Recession? Depression? How Deep, How Far and What Can Be Done?
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As the financial crisis gains steam, moving from overextended American households to global banking giants, fear of a major crash is spreading. Talk of "Another Great Depression" has entered the mainstream discourse, 1 out of 6 homeowners are "under water" -- owing more to the banks than their houses are worth -- and $2 trillion of retirement wealth has evaporated over the course of a few short months. The markets have not been "calmed" by the government's heavy interventions; the Dow Jones Industrial Average touched a five-year low this week, and is now 40 percent below its peak of one year ago.
The question on most people's minds is just how far and deep the fallout from the crisis will go. Are we looking at the kind of recessions we've seen -- and survived -- in the early 1980s, early 1990s and at the beginning of this century, or are we staring into an abyss that will be far more painful, one that will profoundly transform our lifestyles?
There's no definitive answer. We're in uncharted waters, and anyone who says they know what will transpire in the next few years is selling snake oil. But some deep thinkers who have a solid command of the structures of the global economy can help us understand the best- and worst-case scenarios, the way the crisis is changing some of the economic establishment's most cherished and long-standing assumptions and what role government -- the American government and those overseas -- might play in minimizing the damage created by Wall Street's excesses.
I contacted a number of leading experts this week -- all highly respected in their field -- to get their reads on the possible impacts of the financial sector's meltdown, the likelihood of the recent bailout having the desired effect and where we might go from here.
There was quite a bit of consensus on several points. First, all agreed that we're in the early stages of a deep recession. Second, most believed that it was in no way inevitable that the crisis would develop into a full-blown 1930s-style depression, and some were skeptical that such an event is even possible in today's economy. Third, all agreed that the length and depth of the crisis would hinge on the actions taken by governments in the coming months. Finally, there was something approaching a consensus that the economic and political establishment has been deeply shaken by the events of recent months, and that the banking mess might lead to a very different approach to governing the "free market."
The Worst-Case Scenario
In a nutshell, the lack of transparency in the system -- the fact that nobody knows precisely who's holding what liabilities on their books -- has the potential to lead to a global loss of confidence among investors and institutions, and what would effectively be the modern-day equivalent of a bank run on the myriad institutions that hold (or guarantee) "toxic" debt-backed securities.
That prospect has already led to a near-freeze in the flow of loans that individuals and businesses require, and if the credit system doesn't shake loose it will make the economic contraction that's already begun longer and more severe and lead to further financial losses.
That might create a vicious cycle in the "real" economy, as jobs are lost, people lose their homes, local governments' revenues -- in the United States, based largely on property taxes -- are cut and their work forces slashed.
As Max Wolff, an economist at the New School, wrote me via e-mail, "we're dependent on our banks. Thus, their pain is ours. Millions will be fired. Retirements will be decimated. Opportunity will vanish, (and) consumption will fall. Everyone is already deeply influenced. This will become more obvious and more painfully evident with each passing day. When it rains on the top of the hill, those who live on the bottom of the hill drown." He added, "there's now a major flight from all risk assets" which will "cause massive pain and dislocation in the developing world." Wolff predicted that "large sections of the consumption economy" will vanish, which will "slam into the leading exporters' markets and undermine much of the recent surge in commodity prices."
"We have now baked a severe and largely global recession into the cake," Wolff said. "The losses are already way too large to swallow. ... The numbers about failures from car dealerships, stores and many small businesses are alarming and will get worse." He added: "The epicenter of the crisis is already shifting out of America and finance."
That point was echoed by Walden Bello, a giant in the global justice movement and founder of the Third World Network, a group of NGOs focusing on development and poverty relief. Bello offered that "given the globalization of national economies over the last two decades, the downturn is going to be a synchronic one, and there is going to be no decoupling of one region from another." The crisis in the United States will continue to expand worldwide, at just the moment when international cooperation is most necessary. "For instance," Bello said, "China's main market is the United States, and China purchases many of its industrial inputs and raw materials from Japan, Korea and Southeast Asia. So Japan and Southeast Asia cannot rely on Chinese demand to make up for a fall in U.S. demand. China, East Asia and the U.S. are tied together like prisoners on a chain gang."
Robert Pollin, co-director of the Political Economy Research Institute at the University of Massachusetts, thinks there's "a good chance this crisis will become a general crisis, pushing unemployment up to the 10 percent level, as we experienced in 1982-83. This would mean a severe slowdown for everyone," regardless of whether they're in the financial markets or struggling to keep up with a mortgage. "A severe employment crisis would hit lower-income people the worst -- that is, people who have little savings and rent, rather than own, their homes," he wrote me via e-mail. Pollin also believes, "the odds are closer to the worst- rather than the best-case scenario, mainly because I think we are already too far gone for this to be a mild downturn, no matter how successful" the government's bailout of Wall Street might be.
