The persistent imbalances led us to pretend that we could keep borrowing without having sufficient tax revenue to pay for the government. And if your house prices are rising, if the stock market is going up—which of course is going to happen if you have cheap money—it puffs up the value of the assets, and disguises a lot of other structural problems such as rising inequality and corruption.
With this inflow of capital from abroad, the financial sector in the United States also became larger and larger relative to the rest of the economy, with GDP tilted disproportionately toward the financial sector.
How do we start to get out of this? In many ways we’re almost adverse to bringing up the situation in which we find ourselves with the net exporting countries. I thought it was quite interesting a few weeks ago when many Chinese officials were saying that it was proper, and it was good economically, that the US continue to run persistent trade imbalances with China, that the Chinese yuan did not need to be appreciated, that we should continue doing the things we always have, and that the US should make sure that the value of Chinese assets were not diminished by any change in the value of the dollar. It should have been clear that this was not a sustainable relationship, but no one was willing to say that.
So I think we’re going to have to address these chronic global trade imbalances. You might very well see a shift toward more protectionism. We’re going to have to actually do something about raising taxes so that we can sustain government from our own resources rather than depending upon borrowing abroad. And we’re going to have to start stepping back into our former role, one that we abdicated, as managers and guardians in the global economy.
J.M.: I think most people think the US government did what it had to in adopting a serious stimulus, despite the debt. Niall, why don’t you respond to the comments, and then we’ll have a little discussion on that.
N.F.: Well, if you listened carefully to what Paul Krugman said, he actually agreed with me. Because what he said was that everything is just fine as long as the financial credibility of the United States isn’t called into question, but my point is that it will be called into question. Of course it will. According to the administration’s crazily optimistic forecast for a recovery, it’s going to be a 3 percent growth rate next year, 4 percent the year after that, 4.6 percent the year after that. If you believe those numbers, you’ll believe absolutely anything, but they are there in the administration’s budget document. Even if those numbers turn out to be true, the federal debt will rise over the next five to ten years to around 100 percent of gross domestic product.
But since those numbers are clearly wrong, and the trend growth rate of the US will be much closer to 1 percent than to 4, it seems reasonable to anticipate a much more rapid explosion of federal debt to somewhere in the region of 140 or 150 percent of gross domestic product. Even if the private savings rate rebounded to its highest point in the postwar period, it would still account for no more than 5 percent of gross domestic product. But this year’s deficit, as I said earlier, is likely to be north of 12 percent of gross domestic product. So it doesn’t quite add up.
The Fed has committed itself to buying $300 billion worth of treasuries this year, but clearly it will have to buy a great many more than that. Remember, $1.7 trillion or so are coming onto the market. And you assume that the credibility of the United States in the eyes of Americans, as well as foreign investors, is going to withstand this? At some point the United States does start to look like a Latin American economy, not only to people abroad but maybe to people at home. If the Fed’s balance sheet explodes to up to $3 or $4 trillion, who knows how big it could get. At what point do people stop believing in the US dollar as a reserve currency, or even as a store of value for their own savings?
J.M.: Let’s allow Paul and others to respond.
P.K.: The essence of this kind of recession is precisely that the amount that collectively we want to save is greater than the amount that collectively we want to invest. That is the problem. You can’t get around that.
There is a very different question, which is the long-run solvency of the US government, and I do worry about that. I would disagree very much with Niall about those numbers, but this is a factor that should be taken into account. We are currently in debt about 60 percent of GDP. We have in the past been as high as 100 percent of GDP at the end of World War II without having a crisis, but your ability to go that high does depend upon people’s belief that you will behave responsibly, and that is somewhat in question. I hope it is less in question than it was in the past, now that we’ve had some regime changes, but it is a problem.
N.R.: I think that the debate here is about what needs to be done in the short term versus the long term. The lesson of the Great Depression is pretty clear: it started with the stock market crash of 1929, and it actually became the Great Depression by 1933 for four reasons. One, we didn’t believe in a counter-cyclical monetary policy. The money supply contracted rather than being eased. Interest rates were not falling, and that made the credit crunch worse. Two, nobody believed in counter-cyclical fiscal policy. The general theory of Keynes was written only in 1936; in the early 1930s, the government was raising taxes and cutting spending in order to maintain a balanced budget. That made the recession even more severe.
Three, there was a belief that banks should be allowed to collapse. Thousands of them collapsed, the credit crunch became even worse. And four, by 1933, 75 percent of households had defaulted on their mortgages; they couldn’t pay them. So a stock market crash became a Great Depression. Then you add currency wars internationally, trade wars, protectionism, and capital controls; then you had default by countries and the rise of totalitarian regimens in Germany and in Italy, in Japan, and Spain, and we ended up in World War II. So those are the consequences of not taking the right policy actions in the short run.
I agree, however, that we have to worry about the long run. If we’re going to finance budget deficits by printing money, we may have high inflation, even risk of hyperinflation in some countries. That’s what happened in Germany in the 1920s during the Weimar Republic. We are having large budget deficits and increasing the public debt, we don’t know whether it’s going to be $5 trillion or $10 trillion of more debt. But there are only a few ways of resolving that debt problem: either you default on it as countries like Argentina did; or you use the inflation tax to wipe out the real value of the debt; or you have to raise taxes and cut government spending. And given the size of the deficits, over time that’s going to be a painful political choice to make. So we need the stimulus in the short run, but we need to restore medium-term fiscal sustainability.
G.S.: Let’s face it, for twenty-five years we have been consuming more than we have been producing. This living beyond our means accumulated mainly in the housing sector and the financial sector, and now those liabilities are being nationalized. It’s a bit unfortunate that so far we have only nationalized the liabilities of the banks, and not their assets. I think it’s right that we are extending a government credit to replace the collapsing credit, and we are currently in a deflationary situation. When the flow of credit restarts, suddenly there will be a flip-flop where the fear of deflation will be replaced by the fear of inflation. The pressure for interest rates to rise will be very, very strong, and the rise in interest rates could choke off the recovery. And so we are facing a period of stop-go, or stagflation similar to but more severe than what we faced in the Seventies. But that is a favorable outcome compared to what would have happened if we hadn’t done what we are doing.
About regulation, we have to start by recognizing that the prevailing view is false, that markets actually are bubble-prone. They create bubbles. Therefore, they have to be regulated. The authorities have to accept responsibility for preventing asset bubbles from growing too big. They’ve expressly rejected that, saying that if the markets don’t know, how can the regulators know? And, of course, they can’t. They’re bound to be wrong, but they get feedback from the market, and then they can make adjustments. Now, it is not enough to regulate the money supply. You have to regulate credit. And that means using tools that have largely fallen into disuse. Of course you have margin requirements, minimum capital requirements; but you actually have to vary them to counteract the prevailing mood of the market, because markets do have moods. It should be recognized that exuberance actually is quite rational. When I see a bubble beginning, forming, I jump on it because that’s how I make money. So it’s perfectly rational.
It’s the job of the regulators to regulate. However, we should try not to go overboard. While markets are imperfect, regulators are even more imperfect: not only are they human, they’re also bureaucratic and subject to political influences. So we want to keep regulation to a minimum, but we have to recognize that markets are inherently unstable.
N.R.: On this question of regulation, of course, we go into cycles, you know. We had the Great Depression, and then we imposed many actually useful regulations, both on the financial system and on the real economy. Some of them became excessive, and even before Reagan and Thatcher, Jimmy Carter started deregulating some parts of the economy. Eventually policy makers started believing that self-regulation is best; but that means no regulation. We believed in market discipline; but there is no discipline when there is irrational exuberance. We relied on internal risk management models; but nobody listened to risk managers when the risk takers were making all the profits in the banks; and we relied on rating agencies which had massive conflicts of interest since they were being paid by those that they were supposed to be rating. So the entire model of self-regulation and market discipline now has collapsed.
We have to go to a world where there is greater prudential regulation and supervision of the financial system. I think the challenge for the US economy is, can we grow without excessive credit and leverage? Can we grow in a more sustainable way? And what are going to be the sectors of the economy that give us sustainable, long-term growth? I think that’s an open question.
