The Economic Crisis and a Sustainable New Deal

By Mary C. King, Professor, Economics Dept., Portland State University, a talk to the Portland City Club, March 13, 2009.

Good Afternoon! Thank you for the opportunity to speak with you today, on the topic of a Sustainable new Deal.

It’s an honor and a pleasure. I appreciate it, and especially the work that Jeanne Crouch and Joe Sixta are doing to organize this series of programs on the econ situation.

I want to take the chance to talk with you about a few things today

• the genesis of the economic and financial crisis, because we need to know how to avoid repeating this history and to keep our heads while political pundits are so busy spinning and revising history to keep their agendas intact;
• the argument for a big fiscal stimulus by the Federal Government, and why it should be as tilted as much toward spending and away from tax cuts as possible; and
• the case for making this stimulus a Sustainable New Deal, in order both to put people back to work in a hurry and to make the most of our money in the process

by investing in human capacities and transformative green infrastructure, but also to take this moment to reconsider the growth imperative in our current economic model.

It’s not just enormous returns on finance that are unsustainable, but also a business model that seeks growth and expansion above all else.

First, to set the stage, we need to be clear that the current economic crisis was set off by the lack of effective regulatory oversight of financial markets, which allowed a bubble to become huge and, in popping, drag us all down.

In publicity for this talk today, the causal factor for the economic crisis was described as a “collapse in the housing market,” but that isn’t the case. Certainly we had a bubble in the housing market, as we had a bubble before it in the stocks of high-tech firms. The bubble was the problem, rather than anything to do with the particulars of the housing market.

Bubbles are a phenomenon unique to markets, the impact of which is exacerbated by debt. Bubbles are created by people who–seeing that the price of some asset in particular is rising–come to believe that it is impossible for the price to do anything but rise.

If the price of something can be counted on to rise, it makes sense to go into debt to buy in, as you’ll be able to pay off your loan and still come out well ahead. That something might be houses in recent years, or dot.com stocks in the 90s, or commercial real estate in the 80s or–to go way back–tulip bulbs in the 17th century Netherlands.

On the history and nature of financial bubbles, I commend to you an excellent book—short, well-written and funny—by John Kenneth Galbraith called A Short History of Financial Euphoria. Galbraith published this book in 1990, building on a long essay he’d written after the 1980s savings and loan fiasco and stock market meltdown. Well, we called it a meltdown then…

I promise you that you will feel that he wrote this book yesterday

Galbraith makes several critical points:

The first is that bubbles almost always involve new debt instruments, which people think are great innovations. He says “the world of finance hails the invention of the wheel, over and over again, often in a slightly more unstable version…”

The second is that debt is allowed to grow dangerously out of scale to the underlying means of payment, i.e. that financiers are perilously over-leveraged, which I’ll explain in a minute.

The third is that a great deal of money is made on the way up, so that people allow themselves to believe that those making the money are smarter than anybody else, and especially smarter than those attempting to call a halt.

These three things are exactly what has just happened on Wall Street.

One, the most egregious new instruments were derivatives, based on packaging sub-prime mortgages, and the “credit default swaps” sold by AIG.

These “credit default swaps” sounded like insurance, should have been regulated like insurance, but since they had a new name, AIG got away with diverting the revenue from their sale into “profits” rather than putting away a solid capital cushion to cover the risk, behavior that is required of insurers.

Not coincidentally, AIG is bankrupt.

Two, the investment houses were dangerously over-leveraged. Whereas after the Great Depression, commercial banks were regulated, so that they had to limit their loans to approximately ten times their assets–that’s leverage at 10 to 1—the investment houses recently got out to 30, 40 , some people even say 60 times what they had in assets.

The issue with over-leveraging is that you can’t withstand a drop in prices, even one that you should expect to be well within the range of “business as usual.”

Leveraging is buying something with very little of your own money, and a lot of debt. Leverage at 30 to 1 is like buying a house for $103,000, with $3k of your own money and a $100,000 mortgage.

If the price of the house rises to $106,000, you can pay off your mortgage and have $6,000. You’ve doubled your original $3,000 and you and everyone else think you’re a genius.

But if the price falls nearly 3% to $100,000, you’re wiped out.

And if the price falls to $97,000 – less than a 6% drop, and something you should be prepared for–it’s a disaster. You’ve lost twice what you had in, and you have to sell that house AND something else to pay off your loan.

If you’re AND all your best friends are doing that at the same time–all selling houses–the prices of houses will fall and everyone will be in even worse shape.

That’s exactly what the big investment firms did.

Over-leveraging was part of what brought us down in Great Depression, so afterward commercial banks were regulated in a way that only allowed them to loan about 10 times what they have in deposits.

But the investment houses were more lightly regulated, because they represented a kind of banking that hadn’t existed when the post-Depression regulation was put into place.

Also the executives of the investment houses persuaded the SEC to water down the regulation that did exist. Merrill Lynch, Goldman Sachs (led at time Henry Paulson), Lehman Brothers, Bear Sterns and Morgan Stanley pushed for exemption to regulation and got it. In 2004 they persuaded the SEC that they had plenty of capital and could safely be leveraged to far higher ratios.

But they were wrong and all 5 are gone now, bankrupt, sold or transformed into “commercial banks” that are more regulated.

Which brings us to Galbraith’s third point, that people making money in dangerous ways are regarded as smarter than everyone else, and those who would call a halt are described as lacking understanding of finance, as envious of wealth, and as lacking faith in the wisdom of markets, which “will regulate themselves.”

We saw this, not only in the example of the SEC I just mentioned, but also spectacularly when Alan Greenspan and Larry Summers went to Congress in 2000 to keep the new derivatives markets from being more regulated. As was widely reported, with Rubin, they made the cover of Time Magazine as having “saved the world!”

Thanks!!! We sure are better off!

Larry Summers was reported to have browbeaten Brooksley Born, who was chair of the Commodity Futures Trading Commission during the late 1990s. Brooksley Born was arguing that an unregulated derivatives market posed serious systemic risk. She was taking steps to establish a framework for oversight.

Ah Brooksley, I guess she just didn’t understand finance!

Many, like Alan Greenspan, were persuaded the market forces and self interest would keep financiers from taking excessive risks, more on ideological grounds than on evidence.

But de-regulators were not the only voices. Along with people like Brooksley Born were other economists, like Nobel Prize winner George Akerlof, who in the aftermath of the financial crises in the 1980s published a paper he titled “Looters,” showing that private investors who knew they’ll be bailed out by the government, took excessive risks.

When their risky bets pay off, they keep the profits. When the risky bets lose, their institutions are perceived as too large to fail, and the taxpayers would absorb the losses.

We have to re-think “too big to fail.” If you’re too big to fail, you’re far too big not to be closely regulated and–quite possibly–too big to be private. The public sector banks in Germany and Brazil are not experiencing the challenges felt throughout private sector banking.

There is also a question of fraud, not only on the part of people like Bernie Madoff, but in the sub-prime mortgage market.

I remember re-financing my house in 2003, along with the rest of the world, when interest rates hit an historic low. My credit union – a local organization I expected to have high standards for consumer protection–was pushing Adjustable Rate Mortgages with big balloon payments at the end.

Now, I understand people who feel that they did the responsible thing, like we did, getting a 20 or 30 year fixed rate mortgage when rates were low.

But I also have sympathy for people who were aggressively sold products they may not have understood and couldn’t afford if the price of their house didn’t appreciate dramatically in value. Bankers used to make sure you could afford a loan, because they lost money if you defaulted. If the looting dynamic holds sway, only the homeowners and taxpayers lose money

So, while many are saying that “we’re in uncharted territory,” and “no-one saw this coming,” that’s not the case. Those who saw it coming were argued down, and the regulation — put in place after the Great Depression – that would have helped prevent the financial crisis was not extended to cover new financial instruments and institutions and was gradually dismantled.

The regulation was watered down in the face on a long-term lobbying campaign by the financial industries and their allies like Alan Greenspan, who has now realized that his faith in the ability of markets to self-regulate was misplaced.

Now we find ourselves in an economic crisis, touched off by the financial crisis, showing up as climbing unemployment rates and falling GDP, not just here in the U.S., but in much of the world.

There’s a remarkable consensus among economists that we urgently need a massive fiscal stimulus – meaning an increase in government spending and/or tax cuts–despite the deficit, has grown enormous over the last 8 years of tax cuts and war spending.

We need to put purchasing power in the hands of consumers, to counter the layoffs in the private sector and to avoid cuts in spending in the public sector as taxable incomes fall, in order to stop and reverse the downward spiral.

Fiscal policy is required, because we are in the classic situation described by Keynes in the 1930s, when businesses can’t be expected to invest, hire and produce if they don’t see markets for their goods in the near future.

