Azure no. 35, Winter 5769 / 2009
After the Deluge
By Assaf Sagiv
A specter is haunting the financial markets of the world. A crisis of
enormous proportions, which developed slowly from mid-2007 and achieved
dizzying momentum after Lehman Brothers collapsed on September 14, 2008,
is currently becoming a global economic catastrophe the likes of which
have not been seen since the Great Depression. No one dares to accuse the
doomsayers of being hysterical and melodramatic now. On the contrary,
pessimism has become the order of the day.
As anyone who has been following the news over the past few months knows
all too well, this calamity originated in the false prosperity of the
American housing market during the years 2001-2006. As a result of low
interest rates set by the Federal Reserve and other factors, this market
underwent a dramatic expansion without any real supervision or oversight.
Lenders approved billions of dollars worth of mortgages to people with
limited financial resourcesclassified as sub-prime borrowerswho
understandably jumped at the chance to own their own homes, often for the
first time in their lives. As housing prices steadily increased, lenders
were confident that borrowers would be able to make good on their loans.
This in turn fueled a frenzy of speculation on Wall Street. Large and
small investment houses began to repackage mortgage-backed securities in a
decidedly creative way that only the sharpest mathematical minds could
understand. These securities were then bought and sold around the world by
financiers who largely ignored the huge risks involved in such
transactions.
Alas, this financial bacchanalia did not last long. In 2006, housing
prices began to drop. The beneficiaries of the sub-prime mortgage bubble
suddenly started taking considerable losses that became more and more
severe as time passed. From Wall Street to Tokyo, stocks went into a
nose-dive. Worst of all, the chaos created a worldwide credit crunch. In
short, the bubble burst, and major financial institutions once thought
invulnerable burst with it.
In order to limit the scope of the disaster, governments and central banks
around the world rushed to take emergency measures. Trillions of dollars
were earmarked to prop up shaky financial institutions, protect bank
deposits and savings, and reinvigorate paralyzed economies. However,
countries such as Iceland had already suffered a crippling blow. Indeed,
even the worlds largest and most powerful economies now appear unable to
protect themselves from severe recession.
Among informed and uninformed observers alike, the sheer dimensions of
this crisis have created an atmosphere of apocalyptic panic. Some
commentators, especially journalists with a sensationalist streak, have
not been satisfied with broadcasting gloomy forecasts of an approaching
recession, but have rushed to announcein tones either dismal or elated,
depending on their ideologythe imminent demise of capitalism itself.
Indeed, even more restrained analysts have declared that the market
economy will have to undergo dramatic changes. Everyone seems to agree
that the Anglo-American version of capitalism, so-called neo-liberalism,
has suffered a major setback after three decades of economic dominance.
Yet if the reports of capitalisms demise are likely exaggerated, rumors of
the return of the New Deal are certainly well founded. Major political and
economic leaders are pushing for extensive government spending in order to
revive sclerotic economies and provide jobs for the huge numbers of people
who are or will soon be unemployed. Barack Obama, the new president of the
United States, announced before his electionand again shortly afterwardhis
intention to initiate a series of large-scale public-works projects in a
manner reminiscent of the programs enacted by Franklin Delano Roosevelt in
order to salvage his country from the horrors of the Great Depression. The
affinity between the two leadersone of whom became a legend during his
term in office, and the other even before he entered the White Househas
already been translated into visual images by the American media. The
November 13, 2008, cover of Time magazine, for instance, displayed a
Photoshopped picture of Obama resplendent in Roosevelts iconic fedora,
pince-nez, cigarette holder, and toothy grin. In the accompanying article,
entitled The New Liberal Order, journalist Peter Beinart articulated the
expectations of many voters when he urged the president-elect to do what
FDR did [take] aggressive action to stimulate the economy, regulate the
financial industry, and shore up the American welfare state.