Is a Major Crash Inevtitable?
"I won't go so far as to draw parallels with the Great Depression," James Galbraith, a senior scholar with Bard's Levy Economics Institute, told me by phone. "I don't think that's appropriate."
In the best-case scenario, Galbraith said, "the government has the power and should use it, first of all to secure the liquidity of the banking system and the payment system, and then to resolve the underlying housing problem. These things should be done, can be done and if they are, the whole experience would be relatively mild. I mean, it'll be severe by the standards of the past 20 years, but it can be contained and resolved in the next two to three years." He predicted that "if the system is kept liquid," the crisis may be short in duration. "What will happen is that the financial sector will shrink, it will disintermediate, but it will not collapse."
When I interviewed Dean Baker, co-director of the Center for Economic and Policy Research, two years ago, he was one of a very few voices warning of the dangers the housing bubble posed to the larger economy (at the time, he had been discussing it for a couple of years). This week, Baker said that the best-case scenario for the underlying housing market would be for prices to "quickly fall by 10 to 15 percent, returning to their long-term trend levels." That would allow the real estate market to begin to clear "a vast overhang of vacant properties" and unfreeze the credit markets.
In the bigger picture, Baker argued that the recession, while painful, might be mitigated by "large injections of government stimulus ($300 billion to $400 billion) combined with a substantial fall in the value of the dollar." A broader stimulus package -- cash injected into the economy to help keep goods and services moving -- "can sustain demand in 2009, while the fall in the dollar can begin to boost net exports in the second half of 2009 and 2010." Baker added, "even in this case, unemployment is almost certain to rise above 7 percent by early 2009, but hopefully will not get too much higher."
Although Pollin is not optimistic about the prospects of a quick recovery, he told me that in his view the best-case scenario "at this point would be a mild recession that lasts roughly a year. This would be similar to the recession that occurred after that last financial crisis, the 2001 stock market crash. In that case, unemployment rose to only about 6 percent, where we are now. Financial markets would stabilize over the next six months."
A Positive Outcome Will Require Good Governance
All of the experts I surveyed agreed that the modified "Paulson Plan" passed by Congress won't work, but many also thought a large injection of cash into the banking system was a necessary first step. The crucial factor in our economic prospects for the coming years is what will follow next.
Robin Hahnel, an economist at American University, told me that "while it's not necessary for the U.S. financial crisis to become a world financial crisis, and for the U.S. recession to become a depression of the magnitude and duration of the Great Depression of the 1930s, if the short-term, medium-term and longer-term responses continue to be as incompetent as the short-term response in the U.S. has been so far, this worst-case scenario could happen." Hahnel noted that "for the most part, governments in Europe have gone about their bailouts in a competent way -- building up equity in stricken financial institutions by buying shares, making loans to banks in exchange for banks making the loans they have refused to make so far, and making credible government guarantees to depositors."
Pollin agreed. "I do think the bailout will contribute to stabilizing global financial markets, relative to a situation where the U.S. government did absolutely nothing," he said, noting that it was inaction that resulted in the demise of Lehman Brothers -- the decision "to allow the free market to work as its supposed to" -- and that "led to the total panic that has since gripped markets."
But, he added, "that doesn't mean that this was the right bailout strategy. It wasn't. Indeed, it was close to being the worst possible strategy ... because it did nothing to assist homeowners who face foreclosures; it contributed to the sense of panic by emphasizing this huge sum -- $700 billion -- coming out of the Treasury, when in fact, the Fed could have managed the crisis without any tax dollars being committed." He added that the plan "didn't offer any measures to regulate the markets and thereby create a sense of stability moving forward."
Pollin laid out steps that he believed must follow the government's interventions thus far if we hope to stave off a far deeper crisis, including: a new system of financial regulations; increasing the cash reserves required of institutions that deal in the speculative economy; restructuring people's mortgages; and a significant economic stimulus package designed to "create jobs and get people a new stream of income."
Baker emphasized that "paying too much for banks' bad assets is a very inefficient way to address their main problem -- they're under-capitalized" (meaning they don't have enough cash on hand to cover their potential liabilities and also make new loans). In calling for a major stimulus package for the "nuts and bolts" economy, Baker noted that it's "far more efficient to directly inject capital."
Galbraith told me that the "Paulson Plan" was an "act of desperation from an overwhelmed Treasury Department" and that to the extent it might "do anything at all" it would do so "both inefficiently and slowly." He was adamant that it had to be considered as only a first step, and that other measures must follow in short order.