Monetary policy is no longer effective, because interest rates are as low as they can go.

People are fearful of deflation, which we last saw in this country in the Great Depression. It sounds terrific to have prices falling, but it means that by the time businesses are ready to sell something, they can no longer get a price that will enable them to recover the cost of the inputs they had to purchase to make something.

Around the world, people are calling for a fiscal stimulus, and the primary argument is over whether or not what the Obama administration has proposed, what the EU and Japan are doing, is enough.

Christina Romer, the current Chair of the President’s Council of Economic Advisors, is quite optimistic about the adequacy of the stimulus. Like Bernanke at the Fed, she is a scholar of the Great Depression, when New Deal spending was a desperation measure going against the grain of what people thought they knew. As a result, as soon as it started to work, it was pulled back and we fell back into Depression, only really pulled out by high spending for World War II.

Romer says that the lesson of the Depression has been learned, and we will spend now to counter the decline, and continue the spending for the next few years.

Others feel that the stimulus bill is too little, that 3% of GDP–say $900 billion over 2 years–is a minimum, and that the more the stimulus is structured in tax cuts, the more will have to be spent to get the economy moving again.

This has been the other big argument of the past few months, whether the fiscal stimulus should consist entirely of new government spending, or whether it should include – or even be focused on — tax cuts.

This argument is far more political than economic. Spending and tax cuts hit the government budget in the same way, so have the same impact on the deficit, but have different impacts on the economy.

I attended the annual convention of U.S. economists early this January, where the consensus was that the evidence showed that tax cuts of recent history have not provided much in the way of a stimulus.

This is seen in what economists call the multipliers associated with different kinds of spending or tax cuts. The multiplier is the ripple effect of new spending, which theoretically could come from new government investment or a tax cut.

A multiplier is the “bang for the buck” you get for stimulus efforts.

Multipliers will be low or even zero in a time of full employment, because in that case spending can only be shifted, but we can’t really generate more production with given resources. Multiplier effects are larger when people and resources are unemployed, as is the case at the moment.

Multipliers are higher for government spending than for tax cuts, because if the government invests in something like building a subway system, all of the money lost to the federal budget is spent, and then more spending is generated.

People hired to build the subway save some of their new income but buy more shoes than they would have without it; shoe sellers save some of their new income but buy more childcare than they would have without it; child care workers save some of their new income but buy more groceries than they would have without it; and the whole thing adds up to more economic activity than just the initial subway expenditure.

It’s the subway expenditure multiplied by some multiplier that can be measured.

Multipliers on tax cuts are less, because in the very first round of spending, some of the money gets saved, rather than spent. This is less true if the tax cut is geared to people with relatively low incomes, who will spend more and save less than higher income people, though these days they may use the tax cut primarily to pay off debt.

Since there’s never a round of spending where all of the money that is given up by the government gets spent, rather than saved, the multiplier on tax cuts is lower than on government spending.

So, you can figure this out with logic, but the most persuasive way to figure out the multipliers is to measure them.

Of course, so many things are going on at once that it’s hard to isolate the effects of the multiplier, but economists have managed to estimate multipliers on different kinds of spending. You can see these estimates on the web page of the Congressional Budget Office, or in the testimony to Congress of people like Mark Zandi, chief economist at Moody’s and an ex-advisor to John McCain.

According to Zandi, the highest multipliers come from increasing spending on things like food stamps, extending unemployment insurance and investing in infrastructure—because this money all gets spent. He estimates these multipliers from between 1.59 for infrastructure spending to 1.64 for unemployment insurance extension to 1.73 for a temporary increase in foodstamps.

By comparison, the lowest multipliers he estimates are for making the Bush income tax cuts permanent, making capital gains and dividends tax cuts permanent and cuts in the corporate tax rate, all of which he puts at about 0.3 with accelerated depreciation the lowest of all at 0.27.

So the first way that people assess how we should structure a stimulus effort is to compare multipliers, to see the degree to which different fiscal strategies are likely to create more economic activity.

Another important metric for assessing the potential impact of different forms of government spending which could comprise a fiscal stimulus is the number of jobs likely to be created by spending focused on different sectors. That depends upon how labor-intensive vs. capital-intensive different industries are.

The biggest bang for the buck in terms of jobs comes from investments in education, health care and social services. Of course, these are also investments in future productivity, a point that we often forget and which I want to come back to.

Investments in infrastructure also create a lot of jobs, which are not only relatively well paid, but are concentrated in areas like construction that are always hardest hit in an economic downturn, and are also investments in future productivity.

The fewest jobs get created by spending on military hardware, because these are such capital-intensive industries and any impact on future productivity is indirect.

Now, we billed this talk as focused on a Sustainable New Deal! Certainly we need another New Deal, as in the 1930s. We need a substantial fiscal stimulus to counteract unemployment and real hardship.

Government spending on almost anything labor-intensive will get us both a decent multiplier and a lot of jobs. Keynes famously said that we could hire people to dig holes in the ground and then fill them up. But that’s obviously wasteful, and we should think about the best use of our money.

Janet Yellen, head of the San Francisco Federal Reserve said, at the gathering of the economists this January, that we should spend where it will create the greatest social value.

We have been seduced in recent decades in the US by the idea that the market is the best mechanism for figuring out the best use of resources.

Markets have their strengths. Market economies are vital, and reward innovation.

But simplistic reliance on markets only has led us to this moment. Markets are prone to speculative bubbles. Markets are volatile. Markets concentrate wealth. Market processes exacerbate inequality. Markets create pressures to take excessive risks and push costs on to others. Markets direct resources only to those who can pay for them.

For these reasons, development economists, thinking about how to improve conditions in the developing world, have shifted their thinking about how to measure economic progress, away from a simple yardstick of GDP or GDP per capita. They realized that simple GDP growth did not necessarily deliver a better life for the majority of the world’s poorest people.

The United Nations Development Program now focuses on what they call “human development” as both the means AND end of economic progress. Human development is understood as the development of the capacities of each person in all important arenas.

We need to do the same. We need to take charge of our economy again, rather than relying solely on market forces that steer our resources based on nothing more than short-term financial return.

High returns on financial investments based on bubbles are not sustainable. Living on finance while outsourcing our manufacturing is not sustainable. Relying on an economic model based on growth, expansion and intensive resource use is not sustainable. Focusing only on financial gain, rather than human development is not sustainable.

As we think about structuring this stimulus, we need to recognize that in the midst of crisis we have a tremendous opportunity to re-build our economy along more sustainable lines. As Janet Yellen says, we should prioritize spending on what creates the greatest value – real value, not financial returns.

We should be thinking about human needs, and fighting the most serious poverty, which is found among the homeless and single mother families—half of whom with kids under the age of 5 were poor last year.

We should be thinking about investment in our future productivity, which means education, health care and infrastructure.

Often we forget about the contribution of public sector investment in these areas when we think about economic growth, but economists who study long run growth have attributed the vast preponderance of economic growth in the 20th century to education.

Investment in early childhood education–Head Start, universal pre-school, all day kindergarten–pays the highest returns of all in the long run.

Our best chance to have everyone educated, working for a decent wage and paying taxes and keeping down expenses on jails, substance abuse and poverty programs is to make investments that reduce child poverty and minimize social marginalization. Those investments are most effective early.

And we should be thinking about taking this unusual opportunity to invest in green energy, green infrastructure and conservation.

We now know we have to take climate change seriously. It’s obvious that we don’t have the resources to end global poverty and raise living standards worldwide with the kind of resource use that underpinned advances in the US and other affluent countries.

It’s quite clear politically that we have to shift away from dependence on oil, in order to shift toward a foreign policy driven by other forces.

This is a moment, when people are unemployed and public spending on a grand scale is called for us to move decisively toward a more sustainable economy.

The Center for American Progress, in conjunction with the University of Massachusetts at Amherst, has outlined a green recovery program that stresses investment in 6 areas to create 2 million jobs with $100 billion over two years. The six areas they focus on are:

• retrofitting buildings to improve energy efficiency,
• expanding mass transit and freight rail,
• constructing “smart” electrical grid transmission systems,
• wind power,
• solar power, and
• next generation biofuels.

The Institute for America’s Future, in DC, is calling for investment in these areas, supplemented by infrastructure modernization and repair, aid to states, investment in public education, research and development, health care, aid to those in need, and tax credits for people providing family, elder and sick care.

If we’re going to be sustainable, we need to direct our investments in ways that make us more environmentally, economically and socially sustainable.

That means

• stimulus spending on green investments.
• re-regulation of the financial industry and potentially creation of a public segment of the financial sector,
• investment in infrastructure, both physical and human, and
• investment to build human capacities and meet human needs.

Thank you!