Rebooting the economy: The House stimulus package is bitter medicine for a sick economy

Munir Quddus
Online Journal Guest Writer

http://onlinejournal.com/artman/publish/article_4314.shtml

Feb 3, 2009, 01:40

The $819 billion stimulus package approved last week on a 244-188 vote is historic given its size and scope.

It is surprising that the House Republicans did not find anything in the bill to support given that the bill includes at least $275 billion dollars in tax cuts. The Republican support for the Senate’s version of the stimulus package will send a strong symbolic message in these troubling times.

Although, the House bill in its current form is not perfect, it is the right medicine for an ailing economy that shows signs of getting much sicker rapidly. The medicine is never pleasant and sometimes bitter, but if the patient is on the operating table, there are few alternatives to the bitter medicine.

Most economists, including several who have won the Nobel Prize in economics, agree that waiting for the economy to right itself, or to employ the single weapon in the government arsenal acceptable to the House Republicans, a tax cut, will not do the trick. This much is evident from the experience in recent years. In a $14,000 trillion economy, a loss of one percent in the GDP growth represents a loss of nearly $140 billion in incomes and a large reduction to the tax base. If the stimulus package succeeds in adding even 3 to 4 percentage points to the GDP growth in 2009 and 2010, it would have more than paid for itself.

The statistics on the economic slowdown are not in dispute. The US economy officially fell into a recession in December 2008, with the unemployment rate at 6.5 percent, the highest in 14 years. A record 1.2 million Americans lost their jobs in 2008. This represents a loss of roughly $100 billion in incomes each year. If nothing is done, some economists have predicted millions more will join the ranks of the unemployed, as the unemployment rate could reach 8.5 percent by the end of 2009.

Consumer confidence is down sharply and most worrisome is that the financial sector remains in total disarray with a real possibility that large parts of the banking sector may have to be temporarily nationalized. Even though aggressive moves by the Federal Reserve seem to have averted a financial and economic cataclysm, the deepening economic crisis is unprecedented and calls for fresh and bold solutions.

According to Mark Zandi, chief economist of Moody’s Economy.com, “The economy’s long-term, underlying growth prospects have been reduced, not forever but maybe for five or 10 years.”

Warren Buffet, the billionaire investor, recently described the US economic situation to “an economic Pearl Harbor.”

U.S. Rep. Kevin Brady (R-8th Dist, Texas) explained his opposition to the bill in an article published in the Houston Chronicle last Friday. He argued that historically the stimulus packages have seldom worked, and their impact are usually too little and too late. He believes that there is a chance that the stimulus package may do more harm than good “as middle class families and small businesses ultimately shoulder the higher taxes needed to pay for this spending spree.” He went on to say, “I can’t find an economist anywhere who will admit that contraceptives, zoo exhibits and repairs to the Jefferson Memorial are serious economic boosts.”

I am not sure which economists Rep. Brady is listening to, but along with many of my fellow economists, I believe that government spending can stimulate a slowing economy by creating new jobs and incomes. Most macroeconomic models show that in times of such acute distress, direct government spending, not monetary policy, has a better chance of quickly stimulating the economy to create new jobs and incomes in an ever expanding virtuous cycle as the multiplier effect works through the economy. How do we know this?

Let us begin with the ideas of a famous 20th century economist, Lord Keynes. A Cambridge University professor who had worked at the highest levels in government published his last major book, The General Theory of Income, Employment and Income in 1936. The ideas expressed in this book eventually came to be known as the Keynesian Revolution in economics. Keynes produced a fresh and logical analysis of the economic malaise — that it was caused by insufficient demand that can only be corrected by government spending to boost aggregate demand. His recommendations were embraced by most professional economists around the world. Keynes met President Roosevelt who adopted many of his suggestions. The New Deal programs and the vastly enhanced government borrowing to finance the war spending finally pulled the US economy decisively out of the Great Depression. Remember war spending is also a form of government direct spending.

