollock.

In
other words, Roosevelt employed Americans on a vast scale, bringing the
unemployment rates down to levels that were tolerable, even before the
war-from 25 percent in 1933 to below 10 percent in 1936, if you count
those employed by the government as employed, which they surely were.
In 1937, Roosevelt tried to balance the budget, the economy relapsed
again, and in 1938 the New Deal was relaunched. This again brought
unemployment down to about 10 percent, still before the war.

The
New Deal rebuilt America physically, providing a foundation (the TVA's
power plants, for example) from which the mobilization of World War II
could be launched. But it also saved the country politically and
morally, providing jobs, hope, and confidence that in the end democracy
was worth preserving. There were many, in the 1930s, who did not think
so.

What did not
recover, under Roosevelt, was the private banking system. Borrowing and
lending-mortgages and home construction-contributed far less to the
growth of output in the 1930s and '40s than they had in the 1920s or
would come to do after the war. If they had savings at all, people
stayed in Treasuries, and despite huge deficits interest rates for
federal debt remained near zero. The liquidity trap wasn't overcome
until the war ended.

It
was the war, and only the war, that restored (or, more accurately,
created for the first time) the financial wealth of the American middle
class. During the 1930s public spending was large, but the incomes
earned were spent. And while that spending increased consumption, it
did not jumpstart a cycle of investment and growth, because the idle
factories left over from the 1920s were quite sufficient to meet the
demand for new output. Only after 1940 did total demand outstrip the
economy's capacity to produce civilian private goods-in part because
private incomes soared, in part because the government ordered the
production of some products, like cars, to halt.

All
that extra demand would normally have driven up prices. But the federal
government prevented this with price controls. (Disclosure: this
writer's father, John Kenneth Galbraith, ran the controls during the
first year of the war.) And so, with nowhere else for their extra
dollars to go, the public bought and held government bonds. These
provided claims to postwar purchasing power. After the war, the
existence of those claims could, and did, establish creditworthiness
for millions, making possible the revival of private banking, and on
the broadly based, middle-class foundation that so distinguished the
1950s from the 1920s. But the relaunching of private finance took
twenty years, and the war besides.

A
brief reflection on this history and present circumstances drives a
plain conclusion: the full restoration of private credit will take a
long time. It will follow, not precede, the restoration of sound
private household finances. There is no way the project of resurrecting
the economy by stuffing the banks with cash will work. Effective policy
can only work the other way around.

That being so, what must now be done? The first thing we need, in the
wake of the recovery bill, is more recovery bills. The next efforts
should be larger, reflecting the true scale of the emergency. There
should be open-ended support for state and local governments, public
utilities, transit authorities, public hospitals, schools, and
universities for the duration, and generous support for public capital
investment in the short and long term. To the extent possible, all the
resources being released from the private residential and commercial
construction industries should be absorbed into public building
projects. There should be comprehensive foreclosure relief, through a
moratorium followed by restructuring or by conversion-to-rental, except
in cases of speculative investment and borrower fraud. The president's
foreclosure-prevention plan is a useful step to relieve mortgage
burdens on at-risk households, but it will not stop the downward spiral
of home prices and correct the chronic oversupply of housing that is
the cause of that.

Second,
we should offset the violent drop in the wealth of the elderly
population as a whole. The squeeze on the elderly has been little noted
so far, but it hits in three separate ways: through the fall in the
stock market; through the collapse of home values; and through the drop
in interest rates, which reduces interest income on accumulated cash.
For an increasing number of the elderly, Social Security and Medicare
wealth are all they have.

That
means that the entitlement reformers have it backward: instead of
cutting Social Security benefits, we should increase them, especially
for those at the bottom of the benefit scale. Indeed, in this crisis,
precisely because it is universal and efficient, Social Security is an
economic recovery ace in the hole. Increasing benefits is a simple,
direct, progressive, and highly efficient way to prevent poverty and
sustain purchasing power for this vulnerable population. I would also
argue for lowering the age of eligibility for Medicare to (say)
fifty-five, to permit workers to retire earlier and to free firms from
the burden of managing health plans for older workers.

This
suggestion is meant, in part, to call attention to the madness of talk
about Social Security and Medicare cuts. The prospect of future cuts in
this modest but vital source of retirement security can only prompt
worried prime-age workers to spend less and save more today. And that
will make the present economic crisis deeper. In reality, there is no
Social Security "financing problem" at all. There is a health care
problem, but that can be dealt with only by deciding what health
services to provide, and how to pay for them, for the whole population.
It cannot be dealt with, responsibly or ethically, by cutting care for
the old.