There is no doubt that desperate times call for desperate measures. Even
the Bush administration, which no one would accuse of secretly aspiring to
bigger government, understood this and has swiftly come to the aid of
financial institutions nearing collapse. In order to cope with the
challenges of this crisis, however, policymakers must demonstrate not only
aggressive action, but also judgment. They must be able and willing to
distinguish between what is right for times of crisis, and what is right
in general. This distinction is crucial. If political and economic leaders
choose to ignore it, they may inadvertently transform a temporary
emergency into a permanent economic malaise.
Today, the term state of emergency is usually linked to the war on terror.
Since 9/11, several Western countries, led by the United States and
Britain, have enacted a series of exceptional measures to protect
themselves from the threat posed by radical Islamic terrorism. In some
cases, these policies entailed the suspension of basic constitutional
rights in accordance with urgent security needs. The United States, for
example, has imprisoned hundreds of suspected terrorists in the Guant?namo
Bay Detention Camp in Cuba, as well as in secret CIA facilities around the
world, where they have not been granted due process according to American
law. This state of affairs has been publicly opposed by liberal-minded
members of the legal community and by human rights activists. One reason
for this reaction is the fear that the exception will become the rule. An
ongoing, indefinite state of emergency, the critics warn, will lead to the
demise of enlightened legal standards, and thus the destruction of Western
democracy. (A discussion of various aspects of this issue can be found in
my essay, The State of Freedom and the State of Emergency, Azure 28,
Spring 2007; and in Benjamin Kersteins review Batmans War on Terror, Azure
34, Autumn 2008.)
The current financial crisis has forced many countries to transpose the
state-of-emergency paradigm onto the economic sphere. There are, of
course, substantial differences between the two situations: Granting huge
loans to banks and nationalizing insurance companies are not the same as
detention without trial or invasion of privacy. Moreover, an economic
crisis does not stem from the subversive actions of hostile forces, and
does not require the state to expose and neutralize a known or unknown
enemy. Most importantly, the emergency economic measures that have been
implemented thus far do not entail limitations on freedom or basic rights.
However, there is a common denominator between the interventionist
policies that the United States and various European governments are now
promoting and the steps they have taken as part of the war on terror: In
both cases, the state and the institutions acting on its behalf have
expanded the reach of their authority beyond its normal limits, and they
have done so in order to secure public order and prevent social chaos. As
a result, market forces and institutions that were once relatively
autonomous have come under government control. The economic sea, in which
a wide variety of fish once swam, belongs once again to Leviathan.
Opponents of neo-liberalism are making the most of this opportunity to
sneer at adherents of laissez-faire economics. You see? they are saying.
The market isnt so nice anymore. Now everyone is rushing into the arms of
government. For the most part, however, theirs is a straw-man argument.
Even the most outspoken advocates of the invisible hand have been aware of
its potential cruelty. One of them was the renowned economist Milton
Friedman, who led the charge against government intervention in the
economy during the 1970s and 1980s. Despite his staunch free market
stance, he was of the opinion that certain policies of the New Deal were
indeed the right thing to do at the height of the Great Depression. In an
interview with PBS, the American public broadcasting network, in 2000, he
explained his position, saying that it was a very exceptional
circumstance. Wed gotten into an extraordinarily difficult situation,
unprecedented in the nations history. You had millions of people out of
work. Something had to be done; it was intolerable. And it was a case in
which, unlike most cases, the short run deserved to dominate.
There are, of course, those who think otherwise. Some historians deny that
the New Deal was effective even as a temporary solution to a national
emergency. In her recent study, The Forgotten Man: A New History of the
Great Depression, which provoked fierce controversy when it was published
in 2007, the journalist Amity Shlaes presents a serious indictment of
Roosevelts economic policy. Shlaes attempts to debunk the widespread myth
that the New Deal saved America from the quagmire into which it began to
sink in 1929. In reality, she claims, the opposite is true. From 1929 to
1940, she writes, from Hoover to Roosevelt, governmental intervention
helped make the Depression Great. Shlaes maintains that swelling public
expenses, incessant economic experimentation, a higher tax burden placed
on the wealthy and the middle class, and a systematic abuse of the private
sector all contributed to prolonging the Depression until World War II. In
1938, she writes, the unemployment rate in the United States was still
frighteningly high: One out of every six Americans was jobless, and many
others had no job security whatsoever. Ironically, this economic failure
only increased Roosevelts political power. He had the backing of major
interest groups as well as broad support from the masses, who believed the
New Dealers populist rhetoric that blamed big business for the gloomy
situation.