Keynes’ model completely upended the orthodoxy called Classical economics which was based on Say’s Law — the idea that supply creates its own demand in the economy. In other words under the Classical model of economics, production will always result in sufficient income and demand, so that there is never a situation of over production or recession. Since there will never be a recession in the economy, there was scarce need for government intervention. The central bank’s control of liquidity (monetary policy) should be sufficient to ensure full employment and economic growth. This rosy view of the full-employment economy ran into a brick wall in the years after the stock market crash of 1929 and the resulting banking crises. The economies in most of the industrialized world were stuck in a long and deep recession — The Great Depression of the 1930s — and this demanded new models and solutions. The Classical economists had no good answers to get the economy out of the deep and painful economic contraction. The same seems to be true of the position taken by the House Republicans today.

A lot has happened since 1936 and the New Deal. Economic science has progressed. Keynesian ideas considered revolutionary in 1936 are now conventional wisdom. These ideas even sparked a counterrevolution by University of Chicago’s Milton Friedman who revived the Classical model. However, with the collapse in the financial markets and its disastrous impact on the real economy, the pendulum of fashionable ideas is swinging back to the Keynesian model. The mantra of “tax cut for a trickle down solution” and “market knows what is best” stands discredited by the global financial crises.

President Barack Obama and his economic team are the main force behind the House stimulus package. The bill presents a strategy to combine tax cuts and spending increases to jumpstart a badly ailing economy. Many in the business world support the effort. It is unfortunate that millions of Americans who are suffering because of lost jobs and closed businesses are not very vocal. Since they don’t contribute to campaigns as much or employ lobbyists, few politicians speak for them.

The stimulus package includes an estimated $544 billion in new spending and $275 billion in tax reductions mostly for middle income households and businesses, including small businesses. Given the nature of the political process, there are some “shock and awe” type of spending programs in the bill. However, the emphasis is on job creation, immediate relief, investments in education and healthcare, and infrastructure. The bill includes scores of programs to rebuild the fading infrastructure, such as highway construction and mass transit projects, but far more is reserved for immediate relief to those impacted most severely by the slowdown through unemployment benefits, health care and food stamp programs.

The intent of the stimulus package is not to increase welfare, but to create new jobs and save businesses from going under. Tens of billions will go to states to shore up their tottering budgets, and additional funds are set aside to build schools, improve law enforcement and improve energy efficiency.

The president said, “This recovery plan will save or create more than 3 million new jobs over the next few years.”

On the tax relief side, there is a $500 tax break for single workers and $1,000 for couples, including those who don’t earn enough to owe federal income taxes. This last piece is especially irksome to House Republicans as they consider this to be welfare.

To conclude, under normal circumstances few economists like deficit financing, but these are troubling times. During a deep and worsening recession, most economists support government spending as the most effective antidote to the slowdown. Economists understand a percentage of the spending will be wasteful, but the need to reboot the economy for the greater good of the society trumps these concerns. Once recovery is on hand, spending should be quickly scaled back and new sources of revenues added to reduce the budget deficit, and cut the menacing national debt.

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The Great Recession – Why Government Intervention? The Promise and the Pitfalls

The American economy is in the middle of a ferocious retrenchment.  The statistics are not in dispute. The economy shed more than 651,000 jobs in February 2009, on top of over 500,000 jobs lost in January, bringing the total number of Americans looking unsuccessfully for work to a staggering 12.5 million. The national unemployment rate is a record 8.1%, a thirty year high. Drilling down below the national averages, the unemployment numbers are much worse for some groups. The unemployment rate last month was 13.4% for African Americans and a whopping 21.6% for teenage workers. A distressing 15 % of the unemployed have a college degree.  This is a huge waste of precious national resources, and a personal tragedy for those unemployed, and their families.

According to the most recent estimates from the Bureau of Economic Analysis, in the 4th quarter of 2008, the total economic pie as measured by the Gross Domestic Product contracted a stunning 6.3% on an annualized basis. The declines were deep and cut across all sectors of the economy.  Unsurprisingly, the only sector where demand increased was government spending and net exports since imports were down. Warren Buffet, the world’s most famous investor and a shrewd student of the economy, appropriately described the situation as “an economic Pearl Harbor.”

It is not surprising that the average citizen is confused and scared.  There are many unanswered questions.  What happened? How did we get here? How could some of the world’s most profitable businesses make such bad decisions? Why were so many analysts wrong? How could politicians, government officials, and regulators create this mess?  Did institutions of democracy and capitalism fail the people of America?

There is plenty of blame to go around.  Clearly even as some of those responsible for the economic fiasco have paid a price for poor judgment, unfortunately many others have not. This guarantees that the errors that led to the crisis will be repeated. According to most unbiased analysts, the current economic malaise originated in the growth and eventual collapse of a massive housing bubble and subsequent meltdown of several large firms in the vastly bloated and overleveraged financial sector leading to a freezing of the credit markets for important segments of the private economy.

The cumulative impact of greed, excesses, and hubris in Wall Street and in the halls of power was a catastrophic meltdown in the financial heart of the nation, and a collapse in the real economy that has cascaded to the rest of the world. In a blink of the eye, a staggering $14 trillion dollars in wealth has disappeared by some estimates, mostly in equity markets and business bankruptcies.  Despite a massive $700 billion bailout of the rogue financial companies, and an equally big stimulus package, the economy has yet to stabilize from its downward spiral.

Thanks to globalization, the crisis in the US economy has rapidly spread throughout the global economy, infecting one nation after another. Economic historians have to go all the way back to the stock market collapse of 1929 and the ensuing Great Depression of 1930s to find a crisis of similar depth and proportions; the Great Depression was also caused by the collapse of an overly bloated economy and stock market from reckless speculation that eventually spread to shutter down thousands of banks sending the economy into the dark tunnel of a decade long recession.

The trillion dollar question is, should the Federal government and the Central Bank wait for the economy to self-correct, or urgently intervene to prop up the economy? Consider some numbers.  If the economic decline continues at this pace, unemployment rate could be at double digits by summer of 2009.  For a $14.3 trillion economy, a one percent negative growth in the GDP results in the potential income loss of roughly $143 billion on an annualized basis. If the fiscal stimulus can be a catalyst for even a few points of positive GDP growth, it will pay for itself in greater incomes and output.

If nothing is done, no one knows how long it will take the economy to recover on its own. Looking at other major economies in Europe, and China who are caught in the crisis, none seem to be waiting for the economy to self-correct.  China has already announced a massive stimulus of over half a trillion dollars in infrastructure development. After Japan’s real estate bubble burst in the early 1990’s, analysts point to the lost decade in Japan once due to the slow and indecisive  response by the policymakers.  Fortunately, we can learn from Japan’s experience and not repeat errors made by their policymakers.  It would be tragic and wasteful for American workers and businesses to suffer through years of a painful recession which would erode the nation’s competitive position in the global economy.  Most economists agree on what ails the economy, and historically tested remedies are available.  A sufficiently large stimulus in the form of a combination of direct government expenditure and tax cuts should jolt the economy back to path to full recovery.  Like a bitter medicine given to a sick patient, the stimulus would have some unpleasant side effects and would take time to heal the economy, but it eventually it would.  It is a small down payment for nursing the economy back to good health and robust long term growth.

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The Clash of Ideologies – Economic Policy in Dismal Times

April 21, 2009

During the debate on the Senate floor on The American Recovery and Reinvestment Act of 2009, Senator McCain said, “This is not a stimulus bill; it is a spending bill.” Was he correct in making a distinction? By definition, a stimulus package is a spending package.  It is meant to add to the demand in the economy.  John Maynard Keynes, founder of the school of thought that prescribes aggressive government intervention to energize a slowing economy used an interesting metaphor to make his point – suppose the government would employ workers to dig ditches and subsequently fill these up, even though this would be unproductive use of labor, it will indeed benefit the economy through a process of secondary spending and re-spending – the multiplier effect – which will help create new incomes and productive jobs.

