We’re in a global economic mess of the first order, and nobody seems to know what to do about it.
Reluctantly I have come to that conclusion after a spasm of reading about the Eurozone crisis, how the aftermath of financial recessions (as opposed to Econ 101 recessions) is so very toxic for so long, and how broken efforts at real financial sector regulatory reform are.
I don’t need to rehearse for you all that’s so obviously gone wrong in the Eurozone in the past, say, three years (lots of things were going wrong before that–but people honestly didn’t notice or pretended not to). And with one crisis du jour superseding another, one would have to be a Twitter junkie to stay on top of every twist and turn (and in case you had any doubt, I’m anything but a Twitter junkie). Suffice to say politicians have persistently been a day late and a dollar short in all their plans to take care of matters, with the result that what would have been an adequate and effective solution, say, a year ago would today fall hopelessly short of constituting a cure–and the taste for taking drastic measures lags the severity of reality by a consistent 3-9 months.
This is really all I know about the Eurozone: It’s in a profound disequilibrium. It simply cannot go on as currently constituted, and it needs to either become a lot more integrated from fiscal and policy perspectives, or begin to shed its east productive and most challenged peripheral states. I don’t have a clue which way the path ahead lies, but straight ahead is not an option.
Now, as for the aftermath of financial-crisis-driven recessions being so much more dire than the aftermath of garden-variety recessions, I can do no better than to point you to a current interview with Ken Rogoff in the McKinsey Quarterly. You recall that Rogoff and his co-author Carmen Reinhart published the epic This Time is Different: Eight Centuries of Financial Follyin September 2009, canvassing 800 years of empirical data from financial crises. (I read it; you don’t have to.)
Rogoff, by the way, has superb credentials for doing this sort of thing: A 1975 econ BA from Y ale, 1980 PhD from MIT, and professor at Berkeley, Princeton, and now Harvard. Did I mention he’s also a life international grandmaster in chess?
Let’s set the scene:
The historical experience gives a very clear view that the aftermath of a financial crisis brings slow and halting growth, sustained high unemployment, and surging public debt–with the overhang of public and private debt being the most important impediment to a normal recovery from recession.
It has been utterly remarkable how the United States has been tracking the averages of postwar deep financial crises across a broad range of indicators. On average, it takes four and a half years to get back to the same per capita GDP where you started out and about the same amount of time for unemployment to stop rising.
Indeed, we haven’t yet gotten back to the same per capita GDP where we started. Our perspective is that we have never left the recession; we’re still very much in it.
And asked what it would take to get us out of this, he offers no silver bullets (emphasis mine):
It’s not easy, because a postfinancial-crisis recession is characterized by an overhang of private and public debt that is much more severe than it is after a normal recession. There are many mortgages still under water–perhaps 25 percent–and people are more cautious about extending their borrowing than they were before 2007. That leads to slower consumption growth. Businesses in turn invest more slowly.
In 2008, policy makers placed too much confidence in the Keynesian idea that you can jump-start the economy with a big temporary stimulus and then step back and watch the private sector take over. Of course, Reinhart and I argued otherwise, based on the results of a seven-year research project, and our results certainly were acknowledged by practitioners, academics, and policy makers. Nevertheless, most policy makers and markets still insisted, “Well, yes, maybe that is how things always were in the past, but this time it’s different because the policy response was so aggressive.” In fact, the policy response is always very aggressive. Every country does everything it can to claw its way back from a deep financial crisis.
So, unfortunately, there is no easy out. Perhaps the best chance would be to find a way to get ahead of the mortgage defaults–that is, to have restructurings and debt forgiveness, albeit with some kind of quid pro quo. That is very hard to do. But if there were a way to write down and forgive some of the mortgage debt, that would be money well spent. In ten years, we will probably end up forgiving a big chunk of it. As Carmen has noted, this is a little like Third World debt that was carried on the books forever, even though it was a joke.
But then he jumps in with an idea I’ve not heard expressed so powerfully anywhere else: We need to severly limit the market share of nonindexed debt:
Most financial crises have at their root very, very high leverage. To hit the nail on the head, I think we have to do something about the prevalence of nonindexed debt instruments. I would start with changing our corporate-tax law and any overt incentives that favor debt. Obviously, the US home mortgage tax deduction makes no sense, given the risk that debt entails. I understand the political imperative, but let’s not subsidize debt in an overt way. I think public-finance experts need to methodically go through the system and strip debt subsidies out.
