Mercury Rising 鳯女

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Shortening the DeLongation

Posted by Charles II on November 27, 2010

Brad DeLong has an interesting post–endorsed by Krugman himself– on the evolution of the financial crisis. Yet, for all of the theater of breast beating and cries of mea culpa, DeLong manages to miss the point.

He starts from the well-known proposition that the entirety of the financial crisis rests on the building of 5 million homes which should not have been built. This is the basic problem: if we invited five million well-to-do Brazilians (or whoever) to come and live in those homes and pay the mortgages, the problem would have been solved– even despite all the grubby dealings at the ratings agencies, the investment banks, and so on. Five million houses at a builder debt averaging $100,000 comes to $500 B. Although this is a lot of money, it’s 3.5% of our ca. $14T GDP, an amount the government could easily cover.

Nor was it even necessary for the well-to-do foreigners to actually come and live in the houses. As long as they purchased the mortgages through CMOs and CDOs, the problem would have been distributed across the world. Since the world economy is $80 Trillion, it would have been even more easily borne. There was a hitch. The investment banks had treated the mortgages as if they were as certain to pay off as top rated government debt in order to borrow even more money. In some cases, they borrowed 30 times their actual holdings.

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This is not as irrational as it sounds. If I borrow $100 at 3% interest, and invest it in things paying 5% interest, then even a quarter of those investments go south, I am still taking in more than I have to pay out.

The problem is that once many of those investments go south, people may wonder how much the rest of them are worth. If those investments include businesses that rely on the credit markets to stock inventory, for example, they may find it hard to borrow, or find that their borrowing costs rise. They lay off workers in order to be able to remain solvent. Those workers are unable to buy things, bringing down other businesses, and so on. Panic can make the prophecy of bankruptcy self-fulfilling. And, since borrowing depends on asset values, the $500B in houses turns into $20Trillion in asset value declines, which can trigger further panic, further layoffs and business closings, and further asset value declines.

This far, DeLong understands the situation perfectly. But when it comes to policy prescriptions, one starts to shake one’s head. Better regulation could have prevented the crisis, DeLong says. True but, for the purposes of this discussion, irrelevant. Crises develop because things happen which are not foreseen. Policy responses have to be based on a coherent understanding of what the problem is. DeLong says we could have nationalized Fannie and Freddie and purchased all of the mortgages. True. It’s a very expensive way of going about things, costing the full $500B less whatever the government was able to recover. In fact, the banks would have doubtless demanded more than the builder’s cost, since they had written their CDOs based on extravagant notions of what the mortgages would pay off. But, as a first approximation, $500B will do. Politically, this would have been a difficult thing to do.

But DeLong would not have paid such blackmail, instead temporarily nationalizing as many banks as necessary. Nationalization as a means to punish the shareholders would probably have been a good idea. The reason it wasn’t undertaken is because it was practically impossible. The FDIC has a hard enough time keeping up with the banks that it nationalizes. Where would we find the army of auditors and CPAs necessary to unwind Citi or JP Morgan Chase? This is an idea out of the economist’s world of mathematical models, in which the supply of goods and services is inexhaustible. But even so, let us grant that we could have nationalized some banks and scared the remainder into better behavior than they have so far shown. As DeLong says, they would have been unable to lobby against Financial Regulation, so we could have produced stronger protections than the legislation that passed. Maybe. This assumes that people like Lieberman and Nelson only respond to lobbying, rather than their own perverse natures. [Added: and, as DeLong’s commenters have pointed out, getting to 60 votes in the Senate wasn’t an absolute requirement to get some things done.]

So DeLong considers the alternatives: fiscal policy to increase general demand, quantitative easing to stabilize asset prices and prevent a downward spiral, “open mouth operations” by the Fed to convince everyone that inflation is about to break out–witness the speculation in gold to see that this has been successful, guaranteeing the banks (which has effectively been done by guaranteeing so many of the assets held by banks), and targeted temporary nationalizations ala GM, and principal writedowns (a more complicated topic than DeLong allows, but yes). In fact, every one of these approaches is part of the Obama response.

As DeLong says, they have failed, because they were too small in size. But he misunderstands why they were too small in size. He blames the Senate for its ridiculous procedures and the Republicans for their corrupt obstructionism. And these were problems, no question. He blames infighting among Obama advisers. Of course, advisers are supposed to argue for their preferences, and presidents are supposed to tell advisers which of their ideas have won the day… and to then shut up and march in formation. Obama, as a newcomer to politics, surely did not play his hand as well as he might have. Every new president makes mistakes.

