Policy Responses to the Depression--February 2-May 1, 2009--Part III

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So how should the recovery efforts undertaken since February 2, which I discussed in my last two blog entries, be rated? On the whole, I consider them positive. The "easy money," bank bailouts, auto bailouts, and stimulus measures, costly as they are, are justified by the nontrivial risk that in their absence the economy would plunge almost as far as it did in the 1930s depression. Not that that risk can be quantified; but it seemed to the responsible officials in the two presidential administrations that straddle the crisis, and eventually even to the academic economists who had thought there could never be another depression, to be substantial, and if it materialized the economic and political consequences would have been terrible.

But there have been plenty of stumbles since February 2, due in part to political pressures that perhaps should have been resisted, to the new administration's inexperience, but above all to the novelty and uncertainty of the economic challenge. It is increasingly clear that despite the lengthy transition period, the Obama administration took office with no detailed plans for dealing with the crisis. That is a failure of preparation that I find difficult to understand. The effects of that unpreparedness, mirroring the unpreparedness of the previous administration to respond to the near collapse of the banking industry in September of last year, were bound to be bad. The tendency in a depression is for businesses and consumers alike to curtail spending on investment and consumption and instead hoard cash so as to be better prepared to meet emergency needs. Anything that further increases the uncertainty of the economic environment further retards investment and consumption, deepening the economic downturn and retarding recovery. A sense that the government itself is uncertain about what to do in an economic crisis and is therefore improvising its responses only increases the economic uncertainty that besets businessmen and consumers.

Besides being unprepared with a recovery plan, the administration has failed to resist the blind populist rage against "Wall Street" and by this failure further increased the uncertainty of the economic environment for business. The President's joining in the attack (though briefly) on the payment of bonuses to employees of AIG (American Insurance Group), and his leading the attack on the resistance of Chysler's secured creditors (whom he referred to unhelpfully as "speculators," when the government is desperate to encourage lending, including by lenders who will not lend without collateral that gives them a favored position should the borrower go broke), not only throws a monkey wrench into business planning but also reveals either rather base political calculation or a misunderstanding of the relevant economics (or both).

The bonuses were authorized by AIG's dollar-a-year CEO for traders and middle management, not for senior management. De facto control of the board of directors by the senior management of corporations does conduce to excessive compensation--for senior management. AIG's unpaid CEO and the other senior managers of the company have no incentive to overpay subordinate employees. The finance industry is thoroughly international and the best financiers have opportunities to work for enterprises here and abroad whose compensation is not regulated by government. Bailed-out firms are losing key employees because of the increasingly tight strings that the government is attaching to its financial aid to banks. The loss of key employees will reduce bank efficiency and solvency, and thus the value of the government's growing investment in banks, and increase the reluctance of banks and other financial intermediaries to accept or retain federal money that the government thinks it important to recovery from the depression that they do retain.

Stiffing secured creditors will increase the interest rates that firms have to pay to obtain credit, and increasing interest rates is exactly what one does not want to happen in a depression. A similar misunderstanding of depression economics is reflected in the push by the President and Congress to regulate credit-card credit more tightly. Even if increased regulation of the credit-card industry would be a good idea if we were not in a depression, it is a bad idea in a depression because anything that limits the rights of creditors will result in creditors' raising the price of credit, i.e., interest rates, thereby reducing economic activity. Similarly, the President has been talking up frugality at the wrong time, because in a depression we want people to spend, not hoard, money. Hoarding cash does not help production or employment.

The government has conveyed to business and the public the message, which misunderstands the causes of the economic crisis, that "Wall Street" should be blamed (or China too, as Geithner once suggested) and must be punished. This hostility and air of menace make financial firms reluctant to get into or stay in bed with the government, and thus impede the bailout efforts. It may defeat the Geithner plan discussed in my last entry and any other "public-private" partnership to fight the depression. In fact the major culprits in our present economic distress are government officials, such as Alan Greenspan, and academic economists, but they are getting off lightly, because they are obscure and there is more political mileage in denouncing "Wall Street." How many Americans actually know who Alan Greenspan is, or what a macroeconomist is?

It doesn't help that on the cynical ground that a crisis should not be wasted--in other words that the depression should be treated as a pretext for the launch of expensive social programs that might not be enactable in calmer times--as if Frank Roosevelt had announced the day after the Pearl Harbor attack that he would use the occasion of a world war to complete the enactment of his New Deal program--the administration is piling trillions of dollars of proposals of long-term social reform on top of the trillions of dollars of emergency spending committed to fighting the depression and the trillions of dollars of "normal" federal budget deficits that have been enhanced by the decline of federal tax revenues because of the depression. Apart from creating enormous economic risks, the ambitious long-run proposals are ill timed; by further unsettling the business environment, they will further slow the economic recovery.

That said, the President's bow to populist anger against "Wall Street" can be defended as intended to defuse rather than exacerbate the social tensions that an acute economic crisis can create. More important, the President has radiated competence, command, and calm, and the psychological effects on workers and consumers, if less so on business, must be a factor in the rise of confidence about the future that is reflected in recent public opinion polls. A depression is as much a psychological as a strictly economic phenomenon. Restoration of confidence is a key to increasing consumer spending and hence business investment, and along that dimension the President's performance has been impressive.

So is policy as a whole on the right track? No one knows. That is the frustrating thing about depression economics. So many things happen at once that disentangling the effects of any one measure from the effects of everything else that is influencing economic activity is close to impossible. At this writing, the economy seems to be stabilizing, but it would do so eventually without an ambitious recovery effort by the government. Because durable goods are--durable, their purchase is easily postponed--for a time. So when an economic shock strikes and economic activity drops, the sale of durables takes a big hit, inventories swell, production declines, and unemployment in manufacturing soars. But after a while, as the existing durables begin to wear out and inventories are drawn down, demand and production begin to rise. And as the hoarding of cash or equivalents that marks a depression increases, a savings glut results, interest rates fall, and people begin to shift their safe savings into risker forms (where interest rates are higher), or into consumption. That shift causes interest rates on investment to fall, stimulating investment and leading to increased employment.

The problem is that this process of "natural," government-unaided, recovery can be protracted. As we know from Part I of this series of entries, monetary policy cannot do much to speed recovery from a depression when banks, being undercapitalized, are extremely reluctant to lend, and instead hoard cash. Hence the other measures the government has taken, besides simply the monetary solution of "easy money," to accelerate recovery. At a guess, these measures are having an effect in reducing the length and depth of the depression. But their cost is very considerable and by no means limited to current costs--for there may be a severe aftershock to the current economic downturn after recovery is well under way, in the form of inflation, very heavy taxes, huge budget deficits, a recession to break the inflation, etc. It thus is difficult to say whether the costs of recovery are justified in relation to the costs of the depression. We may never know.  

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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