Thursday, May 21, 2009

Recession: Opportunity for Reform

In an important assessment of what it will take to recover from the global recession, Horace “Woody” Brock, head of Strategic Economic Decisions, says:

In our 2008 research programme, we focused on three issues. First, what exactly caused the worst credit crunch the nation has arguably experienced since the depression of the 1930s? Second, how did the downturn in the US morph into a collapse in Planet Earth's GDP rate from nearly 5% in June 2008 to -0.5% in winter 2009? Third, can traditional macroeconomic policy suffice to turn around the economy? More specifically, will a killer application of classical fiscal and monetary policy truly restore the economy to a stable growth trajectory? Or is there an internal contradiction within macroeconomic policy that could prevent it from succeeding this time around?

To explain the "perfect storm" in the credit market, we drew extensively on the new Stanford theory of endogenous risk to demonstrate that there are three jointly necessary and sufficient conditions to predict and explain the perfect storm we have experienced: (i) A mistaken market forecast of some exogenous event that impacts security prices (in this case, a vastly higher than expected default rate on mortgages); (ii) A high level of Pricing Model Uncertainty bedeviling bank assets (the true cause of the "toxicity" of those complex securities that have clogged the arteries of the banking sector); and (iii) An unprecedentedly high degree of leverage in the financial sector (money center banks had off-and-on balance sheet leverage of about 40:1 in contrast to the socially optimal leverage of 10:1). The reader can tack "greed" and "incompetence" onto this triad, although doing so diverts attention from the real causes of today's crisis.

To explain the collapse of economic growth worldwide in an astonishingly short period, we utilized a game theory model that explained how the cessation of inter-bank lending amongst the principal money center banks of the world precipitated the first known case of global credit market emphysema: The availability of credit dried up almost everywhere in the course of six months, from Auckland to Iceland. We stressed that this credit contraction had little to do with "globalization" as properly understood, and had no counter-part in history.-- Horace Brock, "The End Game Draws High--The Future Evolution of the Debt-to-GDP Ratio"

These points are both valuable and just the beginning of Dr. Brock's argument. For the moment, I would simply like to point out that it seems to me, in simple terms, that global growth collapsed so suddenly because it was not real growth. Growth was not simply the normal, healthy, “real” growth of economic production but to a significant degree the paper growth in wealth of a bubble. Houses were not suddenly getting better; they were simply priced higher, and the rise in prices was not a function of real demand of legitimate paying customers who could afford more expensive homes. Rather, the new owners were behaving as speculators – knowing it was too good to be true and gambling that they could grab a profit and escape before the obviously coming crash. The same pattern was seen on Wall Street – investors knowingly gambling in highly leveraged securities in an obviously speculative “get-rich-quick” scheme. Someone should do the numbers. When they do, I suspect they will find that the 5% of global economic value that disappeared in the last six months was mostly just bubble.

Brock has written a highly valuable article with its suggestions for solving the problem, but the bottom line explanation of the cause is very simple. As every five-year-old with a bottle of soap learns, bubbles burst.

This means that it is not a matter of figuring out how to get back where we were a year ago. That should not be the goal. We should not aspire to another irresponsible situation in which criminally irresponsible financial behavior is rewarded while honest labor is penalized. By now all should be aware that since the “Reagan Revolution” reversed the New Deal’s democratic trend, wealth has become increasingly concentrated. The rich loved “trickle down” precisely because they understood that most of the wealth would not trickle down (that’s why they call it “trickle”).

We need to restore New Deal goals of rising together with a guaranteed minimum for all and wealth redistribution to ensure that everyone is not only comfortable but able to consume. In addition, rises in GDP should reflect growth in economic value. Our goal should be to create a different global economy, one based not on speculation but genuine productivity. The recession should not be seen as a tragedy but an opportunity…an opportunity to make a better country. Instead of socialism for the rich and laissez-faire capitalism for the poor, we should take this opportunity to aspire to a degree of socialist protection for the needy (be they poor, old, or sick) plus government-regulated, humane capitalist opportunity for all.

No comments: