Recovery is impossible without some change

The longer the credit crisis wears on, it seems, the less we learn. In the early days the signal-to-noise ratio in the commentary was relatively high, as these things go. But since the crisis intensified last fall, the volume of nonsense has grown exponentially, and not all of it in Paul Krugman’s columns.

Each new intervention only spurs calls for still more radical measures, often to deal with the consequences of the last. So the expenditure of trillions of borrowed dollars in fiscal “stimulus,” much of which will, as critics suggest, be dissipated on imports from other countries, becomes the pretext for “Buy America” rules, to prevent such “free riding.” In the same way, corporate bailouts are used to justify capping the salaries of executives at recipient firms—which may at least make these CEOs think twice before taking the government dosh.

Before things go completely off the rails, it’s time for a little review. Let’s start by understanding that there is nothing particularly new in what we are going through. Manias, panics and crashes are as old as capitalism, or older. The linkages between sectors may be more intricate, the effects may spread more rapidly around the globe, the feedback loops may be more violent, but the essential elements are neither mysterious nor novel. Arguments that they reveal a crippling weakness in “free market ideology” would be more persuasive if the crisis had not been encouraged and exacerbated at every turn by government action, from the Fed to Fannie Mae, from mortgage interest deductibility to Basel II—and if those making such arguments were not so obviously peddling their own ideologies. Faddish claims that rational “economic man” must give way to the insights of behavioural psychology will likewise prove overhyped in time, not because men are not often or even always irrational—an insight with which I assure you economists since Adam Smith have been entirely familiar—but because rationality, the idea that people respond in relatively predictable ways to incentives, remains the best working assumption.

As we should beware of casting too broad a net in our search for causes, so we should not overreach in listing the possible consequences. Attributions of the crisis to “global imbalances,” in which the U.S. saves too little and China saves too much, only get it half right. The willingness of Chinese households to save was not a cause of the U.S. housing bubble—they simply replaced U.S. savings, which had fallen to near zero—nor did China invest all those billions of surplus dollars in the U.S. as some sort of favour, but rather because it made sense on its own terms. That is unlikely to change. The U.S. dollar is and will remain the world’s reserve currency—the euro is in far greater danger of collapsing—so the feverish scenario often painted, of a cataclysmic fall in the dollar leading the Chinese to cash out (and thus make things worse, not least for themselves), is unconvincing.

What is more true is that Americans were saving too little—or in the case of their government, dissaving (running deficits) to the tune of hundreds of billions of dollars a year. With the stock market collapse having wiped out much of their nest eggs, American households are responding appropriately—rationally, you might say—by rebuilding their savings. Yet their government is doing everything in its power to prevent this necessary adjustment, not only tripling its own annual borrowing but offering Amercians hefty bribes to carry on with their previous extravagance. Not content with indirectly subsidizing mortgage interest payments, via the tax code, the Obama government now proposes to subsidize them directly as well. All of this is not merely an attempt to forestall the inevitable—auto bailouts, anyone?—but actively harmful to growth in the long run. Households need to save more. Corporations need to reduce their leverage. Banks need to rebuild their capital. These are not bad things. These are good things. No lasting recovery is possible without them. It may be that they entail some additional pain in the short run, but if you’ve noticed, the road to the long run runs through the short.

That does not mean that governments should, in the caricature of stimulus proponents, “do nothing.” (Or as Obama put it in Tuesday’s address to Congress, “I reject the view that says our problems will simply take care of themselves.”) Be clear on this: the choice in these debates is not between doing something and doing nothing. Everyone, or nearly everyone, agrees the crisis is of a kind that requires massive government intervention (even if, as I say, government was massively implicated in causing it). The question is what kind of intervention. Fiscal stimulus, of the kind proposed in both Canada and the U.S., is at best a diversion. If the problem is averting an all-out 1930s-style implosion, monetary policy is the necessary and sufficient remedy: central banks can supply whatever amounts of money are necessary. If the problem is fixing broken credit markets—which remains the nut of the crisis—that will require more money, and still more ingenuity: the parade of plans for relieving banks of so-called “toxic” assets, under first the Bush and now the Obama administrations—TARP, TALF, PPIF, on and alphabetically on—are forgivable, given the complexity of the problem. And yes, if the problem is ensuring this never happens again, one part of the solution will be intelligent reforms to financial regulation, though these will as often mean repairs to existing, and comprehensive, regulations as they will new ones.

But if the problem is avoiding a necessary process of adjustment, I’m afraid no amount of policy can spare us from that.