But there’s a better explanation for why our elected representatives failed in their duty to restore the economy. They did not believe the political will existed to take the large–expensive–steps that were being advocated, perhaps in part because certain liberal economists ::cough:: Krugman ::cough:: were telling them that they should just spend, spend, spend without regard for how the money would be spent [Added: To be fair to Krugman, by early 2009, he had clarity on the importance of political will]. They contributed to our political representatives’ confusion about how demand is generated. And, since generating public support for tax cuts is much easier than generating it for a project to build a bridge in someone else’s district, that’s principally what the Congress did. To marshal public support for spending an amount of money equivalent in magnitude to expenditures on the Iraq War requires political skill, and part of that skill is making it clear to the public that each piece of spending is being carefully chosen and monitored.

One cannot disagree with DeLong’s diagnosis of why in the broader picture there was such a failure: the collapse of the union movement, the disconnection of elites from the consequences of their policies, the unwillingness of Washington to make the banks pay for their rescue leading to cynicism, the disunity of economic prescriptions by economists making policy makers leery of following their advice, and finally an idea that he dresses up in Nietszche but is actually what is generally called crabs in a pot: there is such seething resentment by the losers of economic distress that they demand that other people suffer. Similarly, crabs placed in a pot to be boiled will not suffer their fellows to escape– even though this might allow all to escape– but prefer rather to pull the other fellow down as he tries to climb out.

On this cheery note, DeLong tells us that we are doomed.

The reality is this: that $500B in excess housing is neither excess nor does it cost $500B. Homeowners can afford to pay perhaps two-thirds of their mortgages. Even if there are no homeowners to fill a house, there are millions of people who are homeless and capable of taking care of a house in exchange for shelter (it would not do to have the mentally ill, alcoholics and drug addicts take over responsibility for a house, but these are only a fraction of the homeless). Furthemore, over time, the nation will grow such that it needs those houses– if we weren’t so energetically deporting people, we might already be there. At any rate, the real cost of $500B in housing is roughly $25B per year (i.e., 5%). Of this, many homeowners could pay roughly 2/3. The remaining houses could be filled by people who offered to take care of the houses in exchange for lodging. And we could probably get the banks to agree in exchange for not prosecuting them for the incredible frauds they have committed in the course of covering up their original crimes.

So, not only is the housing problem not anywhere near as serious as DeLong seems to think it is. It would take presidential will and a modest amount of money. If I were president, I would declare that the recession is a national emergency threatening our capacity to fight the war on terror, and take it from there. It’s not as if the Congress has shown any capacity to resist executive power, and the best possible fight in which to engage the Republicans would be for them to be arguing in favor of more foreclosures and no jobs for the unemployed.

And just as the housing problem is nowhere near as serious as DeLong thinks, our real economic crisis is that we have something like 10 million people who need jobs. The entire cost to employ all of them at $25,000 per year ($12.50/hour) is $250B annually, not including overhead. There are millions of kids who need tutors and teacher aides. The Gulf Coast needs drastic environmental remediation, not just because of the oil spill but to preserve wetlands. There are huge national problems waiting only for leaders who are not too mired in their own guilt for their past complicity or too venal in seeking their own advancement to find and implement the solutions. And, there are nonprofits everywhere who would be willing to supply the necessary accountability and overhead at a very modest fee. [Added: these costs would easily be covered by genuine reform of the medical care system, which doesn’t even absolutely require government intervention. Doctors could band together to form non-profit insurers to compete against the for-profits and/or establish low cost best practices, community by community.]

