Tuesday, June 21, 2011

The Fire Next Time?

John Buell
John Buell (jbuell@acadia.net) is a columnist for The Progressive Populist and a faculty adjunct at Cochise College. His most recent book, Politics, Religion, and Culture in an Anxious Age, will be published by Palgrave/Macmillan in August.

As the financial crisis deepened in 2008, the world's economic gurus were caught off guard. Political leaders, academics, and the mainstream media had converged on a new consensus. The era of volatility in financial markets had ended. Free markets, sophisticated technologies, and computer models had given us a new world. Risk could be modeled and quantified and banks, always eager to pursue their own financial interests, could be counted on to continually refine risk models and converge on prices that would reflect real underlying value.

When Lehman Brothers failed, setting off the cascade of bankruptcies that brought the banking system to its knees, Alan Greenspan blamed a once in a hundred years storm. Though on one level Greenspan's remark seemed to be an admission of a major flaw in conventional wisdom, it is better seen as the claim that, however dire current events were, political leaders should not draw long- term policy conclusions from the crash. Recent events also suggest that policy elites prefer to return to business as usual and, more surprisingly, that they are going to get away with it a mere two years after the near collapse of the system.

It has become almost an article of faith, not only in the US but in most of the other G-20 nations, that fiscal profligacy caused the Great Recession, that the stimulus did not work, and that austerity is the only way to restore growth. Mark Blyth, professor of international political economy at Brown University, points to the irony in this state of affairs" "Investment houses that two years ago demanded costly bailouts from government now criticize those same governments for excessive debt." Yet as Blyth, as well as Paul Krugman, Mark Weisbrot, and Dean Baker, point out, many of the governments now blamed for fiscal excess (Greece being the exception) were in sound shape before the crisis. The collapse of the speculative bubble in housing took down highly leveraged banking systems. Government revenues declined and government expenditures for both bailouts and for automatic stabilizers like unemployment compensation rose. As for the failure of the stimulus package, Blyth reminds us that several Eastern European nations failed to adopt stimulus packages and have seen their economies endure extraordinary hardships. Latvian GDP fell 17% in the fourth quarter of 2009.

Austerity proponents base their case on several related notions. Austerity leaves business with less concern about future tax increases and thus willing to invest more. Government spending will no longer crowd out private investment. By historic standards, however, interest rates are already low. In addition, Baker points out that if business feared future tax increases, they would jump to invest and earn money now while taxes are low. Many major corporations are sitting on large piles of cash. They are reluctant to invest not because of fear of government policy but because demand is absent.

Despite sluggish domestic demand, US based multinational corporations have done well. They continually squeeze more productivity out of a diminished workforce and move operations to foreign markets that continue to expand. Nonetheless, there is a physical limit to what management can get out of workers, and inflation has become an increasing concern in the so- called emerging markets. International capitalism's business model may be fundamentally flawed.

The most likely scenario for the US economy is slow growth and persistently high unemployment. Nonetheless, one cannot rule out a more dire double dip. Such a scenario might be provoked if the major G-20 nations do manage substantial simultaneous reductions in government budgets and or if default by a core EU nation like Spain triggers a run on the Euro, thereby putting pressure on holders of its bonds. The breakup of the European Union, a concern of even such mainstream commentators as Nouriel Roubini and Martin Wolf, would have complex and especially hard to predict legal, political, and economic consequences.

Furthermore, as Blyth points out, the major economic powers have learned all too little from 2008. They continue to treat finance as a realm where risks can be modeled and quantified. Government at most only need to demand that derivatives be traded on open markets and to develop its own risk models to assess any possible future problems.

Financial markets, however, do not perform with the orderliness and predictability of billiard balls on a pool table. It is not surprising that the era of financial deregulation has been accompanied by increasingly frequent and ever more severe financial crises. Once in a hundred year storms in the financial markets are now occurring almost as often as the "historic" draughts and floods that have filled our weather casts for several years now. Failure to recognize and acknowledge both phenomena is as much rooted in confidence in linear, predictive models of social and natural science as in economic interests.

Blyth argues that
financial markets are social phenomena... economic performance is as much determined by market participants' beliefs as it is by fundamental indicators... prices can move on momentum whereby disequilibrating price movements compound one another, further driving market prices away from their true worth. Imagine... a case in which a number of creditors believe that a certain state is likely to become insolvent in the next few months. The state's creditors would demand... higher yield for holding the debt...Eventually the pressure from speculators would cause the state to run out of cash thereby creating the very situation that investors feared.but from which they would also profit through the short selling of bonds.
Government risk models might ironically compound such problems. If public authorities and private forecasters converge on a scenario, traders may embark all the more confidently on that path. This is the stuff of which immense bubbles are made. And major investment banks, often using cheap cash from the government, have once again embarked on risky and complex derivative trading. And when the next bubble bursts, governments asked to bail us out will be in far worse shape than last time.

credit: sadguysontradingfloors.tumblr.com

Blyth points out that complex systems need simple rules. Automobile traffic is a complex, nonlinear system, but one simple rule, that everyone drive on the right, prevents 90 percent of possible accidents. Blyth advocates countercyclical capital charges tied to growth in particular asset classes. He also argues that attempts to crush all volatility are futile. Allowing some banks to fail, wiping out stockholders and management while protecting only small depositors, is therapeutic. It exposes defects in the system and prevents larger turmoil. Allowing small forest fires often reduces the likelihood of major events.

Unfortunately neither of these proposals is likely to receive attention. The very sluggishness of the economy gives banks ammunition to argue that "now is not the time" to make it harder for banks to invest and make loans etc. And bank profits have been recycled to buy political leaders. Mainstream media remain in awe of finance capital as they are also increasingly funded by it. Much of the electorate still scapegoats ethnic minorities. Many also extrapolate from their own debt position to the conclusion that more deficit spending by government to stimulate job growth is dangerous. Krugman points out that investment banks and the wealthy in general hold much of their assets in bonds and benefit from deflation or at least low rates of inflation. This may be a dangerous game on their part. If debtors are squeezed to the point of default, how valuable will these bonds be?

In a more long- term sense, Krugman has pointed out that many of today's economists, whom he labels freshwater economists (based at such Midwestern powerhouses as the University of Chicago) have never even read Keynes. They practice a kind of "epistemological closure."

Economic crisis and intellectual and political stagnation are enfolded with each other. Politics, however, is as nonlinear and momentum driven as markets. New hopes, fears, and coalitions may yet help us extricate ourselves from the conventional wisdom that imperils us.



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