P.K.: I think there are two big structural changes that we’d want to see. One is we need to reduce the role of the financial sector in the economy. We went from an economy in which about 4 percent of GDP came from the financial sector to an economy in which 8 percent of GDP come from the financial sector, and in which at its peak 41 percent of profits were being earned by the financial sector. And there is no reason to believe that anything productive happened as a result of all of that. These extremely highly compensated bankers were essentially just finding new ways to offload risks on to other people.
As I’ve written, we need a boring banking sector again. All of this high finance has turned out to be just destructive, and that’s partly a matter of regulation. But in the political economy there was also a vicious circle. Because as the financial sector got increasingly bloated its political clout also grew. So, in fact, deregulation bred bloated finance, which bred more deregulation, which bred this monster that ate the world economy.
The other thing not to miss is the importance of a strong social safety net. By most accounts, most projections say that the European Union is going to have a somewhat deeper recession this year than the United States. So in terms of macromanagement, they’re actually doing a poor job, and there are various reasons for that: the European Central Bank is too conservative, Europeans have been too slow to do fiscal stimulus. But the human suffering is going to be much greater on this side of the Atlantic because Europeans don’t lose their health care when they lose their jobs. They don’t find themselves with essentially no support once their trivial unemployment check has fallen off. We have nothing underneath. When Americans lose their jobs, they fall into the abyss. That does not happen in other advanced countries, it does not happen, I want to say, in civilized countries.
And there are people who say we should not be worrying about things like universal health care in the crisis, we need to solve the crisis. But this is exactly the time when the importance of having a decent social safety net is driven home to everybody, which makes it a very good time to actually move ahead on these other things.
N.F.: Well, I tell you what, I feel depressed after what I’ve heard tonight. We are now contemplating a massive expansion of the state to substitute for the private sector because that’s the only thing Paul thinks will deliver growth. We’re going to reregulate the markets, we’re going to go back to those good old days. Where were you in the 1970s when all these wonderful regulations were in place? I don’t remember that going too smoothly. But what else are we going to do? We’re going to print money. Almost limitlessly we’ll print money. That’s going to be fine, too. And when we’re done with that, we’re going to raise taxes. What a fabulous package we have in store for us. You know, back in late 2007, I was asked what my big concern was, and I said, “My concern is that we’re going to get the 1970s for fear of the 1930s.” It’s very easy to forget, in your iron indignation at the failure of the market, where the true mainsprings of economic growth lie. The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from the private sector, not from the state.
B.B.: As we look at the future, we also have to look at the mistakes policymakers made in the last ten years. It’s not news that people are greedy. But we made conscious decisions not to put limits on that natural human impulse. What were the mistakes? In 1999, we allowed investment banks, banks, insurance companies to combine: we eliminated the Glass-Steagall Act, which prohibited commercial banks from operating as investment banks. Why was Glass-Steagall put into law? Because the last time we didn’t limit greed we got into trouble, the Great Depression.
The second mistake was in 1999, the explicit decision by the Clinton administration and Congress not to regulate derivatives, in particular credit default swaps. In 2002 they were worth $1 trillion and today they’re worth $33 trillion, and that decision not to regulate derivatives created the following sequence: you have mortgages; then a thousand mortgages are packaged and sold as a mortgage-backed security; a thousand mortgage-backed securities are packaged and sold as a collateral debt obligation [CDOs]; then a thousand collateral debt obligations are packaged and sold as a CDO squared; and insuring each one of those bundles are credit default swaps, which are a part of that $33 trillion. And our government deliberately decided not to regulate this chain of investments.
One result was that the 374 people in the London office of AIG who were responsible for AIG derivatives destroyed a company that had 116,000 employees in 120 countries. Why? Because there was no regulation at all.
The third decision was in 2004. The SEC allowed banks to go from 10 to 1 leverage to 30 to 1 leverage. And guess what? Once they were allowed to do it, they did it. So if we’re going to look at the future, we might think of undoing those three mistakes.
Finally, we might want to remember that the chairman of the Federal Reserve is supposed to remove the punch bowl from the party when the party gets out of control. And that did not happen in the Greenspan years. The opposite happened.