The GOFFU and the Big Question

The surprising uptick in housing starts almost persuaded me that the recession might not last as long as feared. James Galbraith argues otherwise...

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return.

The Great Depression taught us the danger of this presumption. The current Depression should teach us the danger of revising the history of the Great Depression, as the conservative press has done for the past thirty or forty years.

Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief.

On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.

Galbraith confirms that Obama hopes to pay for his doomed recovery plan by going after Social Security and Medicare. In essence, he will use the current Depression to undo the social programs enacted in the wake of the previous Depression.

Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.

Now we see the full scope of the GOFFU -- the Great Obama Financial Fuck-Up. By guaranteeing the assets of failed large institutions -- instead of taking over those institutions and giving an accurate appraisal who did what damage -- Geithner will encourage further looting.

Geithner’s plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.

Delay is not innocuous. When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.

I hate to say it, but perhaps Paulson's "make-'em-feel-the-pain" approach made more sense.

In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis.

Alas, our national religion equates Keynes with Satan. We cannot do historical analysis if an accurate reading of the record is damned as theologically incorrect.

Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record.

Auerback is one man. He cannot compete with a propaganda barrage.

I'll summarize Galbraith on Auerback: Massive government spending during the New Deal brought 25% unemployment down to a more manageable 10%. Things began to go wrong again when FDR temporarily initiated more conservative policies in 1937; hence, the new New Deal.

It is true that the banking system did not rebound until the war. Conservatives harp on this point because they believe that spending on armaments is inherently more moral than spending on dams and roads and, God forbid, public art. But war, in and of itself, did not restore health to the credit system. (We have two wars going on right now, in case you have not noticed.) What did the trick was the institution of price controls.

Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.

All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.)

Although JKG did not know it at the time, one of his underlings was a young lawyer named Richard Nixon.

I've been arguing for a while now that what we need is a massive infusion of cash (and I mean cash, as in paper money) into the pockets of struggling working people. A certain amount of inflation would be a good thing right now. If and when inflation becomes a bad thing, institute wage and price controls until the crisis passes.

Back to WWII:

And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s.

All of which brings me to today's Big Question:

The people buying bonds today are foreign investors, not average American citizens. How, then, will recovery occur?