Post-Bubble Economics

I thought Larry Summers gave an interesting speech yesterday. Clearly the White House is interested in having him in public right now. He dominates the Sunday shows tomorrow, and with Geithner's credibility in question, he's the biggest voice on economic issues coming from that point of authority. Most progressives have a dim view of Summers because of his past association with the deregulation and corporate-friendly policies of the Clinton Administration. But let's look at a bit of what he said yesterday.

The beginning was a reassurance that this crisis will pass, that the policies being put in place will lead to economic growth. The White House is clearly trying to project confidence on this front, using their blog to pick out examples of "Recovery in Action" from across the country. But then Summers summarized the current problem, and offered what was, for me, a novel way of thinking about it.

It was a central insight of Keynes' General Theory that two or three times each century, the self-equilibrating properties of markets break down as stabilizing mechanisms are overwhelmed by vicious cycles. And the right economic metaphor becomes an avalanche rather than a thermostat. That is what we are experiencing right now.

• Declining asset prices lead to margin calls and de-leveraging, which leads to further declines in prices.
• Lower asset prices means banks hold less capital. Less capital means less lending. Less lending means lower asset prices.
• Falling home prices lead to foreclosures, which lead home prices to fall even further.
• A weakened financial system leads to less borrowing and spending which leads to a weakened economy, which leads to a weakened financial system.
• Lower incomes lead to less spending, which leads to less employment, which leads to lower incomes.

An abundance of greed and an absence of fear on Wall Street led some to make purchases – not based on the real value of assets, but on the faith that there would be another who would pay more for those assets. At the same time, the government turned a blind eye to these practices and their potential consequences for the economy as a whole. This is how a bubble is born. And in these moments, greed begets greed. The bubble grows.

Eventually, however, this process stops – and reverses. Prices fall. People sell. Instead of an expectation of new buyers, there is an expectation of new sellers. Greed gives way to fear. And this fear begets fear.

This is the paradox at the heart of the financial crisis. In the past few years, we've seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying. Today, however, our problem is exactly the opposite.

It is this transition from an excess of greed to an excess of fear that President Roosevelt had in mind when he famously observed that the only thing we had to fear was fear itself. It is this transition that has happened in the United States today.

This is kind of a recitation of the theory of animal spirits that the White House is consumed with, the psychological theory for the crisis in the markets. The financial barons had an "irrational exuberance" on the way up, and now they have an irrational pessimism on the way down, the theory goes. Only I don't think it's all that irrational - the phantom wealth created by the derivative markets and on-paper assessments of assets really has vanished and it's not coming back. Ultimately, restoring confidence isn't going to paper over the giant hole in the balance sheet.

Nevertheless, here was Summers' assessment of the solution, after laying out the problem:

While greed is no virtue, entrepreneurship and the search for opportunity is what we need today. We need a program that breaks these vicious cycles. We need to instill the trust that allows opportunity to overcome fear and enables families and businesses to again imagine a brighter future. And we need to create this confidence without allowing it to lead to unstable complacency.

While the economy is falling far short today, perhaps a trillion dollars or more short, we should never lose sight of its potential. We have the most productive workers in the world, the greatest universities and capacity for innovation, an incredible amount of resilience, entrepreneurship, and flexibility, and the most diverse and creative population of any major economy [...]

Taken together, these steps to support incomes, increase the flow of credit, and normalize housing market conditions address each of the vicious cycles that is leading to decline.

With the passage of time, it will permit the re-engagement of the normal processes of economic growth: rising incomes and employment, greater credit flows, increased spending, a stronger US economy and a stronger global economy. They will reinforce crucial dynamics that will also operate to promote recovery.

There's a substantial amount of question about whether those steps, particularly with respect to the banking sector, are going to work. And really, recovery hinges on getting those steps right. But what I really, really liked about Summers' approach was that he rejected the idea of reinflating bubbles as the road to recovery, and using this crisis as an opportunity to rebuild the economy on a sustainable path. This sequence is solid.

Bubble driven economic growth is problematic because of disruption and dislocation – affecting those who took part in the bubble's excesses and those who did not. And, it is not entirely healthy even while it lasts. Between 2000 and 2007 – a period of solid aggregate economic growth – the typical working-age household saw their income decline by nearly $2000. The decline in middle-class incomes even as the incomes of the top 1% skyrocketed has a number of causes, but one of them is surely rising asset prices and the fact that financial sector profits exploded to the point to where they represented 40% of all corporate profits in 2006.

Confidence today will be enhanced if we put measures in place that assure that the coming expansion will be more sustainable and fair in the distribution of benefits than its predecessor. That is why the President has priorities that go beyond the immediate goal of containing the downturn and promoting recovery.

I think that is the perfect way to rebut the stodginess of the naysayers who have decided Obama is doing too much too fast. In fact, laying the foundation for sustainable growth goes hand-in-hand with that progress on health care and energy and education. It will make business more competitive, and increase home-grown manufacturing industries. Most of all it will bring the economy into balance, so that the "industry" of wealth creation isn't too big to fail and instead performing its actual function of facilitating the flow of capital through the real economy. Obama addressed this as well in remarks to the Business Roundtable. We can't have bubble and burst cycles anymore that rip up the middle class who didn't create them.

You see, we cannot go back to endless cycles of bubble and bust. We can't continue to base our economy on reckless speculation and spending beyond our means; on bad credit and inflated home prices and over-leveraged banks. This crisis teaches us that such activity is not the creation of lasting wealth -- it's the illusion of prosperity, and it hurts us all in the end.

Instead, we must build this recovery on a foundation that lasts -- on a 21st century infrastructure and a green economy with lower health care costs that create millions of new jobs and new industries; on schools that prepare our children to compete and thrive; on businesses that are free to invest in the next big idea or breakthrough discovery.

In addition, Summers defended the need for increased labor protections.

If we want to propel this economy forward and we want to have a sound expansion, it has to be an expansion whose benefits are more broadly shared. And that goes to questions of tax policy... It goes to the questions of education over the longer term. And it goes to the question of having a healthy and well-functioning trade union movement. And I think it is hard to avoid the conclusion that the way in which our labor laws have functioned, and have been enforced and been acted on over many years, have not been constructive from the point of view of having a healthy trade union movement. And an attempt to redress that balance seems to me something that is appropriate at such a time.

I think this is a good philosophy going forward. It's the right message, and one that's harder to argue with. The Masters of the Universe broke the economy, and now we have to take the steps to ensure it never happens again. But in addition, we have to reward work and not wealth, so that these greedheads aren't even in the position to try it.