Refreshingly, he also has a contrarian view of Too Big to Fail:
I believe that size is overrated as the issue. There is this view that if we can just break up the big banks into smaller ones, we won’t have a problem. But if you look at systemic crises, usually a lot of banks are doing the same thing. So if we take one big bank and break it up into ten smaller banks that act similarly, I’m not sure how much we really would have bought ourselves. The incentives that would make a big bank go whole hog in one direction would probably make ten smaller banks do the same thing.
Now, what are the odds of any of these serious structural reforms atually happening?
Paul Volcker seems to think: Between slim and nil.
Financial Reform: Unfinished Business is his lengthy but penetrating piece. He lays much of the blame in the growth of the shadow banking system–nondepository banks, hedge funds, insurers, money market funds, and so on–and their enormous growth from 2000 to 2008, at which point it was roughly the same size as the conventional banking system. He’s skeptical that imposing heightened capital standards on shadow players, as well as traditional players, will get us too much, but he believes it’s a start.
He also suggests these changes:
- greater integration and harmonization of financial regulatory standards around the world;
- agreement on international accounting standards;
- truly independent auditors, perhap enforced by mandatory periodic rotation; and
- an end to the oligpoly of rating agencies.
Volcker, pace Rogoff, does think Too Big to Fail is a problem–indeed, it is The Key Issue.
He would address it in three parts:
- First and simplest, the risk of the TBTF’s failing has to be cut, by one or a combination of three ways: Making them smaller, curtailing their interconnectedness, or fencing in their permitted activities.
- Second, an orderly way to wind down and dissolve firms that nevertheless do fail has to be laid out.
- And last, these arrangements need to be harmonized and synchronized across borders.
He also thinks (the famous “Volcker Rule”) that banks’ trading for their own accounts needs to be limited, particularly since it has grown to so grossly exceed what is needed for simple market liquidity. He quotes an un-named “astute observer” as calling it “trying to extract pennies from a roller coaster.”
Ultimately, he favors a return to what I’ll call “Glass Steagall Lite,” although he does not invoke the old law by name: The separation of retail from investment banking activities. This would presumably be in the form of firewalls and other prohibitions on transactions between a bank’s affiliates. He immediately notes, drily, that ” , the philosophy of US regulators has been to satisfy themselves that a financial holding company and its nonbank affiliates should be a “source of strength” to the commercial bank…has not been highly effective in practice.”
But he concludes by making it clear he believes we are by no means done:
One thing is sure: we have passed beyond the stage in which we can expect the officials of central banks, regulatory authorities, and treasuries to rely on ad hoc responses in dealing with what have become increasingly frequent, complex, and dangerous financial breakdowns. Structural change is necessary. As it stands, the reform effort is incomplete. It needs fresh impetus. I challenge governments and central banks to take up the unfinished agenda.
Still, I recur to conviction that nobody knows what we really need to do: Contradicting Richard Nixon’s famous confession that “we’re all Keynesians now,” I think nobody is a Keynesian now–at least not with any degree of conviction. Nor is anyone a Friedmanite or a Hayekian. Still, we need thinkers on that scale and we don’t have them. We have lost the grand thinkers in what might be called “comparative macroeconoimcs”–what really works, and why, for which societies with what historic path determinants?
Many economists say that what matters are questions like whether markets are competitive or monopolistic, or how monetary policy works. Using broad, ill-defined notions like capitalism invites ideological grandstanding and distracts from the hard technical problems.
There is a lot in that argument. Economists do much better when they tackle small, well-defined problems. As John Maynard Keynes put it, economists should become more like dentists: modest people who look at a small part of the body but remove a lot of pain.
However, there are also downsides to approaching economics as a dentist would: above all, the loss of any vision about what the economic system should look like.
This is from Roger Backhouse and Bradley Bateman’s piece in The New York Times, “Wanted: Worldly Philosophers.”
The “dentist’s” approach to economics overlooks everything that matters. One does cut, after all, “government spending,” one cuts Medicare or defense spending or unemployment compensation or the EPA. One does not raise “taxes,” one raises taxes on the rich or on the poor or on the mythical middle class, and one does it through payroll withholding or the income tax itself, or a VAT or excise taxes or taxes on sugary soda or whatever the politically correct target of the day is.
We need to be having these kinds of conversations, and we’re not.
And why not?
Because, I suspect, dentists lead safe and conventional lives. We are choosing comfort over hard analysis, punting over going for it on 4th and long, postponing the day of reckoning until (hopefully!) we’re out of office or out of the executive suite or off the Managing Committee. You can’t play this game forever.
And if you’re wondering what all this has to do with the economics of law firms, it’s syllogistic: Our clients cannot, in aggregate, evade the consequences of a sputtering economy. Which means we can’t either.
