A Failure of Capitalism (V)--Doing Too Much at Once

by Richard A. Posner

In an article in Monday's Washington Post, David Cho reports that the Treasury Department is having a good deal of trouble implementing its ambitious program of recovery from the depression. Cho and the people he has interviewed attribute the problem to delays in appointments of high-level officials (the number two man in the department has yet to be confirmed), but also to an excess of cooks spoiling the broth, the excess consisting of White House officials, such as members of the staff of the National Economic Council, which is headed by Lawrence Summers, prowling the corridors of the Treasury building and distracting the denizens with demands and commands.

I have been concerned since the beginning of the Obama Administration with what seems a determined effort at overcentralization.

The tendency in American government in recent times has been to centralize power more and more in White House staff. The effect is to insert a layer of managerial control above the Cabinet officers, who themselves constitute a layer of control above a number of other political appointees in their departments (laterals), who in turn are layered over the career civil servants. A recent and very pertinent literature in economics--"organization economics"--emphasizes the costs of hierarchical management in slowing and distorting the flow of information up the chain of command and the flow of orders down it. The problem is compounded when as in the federal government the top layers are political appointees who may have little experience with the operation of the agency they find themselves managing.

Obama is extremely able and self-confident and has appointed on the whole very able people to his staff and to the departments; some of them are brilliant. But the capacity of brilliant people, appointed to high positions in the federal government from outside, to screw up is legendary. The danger is amplified when the government tries to do too much. The economist Frank Knight used to quip that although production beyond capacity is a contradiction in terms, it is observed every day in academia--to which we can add, in the U.S. government as well. There is danger that the government is trying to do too much and that the economic consequences will be negative and serious.

We begin with the fact that the federal government has spent, lent, committed to spend or lend, or guaranteed a total of almost $13 trillion to fight the depression. Something more than half of this Brobdingnagian sum consists of expenditures or commitments by the Federal Reserve, and about two-thirds of the remainder consists of expenditures or commitments by the Treasury Department; the rest consist mainly of guarantees by the Federal Deposit Insurance Corporation. The total number will probably grow. Only about a third had (as of March 31 of this year, the latest date for which the data are available) been spent, and perhaps not all of the committed funds will actually be disbursed. Even if the total amount allotted to spending (mainly buying stock in failing financial institutions, such as AIG) and lending is actually disbursed, much of it will be returned or "unwound" (I'll explain the difference in a moment), and the guarantees will not cause a loss to the government if there are no defaults in the guaranteed obligations (such as the guaranty of bank deposits if a bank fails).

Thirteen trillion dollars is more than the national debt and almost as great as a year's Gross Domestic Product. Although it is as yet largely a contingent liability, some trillions of dollars will doubtless be lost, adding to the national debt, and it is small comfort that the loss of the nation's wealth would probably be even greater if no costly depression-recovery efforts were undertaken. The Federal Reserve's share of the liability is especially worrisome, because it creates a serious risk of future inflation. As I've mentioned previously in this series of blog postings, the banks are, thanks to the Federal Reserve's "easy money" rescue efforts, awash in excess reserves (i.e., lendable cash). When recovery is well under way, and demand for loans soars, and the banks start lending those $800 plus billion in excess reserves, the amount of money in the economy will jump. And it will jump further because the Federal Reserve is continuing to pump cash into the economy by buying private and long-term private and public debt. As economic activity quickens, and confidence returns, consumers as well as businesses will spend hoarded cash, increasing the ratio of cash to goods and services.

In principle, and perhaps as a technical matter in practice, the Federal Reserve can sop up all the excess cash in the economy by selling the debt that it bought in order to put cash into the economy, thus bringing the cash back into the Fed, where it can be retired. (The cash that the Fed creates it can also uncreate.) But the effect of a sudden withdrawal of huge amounts of cash from the private economy is likely to be, as in the 1979-1982 induced recession (and before that in the 1937-1937 recession that set back recovery from the Great Depression by several years), a sudden rise in interest rates and resulting contraction in economic activity.

If at the same time that the Federal Reserve is trying to unwind its stimulus efforts the Treasury is trying to pay for its heavy expenditures on recovery from the depression, the risk of inflation (and an ensuing corrective recession) will increase. As government debt mounts up, the interest rate the government must pay to service the debt is likely to rise, and so the deficit will rise farther. If tax increases to pay down the debt prove politically infeasible, the government may resort to inflation--paying its debts in cheaper dollars--to alleviate the debt burden.

But this is just the beginning. For the current depression has greatly reduced the government's tax revenues, as a result of which the budget deficit would be growing by leaps and bounds even if there were no extraordinary expenditures on recovery from the depression. The budget deficit for the current fiscal year (which ends on September 30, 2009) is estimated to be $1.8 trillion, and this may well be an underestimate. Further compounding the budget problem, the Administration wishes to spend trillions of dollars on ambitious social programs without having any good prospects of being able to finance the expenditures either by higher taxes or by reducing other spending.

And if that isn't enough to frighten one, the immense financial problems crowding in on the government, and the variety and complexity of the short- and long-range spending programs, make it extremely difficult for a poorly structured, top-heavy government to execute competently any of the multidinous problems that clamor for solution now, so that the government's efforts to speed recovery from the depression can succeed.