A Review of Views on the Economic Collapse

Here are some bits from a book review by Liaquat Ahamed that discusses several books that have recently been published that analyze the financial crisis:

For those who want to relearn the forgotten lessons of the past, This Time is Different, by economics professors Carmen Reinhart and Kenneth Rogoff, is an excellent place to start. The authors attempt to give our long history of hope and disillusionment some order by identifying systematic regularities in the way the cycle of booms and busts has played itself out. These are lessons worth learning. While financial debacles may come in all sizes and shapes—Reinhart and Rogoff identify seven different generic types—they can all ultimately be reduced to too much borrowing.

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ONE OF the more fervent evangelists for this revival of the free-market creed was Alan Greenpsan. In October 2008, in the middle of the turmoil, Greenspan caused a major stir when he testified to Congress that he was “shocked” to find that his whole worldview had been wrong. Pressed to justify his promotion of unregulated financial markets, Greenspan, suddenly looking almost defeated, admitted that he had miscalculated: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”

But this oh-so-heralded epiphany from Maestro Greenspan does not tell the whole story. For the financial crisis has revealed two problems. The first, as the former Federal Reserve chief confessed, is that bankers cannot always be counted on to act in the interests of their own shareholders—the so-called principal-agent problem. Yet it is the second conundrum that is perhaps more profound and poses a still-greater challenge: even if bankers had acted in the best interest of their shareholders, there is no guarantee that would have ended up being in the best interest of everybody else. What is good for banks is not necessarily good for society. It is this disconnect that is the central theme of How Markets Fail by John Cassidy, a writer for the New Yorker.

The heart of this wonderful book is the tale of how economists have gone about addressing one of the central questions of economics: do markets work, and if so, why? Not in practice of course—after all, these are economists we are talking about—but in theory. If, let us suppose, producers and consumers were allowed to choose what they could buy and sell freely in competitive markets, would the result in any sense lead to a beneficial outcome for society as a whole?

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Two new books — Freefall, by the Nobel Prize–winning Joseph Stiglitz and The Crisis of Capitalist Democracy by the Federal judge, University of Chicago lecturer, polymath and part-time economist Richard Posner — provide accounts of the crisis and analyses of the actions the government has taken to date to save the financial system and promote recovery. Neither adds much to Cassidy’s story of how the meltdown happened. The controversies begin with how the authorities responded—no more so than with the bailouts.

Both authors are highly critical of the U.S. government for the various false starts and blind alleys it went down in 2008 and 2009. It is hard to dispute this conclusion. For much of 2008, the Fed, but more especially the Treasury, kept misdiagnosing the problem, viewing it as a liquidity crisis (in which banks faced a temporary shortage of funds that could be cured by short-term loans from central banks) rather than a solvency crisis (which could not be fixed by temporary loans and required the provision of new long-term capital). It was only very late in the game, in October 2008, that the authorities finally recognized the true nature of the calamity and accepted the need to inject public money into the banks to bolster their equity. All that can be said in defense of the key participants in the drama—Treasury Secretaries Hank Paulson and Tim Geithner, and Fed Chairman Ben Bernanke—is that they were operating in the “fog of war” and dealing with a dysfunctional political system. I suspect that even they would agree, however, that with the benefit of hindsight they would have done things differently.

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A theme that runs through both Freefall and The Crisis of Capitalist Democracy is the notion that the finance industry has become overblown, that it accounts for far too much of the GDP and that it is unproductive to devote so much of the nation’s resources to moving money around rather than making things. This carries a certain resonance after the massive injections of public money in to the banking system and the subsequent rebound in the fortunes of Wall Street. My own intuition is that the financial sector is too large, and I have never quite grasped why bankers get paid so much more than other professionals. Yet again, however, I found myself wishing that Stiglitz and Posner had used their analytic firepower to give me a more solid basis for my views rather than simply echoing and reinforcing my own prejudices.

PAST ECONOMIC cataclysms have led to dramatic changes in international financial arrangements. The Great Depression knocked the world off the gold standard. The economic turmoil of the late 1960s and early 1970s led to the collapse of Bretton Woods. Will the current crisis bring about similar changes? Berkeley professors Stephen S. Cohen and Brad DeLong argue in The End of Influence: What Happens When Other Countries Have the Money, that since the end of the Second World War, it has been the locomotive of the United States that has propelled the global economy and kept it on its tracks.

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American economic historian Charles Kindleberger used to argue that ultimately the Great Depression happened because of this failure of economic leadership on the world stage. He believed that a well-functioning global economy required one country to act as the leader, in effect to do more than its fair share of keeping the global economy moving, fully recognizing that smaller countries will freeload off of its efforts. If we are at a similar transition point in world leadership, if the United States has indeed been knocked off its pedestal in much the same way as was Britain in the early twentieth century, it does not bode well for the ability of the global economy to navigate its next storm.

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In 1930, Keynes, in an essay entitled “Economic Possibilities for Our Grandchildren,” wrote that he looked forward to the time when “economists could manage to get themselves thought of as humble, competent people, on a level with dentists.”

We are clearly still a long way away from that point, I fear, and we may never reach it. Our grasp of the way the economy functions and what to do when it breaks down is still significantly less than our still-imperfect knowledge of human anatomy. Our understanding of the economy is likely more akin to our even-murkier grasp of the human mind with its unfathomable processes, its bizarre synaptic firings.

Perhaps the best economists can achieve, therefore (in the present state of the discipline), is to be thought of as on par with psychologists. They are most useful when, like Reinhart and Rogoff or DeLong and Cohen, they contribute to our knowledge of how the world actually works. In the instances when those in the economics profession are called upon to tell us what we should do, like good clinical psychologists, they need to be modest about the cures they promise, recognizing that their advice is quite often mixed up with their own values and set of prejudices. They can be most helpful when, rather than lecturing us, they act as a sensible sounding board and give us the tools for thinking through our problems on our own.