Galbraith said it's "absolutely essential" that the government do more to protect homeowners. "If nothing is done, the fact that there is excess inventory of 4 million homes in foreclosure and many more to come" will be a drag on the housing and credit markets "for a long time."
But that's just the first of what he called "three necessary steps" for stabilizing the "real economy." The second is dealing with the inevitable fiscal crisis that will face states and localities, which "will be cutting expenditures as their property taxes implode." Galbraith urged the federal government to bail out struggling local governments with revenue-sharing plans and infrastructure investment, "on the condition that they maintain their level of spending," meet "their public sector needs" and avoid "mass layoffs of their work force." Finally, Galbraith said, the elderly and near-elderly who have seen their retirement accounts take a heavy hit are going to need help -- through increased Social Security payments if need be.
If those steps aren't effective, Galbraith suggests that more dramatic measures be taken, including a temporary suspension of the payroll tax, which would give every working person (making under $97K per year) an effective 7.65 percent raise to make ends meet, while giving businesses a tax break on their payrolls.
Those measures would greatly expand a budget deficit that has already become bloated during the Bush era. But, as Pollin pointed out, "The fiscal deficit in 1983 was 6 percent of GDP -- that was under Reagan -- and that pulled the economy out of crisis then. Right now, the fiscal deficit is in the range of 3 percent of GDP. Increasing the deficit to, say 5 to 6 percent of GDP now would inject more than $300 to $400 billion in new spending into the economy -- to go for state and local spending on schools and health care, investments in energy efficiency and renewable energy, raising unemployment insurance benefits and food stamps."
Reason to Be Hopeful, as a Failed System's Flaws Are Exposed to the Light of Day
It was during an earlier economic crisis that Richard Nixon famously said, "we're all Keynesians now." According to those I contacted, that's more true today than at any time in recent history; there's broad agreement in Washington that more government action will be required.
When I asked Galbraith about the prospect of running up large deficits, he responded that today "no serious person" in the economic establishment is a deficit hawk, adding that "it's striking how quickly consensus is moving" in Washington toward the idea that a major bailout of the "nuts and bolts" economy is needed. (Deficit spending to kick-start the economy during a downturn, as opposed to financing tax cuts for the wealthiest or paying for wars of choice, is a tried-and-true policy tool.)
Despite the general consensus among the experts I surveyed that we are almost certainly headed into very rough waters, there was cause for optimism as well, in that most agreed that aggressive and coordinated actions by government could contain the damage. More importantly, the bright spot in this crisis may be (stress on the word may) the blow it deals to the center-right, anti-regulatory paradigm that has guided economic policymakers both at home and in many of the world's capitals over the past three decades.
Of that paradigm, Bello said, "goodbye to all that," adding, "We should not underestimate the sea change that is occurring. Neoliberalism and free-market fundamentalism have been severely discredited, as has globalization." He predicted that "capitalism itself will come under severe questioning, and many will think that regulating or re-regulating it is not enough. I think you will find the same fundamental questioning happening throughout the world." He added, "Radical economics and Keynesian economics will regain respectability, and neoclassical or neoliberal (trickle-down) economics will be delegitimized."
Pollin wrote that he has hope that "the commitment to financial deregulation by mainstream economists and politicians -- Democrats as well as Republicans -- is now dead." He added: "It is time to recognize that unregulated financial markets always have, and always will, cause financial crises. There are no historical exceptions to this observation at all. This point has to be grasped."
According to Baker, the degree to which that point sinks in is an open question. "In principle," he said, "the Wall Street mentality that has dominated the political thinking of both parties should be on the defensive. These guys had it all their own way, and it led to a colossal disaster." But, he added, "in this country, failure doesn't count against you. It will be necessary for progressives to demand an end to Wall Street-driven policy. If there is successful organizing on this front, then it is possible that the next administration will take a very different course. But the Wall Street boys have to be pushed away -- they will not surrender power voluntarily."
Hahnel offered a word of caution, noting that "80 years ago people thought (unregulated) free market finance was dead. If the funeral had a name, it was Glass Steagall (the New Deal-era legislation that made banks choose between issuing mortgages and securities). In 1999 Phil Graham, Robert Rubin and Bill Clinton killed Glass Steagall, signaling the return and triumph of free market finance. Hopefully this crisis will kill free market finance once and for all. 'Never again' is the appropriate response."
He added what was perhaps the most salient point: "I hope this lesson will be the beginning of a larger lesson: The economics of competition and greed does not serve us well."
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