Third, we
will soon need a jobs program to put the unemployed to work quickly.
Infrastructure spending can help, but major building projects can take
years to gear up, and they can, for the most part, provide jobs only
for those who have the requisite skills. So the federal government
should sponsor projects that employ people to do what they do best,
including art, letters, drama, dance, music, scientific research,
teaching, conservation, and the nonprofit sector, including community
organizing-why not?

Finally,
a payroll tax holiday would help restore the purchasing power of
working families, as well as make it easier for employers to keep them
on the payroll. This is a particularly potent suggestion, because it is
large and immediate. And if growth resumes rapidly, it can also be
scaled back. There is no error in doing too much that cannot easily be
repaired, by doing a bit less.

As these measures take effect, the government must take control of
insolvent banks, however large, and get on with the business of
reorganizing, re-regulating, decapitating, and recapitalizing them.
Depositors should be insured fully to prevent runs, and private risk
capital (common and preferred equity and subordinated debt) should take
the first loss. Effective compensation limits should be enforced-it is
a good thing that they will encourage those at the top to retire. As
Senator Christopher Dodd of Connecticut correctly stated in the
brouhaha following the discovery that Senate Democrats had put tough
limits into the recovery bill, there are many competent replacements
for those who leave.

Ultimately
the big banks can be resold as smaller private institutions, run on a
scale that permits prudent credit assessment and risk management by
people close enough to their client communities to foster an effective
revival, among other things, of household credit and of independent
small business-another lost hallmark of the 1950s. No one should
imagine that the swaggering, bank-driven world of high finance and
credit bubbles should be made to reappear. Big banks should be run
largely by men and women with the long-term perspective, outlook, and
temperament of middle managers, and not by the transient,
self-regarding plutocrats who run them now.

The
chorus of deficit hawks and entitlement reformers are certain to regard
this program with horror. What about the deficit? What about the debt?
These questions are unavoidable, so let's answer them. First, the
deficit and the public debt of the U.S. government can, should, must,
and will increase in this crisis. They will increase whether the
government acts or not. The choice is between an active program,
running up debt while creating jobs and rebuilding America, or a
passive program, running up debt because revenues collapse, because the
population has to be maintained on the dole, and because the Treasury
wishes, for no constructive reason, to rescue the big bankers and make
them whole.

Second,
so long as the economy is placed on a path to recovery, even a massive
increase in public debt poses no risk that the U.S. government will
find itself in the sort of situation known to Argentines and
Indonesians. Why not? Because the rest of the world recognizes that the
United States performs certain indispensable functions, including
acting as the lynchpin of collective security and a principal source of
new science and technology. So long as we meet those responsibilities,
the rest of the world is likely to want to hold our debts.

Third,
in the debt deflation, liquidity trap, and global crisis we are in,
there is no risk of even a massive program generating inflation or
higher long-term interest rates. That much is obvious from current
financial conditions: interest rates on long-maturity Treasury bonds
are amazingly low. Those rates also tell you that the markets are not
worried about financing Social Security or Medicare. They are more
worried, as I am, that the larger economic outlook will remain very
bleak for a long time.

Finally,
there is the big problem: How to recapitalize the household sector? How
to restore the security and prosperity they've lost? How to build the
productive economy for the next generation? Is there anything today
that we might do that can compare with the transformation of World War
II? Almost surely, there is not: World War II doubled production in
five years.

Today
the largest problems we face are energy security and climate
change-massive issues because energy underpins everything we do, and
because climate change threatens the survival of civilization. And
here, obviously, we need a comprehensive national effort. Such a thing,
if done right, combining planning and markets, could add 5 or even 10
percent of GDP to net investment. That's not the scale of wartime
mobilization. But it probably could return the country to full
employment and keep it there, for years.

Moreover,
the work does resemble wartime mobilization in important financial
respects. Weatherization, conservation, mass transit, renewable power,
and the smart grid are public investments. As with the armaments in
World War II, work on them would generate incomes not matched by the
new production of consumer goods. If handled carefully-say, with a new
program of deferred claims to future purchasing power like war
bonds-the incomes earned by dealing with oil security and climate
change have the potential to become a foundation of restored financial
wealth for the middle class.

This
cannot be made to happen over just three years, as we did in 1942-44.
But we could manage it over, say, twenty years or a bit longer. What is
required are careful, sustained planning, consistent policy, and the
recognition now that there are no quick fixes, no easy return to
"normal," no going back to a world run by bankers-and no alternative to
taking the long view.

A
paradox of the long view is that the time to embrace it is right now.
We need to start down that path before disastrous policy errors,
including fatal banker bailouts and cuts in Social Security and
Medicare, are put into effect. It is therefore especially important
that thought and learning move quickly. Does the Geithner team, forged
and trained in normal times, have the range and the flexibility
required? If not, everything finally will depend, as it did with
Roosevelt, on the imagination and character of President Obama.