Shlaess book is convincing enough to give the new-New Deal enthusiasts
pause. At least it should. Experience demonstrates that, in the long run,
a massive expansion of the public sector does not help the economy. It
creates an inflated and ineffective bureaucracy, increases the deficit,
squeezes taxpayers, and suffocates free enterprise. Given our current
circumstances, however, it is hard to justify a sweeping objection to
emergency measures. Abandoning the global economy to the invisible hand is
simply unacceptable. In a crisis like this, swift and decisive government
intervention is inevitable. It prevents, or at least restrains, the kind
of mass panic that could lead to further deterioration, and gives the
economytrapped in a worsening credit crunchroom to breathe. It is also,
unfortunately, hugely expensive. But at the moment, such actions are all
that stand between billions of people and a life of poverty and despair.
No government can avoid intervening in such a situation with all the power
at its disposal. We can only hope that it will also know when the time has
come to withdraw.
In the long run, John Maynard Keynes once said, we are all dead. This may
be true, but that is no excuse for shortsighted thinking. Indeed, it is
precisely because todays politicians and economists are being forced to
consider extreme measures that they must also contemplate what will happen
after the crisis is over. They must remember that a policy suitable for
times of crisis may notand perhaps should notbe suitable in times of
normalcy. After all, a drug that cures a critically ill patient may be
poisonous to a healthy person.
So what will the global economy look like when the storm has passed? It is
clear that the American financial sector, and probably those in other
countries as well, will be placed under stricter public supervision.
Investment banks, insurance companies, and credit-rating agencies, all of
which bear the lions share of the blame for this catastrophe, will be much
more heavily regulated by the government. In all likelihood, the most
important lesson these regulators will take from the experience of the
past two years is the need to change incentive structures. In an article
published in Harpers in November, Nobel Prize for Economics laureate
Joseph Stiglitz warned that:
Too many bankers and other lenders have been focused on trying to beat
the system by getting around accounting and banking regulations (through
what is called accounting and regulatory arbitrage). Indeed, with bonuses
based on short-term profits, they had every incentive to gamble and
connive. And now that theres a bust, no one is being asked to pay back the
hefty bonuses earned during the boom. On the contrary, even as they are
dismissed, those who helped send their firms and the American economy into
a tailspin are rewarded with generous severance packages. They are
enriched regardless of what happens to investors, homeowners, and others
who lost so much. Unless we reform incentives, the financial sector will
only try to circumvent whatever new regulations are put in place. We
simply have a short respite before the next crisis.
It seems, therefore, that there is no way of avoiding a certain degree of
regulation in the short run, and perhaps even in the long run as well. Yet
it is best to minimize this regulation and not set our hopes too high.
After all, bad regulation is no less responsible for the current downturn
than lack of regulation. Indeed, decisions made by senior government
bureaucrats turned out to be just as ruinous as the shenanigans of
financial moguls. The United States Securities and Exchange Commissions
2004 decision to allow investment houses to use their reserves as
investment capital proved disastrous. Likewise, the fact that Freddie Mac
and Fannie Mae are sponsored by the American government did not prevent
them from acting in an extremely reckless manner, accumulating such
enormous losses that they had to be nationalized in September 2008.
In the final analysis, this crisis, however severe and unprecedented, does
not change one basic truth: The state is not the most qualified or
rational actor in the economy. Its conduct tends to be inefficient and
often simply unintelligent. In most cases, it is best to permit the
mechanisms of the free market to operate without hindrance. Their ability
to repair themselves is vastly more efficient than bureaucratic attempts
at central planning. Accordingly, governments that currently control
larger and larger segments of the financial market would be wise to
transfer some of this power back to private hands as soon as possible. The
most troubling question that remains, however, is when that soon as
possible will be, and what we must do until then in order to weather the
storm.
Assaf Sagiv
December, 2008
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