Galbraith writes "No Return to Normal"

No Return to Normal: Why the economic crisis, and its solution, are bigger than you think, by James K. Galbraith

Galbraith conducts an introductory inquiry into the basic assumptions behind the economic policy responses of Team Obama, and warns that they fail to come to grips with the severity of the liquidity trap the entire world has now fallen into.

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. . . The difference between conservatives and liberals is over whether policy can usefully speed things up.

But, Galbraith argues, we are in a collapse of the financial system, and the only comparable event, the Great Depression of 1929-1939, simply is not built into economists’ models. For example, there is the assumption of a "natural rate of unemployment" of 4.8 percent; Ga;braith motes that the CBO’s economic “model moves the economy back toward that value no matter what.”

Galbraith highlights other crucial assumptions of Team Obama that are dangerously in error.

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 protégés 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."

Galbraith argues that this economic downturn is so severe, that the thing to do now is to increase social security benefits and lower the mandatory retirement age, because we need to

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.

Finally, there is the assumption about the primacy of finance in the economy.

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 the plain fact is that the big banks are insolvent, and actual examinations of the loan files which were securitized reveal “a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud” that make it extremely unlikely that derivatives based on these loans will ever again reach a market price that will make the banks solvent. And, there has to be a sea-change in the way bank managers see and work with the world:

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.

Galbraith then turns to a discussion of the liquidity trap, which is entirely outside the experience of all economists living today.

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?

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.

Here, I think it instructive to interject the sobering assessment by Numerian on February 20, 2009 that this new behavioir by American consumers works out to a $20 or $30 trillion drop in economic activity over the next five years. From Why the Banks Won't Lend:

What we are seeing, therefore, is an economy that is deflating to a level that will allow the consumer to save at least 8% of their disposable income every year, plus have some cash flow left over to be used to pay principal and interest on consumer loans. Economists can do any number of studies to figure out what the equilibrium level of GNP would be to allow this to happen, but there is an easier way to think about it. We need to return to the days when the consumer did in fact save over 8% a year, have enough to pay down a mortgage (after putting 20% cash down on the purchase of the home), and purchase one car. The last time the consumer was able to do this was about 1992.

So, the economy needs to be much smaller than it is now if consumers are going to live off their income and not their assets. As we work our way to that level of economic activity, bank lending must and will remain stagnant. No amount of government money will be used by the banks to lend to the consumer in a significant way, because there is no economic justification for making loans that cannot be repaid solely from personal income.

The government can force the issue by nationalizing the banks and mandating that they make uneconomic loans, backed by a federal government guaranty against loss. But even here, the government can only provide a drop in the bucket against what must invariably be a $20 or $30 trillion drop in economic activity over the next five years (this is the incremental 5% savings of disposable income necessary to get the country to at least an 8% saving rate) .

Indeed, Galbraith notes that “What did not recover, under Roosevelt, was the private banking system.” It was only after the industrial mobilization of World War Two forced an actual halt to the production of consumer goods, creating a massive reservoir of pent-up demand. This, coupled with war-bond induced family savings that rebuilt household spending power during the war, is what was unleashed once the war was over. Thus, Galbraith notes “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.

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, 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.

Galbraith points to a recent paper by economist Marshall Auerback, who has tackled the wrong-wing meme that Franklin Roosevelt’s New Deal did not end the Depression.

[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.

Only by these extraordinary government measures, Galbraith notes, was the unemployment rate brought down from a pre-revolutionary 25 percent in 1933 to a barely tolerable 10 percent in 1936. And as we know, Roosevelt and Harry Hopkins were able to put nearly four million Americans to work on an emergency basis in November-December 1933.

We did it before, and we can, and must, do it again.

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