This is doable, folks. In fact, it’s what we will inevitably do, once we have exhausted the less effective alternatives. In short, despair and the consequent Delongation of the crisis is not an option.
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Elongating the DeLongation:

Professor DeLong asked me to provide a comment rather than a link to this post. I said that I stopped posting comments because he did an egregious edit on one of mine, but that if he wanted to add the following to my post, he was welcome to do so:

On many points, what Professor DeLong has to say in Battered and Beaten is obviously true. In particular, the kernel of economic damage at the heart of the financial crisis is much smaller than the damage that we will endure as a consequence of our failure to apply the lessons of the past. It is also true that this damage is the result of a failure of leadership across society: in business, in government, and in academia. Certainly the willingness of the Republicans to sacrifice the American people on the altar of co-called “free markets” is despicable, while the Obama Administrations failure to follow up the original stimulus is all but inexplicable. And the preference of the more vocal losers of the financial crisis, the Tea Party, for vengeance rather than redress deserves note, but more in this sense: the lack of demand in the economy is a consequence of decades of hard heartedness against the losers of economic struggles: against the poor, against blue collar workers, against older workers, and so on. The Tea Party is not a new phenomenon, but the embodiment of the callousness of an entire nation. Callousness leads to wealth polarization, and extreme wealth polarization to a collapse in demand.

But there are a number of points on which Professor DeLong is incorrect. Some points are these:
1) The initial costs of resolving the crisis were probably much smaller than $500B, perhaps as small as $100B. Even the current costs are probably smaller.
2) The reason that policy actions like nationalizing the banks were not taken is probably that the human resources to accomplish such an enormous step were not available.
3) The Congress probably was correct in perceiving that the political will to take major steps had not been marshaled, which is why it chose the politically easier terrain of tax cuts.
4) Most importantly, the consequences of allowing the right wing to destroy the economy are, actually, serious– so serious that we cannot afford to become mired in hopelessness, as Battered and Beaten, in a manner reminiscent of Herbert Hoover’s last assessment, leaves the matter. The president has powers he can use. And the people have power they can use.

We need to focus on the prize: reinvigorating demand. This can come from two sources. First, keeping people in their homes, which could emerge from the delicate application of brass knuckles to banks engaged in fraudulent foreclosure and a willingness to rent vacant houses to the non-mentally ill/non-alcoholic/non-drug dependent homeless on the condition that they maintain them. Second, from ending misdirection of so much of our economy into medical insurance. One example: doctors have the power to start non-profit health insurance networks, and best practices panels, to compete United and Humana into the ground. Certainly if the ca. $800B excess that we spend on health insurance over and above what it should cost went back into the pockets of small business, the self-employed and state governments, there would be a pickup in demand.

Yes, many/most economists have been idiots with respect to failing to grasp the need to stimulate demand in a recession. They always have been idiots in this regard, and probably always will be. The American people, however, need to stay focused. We need to keep people in their homes, get people employed, and move more money out of corporate pockets into the pockets of the American people. When people have money to spend, and the confidence in the future to do so, the crisis will be over.

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5 Responses to “Shortening the DeLongation”

  1. Roberta in MN said

    Very good article.Send it to the President.Or maybe Amy Klobuchur or Al Franken. Maybe something can be done with that on an Executive Order? Maybe?

    • Charles II said

      Thank you, Roberta. Please feel free to use it as inspiration to write to your representatives. I do often write the Congress, and will do so in future.

      As for an Executive Order, I don’t know. Certainly declaring a national emergency would go that route. An EO to force writedowns in the HAMP program might work. But I think there may be some flexibility in spending money made by the successful bailouts.

  2. jo6pac said

    If I were president, I would declare that the recession is a national emergency threatening our capacity to fight the war on terror, and take it from there.

    Sorry but I won’t be voting for you in the future, LBJ found to late you couldn’t do both. Will you be reinstalling Glass-Steagall Act and giving the citizens of this nation their rights back? You have a start, that’s all, without ending all wars and closing 900 unneeded bases around the world we the little people are doomed to being serfs of the 1% overlords. Fear will rule us.

    • Charles II said

      Joe, when the Congress is held by the opposition party, the President is very limited in what he can do. Ending the wars, closing bases, and reinstating Glass-Steagall are things that are not going to happen for the next two years.

      What little the president can do will be through his executive powers. Unfortunately, the agencies are understaffed, so he’s forfeited a lot of power he might have through regulation. The Republicans have all but created a situation where the president, if he cares about the country, must assert extraordinary powers.

      And, yes, that’s dangerous, both per se and as a precedent. But something very good might come out of it: the Congress might re-assert itself.

      • Indeed. Bush and Rove used the Trent Lott/Strom Thurmond hoo-ha as a pretext to replace Lott, who as Senate Majority Leader actually believed in the legislative branch as separate from and not subordinate to the executive, with the supine idiot Bill Frist.

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