If the outcome of the Obama administration’s $787 billion Stimulus Package is a lasting improvement in the physical infrastructure, in the schools and bridges, in new energies, in the development of the first high speed train in the country, and the education of the young – this not only adds to demand in the short run but also creates conditions for a boost in productivity when the recovery gets underway.  These spending are not consumption or wasteful – they are investment in the future of the nation.  Over the years, both Democrat and Republican administrations have used the idea of fiscal stimulus to rescue a slowing economy.  In 1971, Richard Nixon, no liberal, famously remarked, “We are all Keynesians now.”

Yes, it is the entrepreneurs and the small businesses whose ingenuity and hard work create most of the jobs, but even the entrepreneurs need a framework to be successful.  This includes a healthy banking system, availability of credit, and customer confidence.  Both the House and the Senate versions of the Stimulus package include tax cuts that would result in higher disposable income for low income household to spend.

Tax cuts by themselves are seldom a cure-all for a slowing economy.  Consider the $168 billion Bush tax rebate introduced in February 2008 as part of the $300 billion Bush stimulus package. By most accounts, the impact was minimal. Most economists believe that tax cuts have a smaller bang for the buck due to our propensity to save a chunk of the tax check and the fact that some of the spending is on imported goods.  The supply side benefits of a tax cut popularized by A. Laffer have been found to be wanting.

Jesse H. Jones, the legendary Houston banker appointed as the Federal Loan Administrator by President Roosevelt, wrote, “Old and deliberate methods, dear to many, were necessarily brushed aside in order the people may have food, clothing and shelter, and that their homes and savings may not be taken from them. Fighting a depression is no different than from fighting a war.  In either case the entire resources of a nation must be used in necessary.”

If there was a time to set aside ideological differences, this is the time.  The Republicans should check save their mantra that free market does best when left alone for normal times. We are facing a crisis of historical proportions. A lot of factors cause and sustain an economic slowdown.  Not the least is the fear of failure.  Consumers and businesses pull back and the fear is infectious.  It will help dispel this fear, if the politicians act in a united manner to show their intent and determination to meet the challenge.  A house divided is a house weakened.

There is a clear and present danger that the nation’s economy could get much worse before eventually recovering.  By voting into law a bold stimulus package, Congress has conveyed a strong message to the rest of the world that America is serious not only about defeating terrorism, but also in once again leading the world as the world’s largest and most dynamic economy.

As President Obama recently said China and other creditor worldwide should feel their investments in America is safe. The American economy is by far the largest in the world and has been a growth engine pulling the global economy.  It is incumbent on the politicians and policymakers to act decisively and responsibly to restore confidence at home and abroad so that America emerges from the recession stronger than before.

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Managing Future Price Bubbles in Crude Oil Markets

Munir Quddus
muquddus@pvamu.edu
July 9, 2009

Federal regulators, including the Commodities Futures Trading Commission (CFTC), are considering new restrictions on “excessive speculation” in markets for oil, natural gas and other energy products. Similar regulations already exist in markets for agricultural products such as wheat, corn and soybeans to preclude manipulation by large players.

These efforts has gotten some folks roiled up.  Critics have claimed that any attempt to regulate speculative trading would be anti-free market.  Others have noted that speculation is an essential force that moves markets towards equilibrium.  Therefore, any attempt to reduce speculation will retard market innovations and benefits such as risk sharing, liquidity and efficiency.

These critics miss the point.  Contemporary research by economists, and study of business and economic history reveals that speculative trading can be both healthy and unhealthy for market integrity and efficiency.  Although, without traders and speculators markets cannot function efficiently, too excessive speculation can be fatal to market stability and efficiency.  The recent painful collapse of the housing bubble which led to the global financial meltdown should at the minimum serve as a stark reminder of the dangers inherent in markets that sometimes spin out of control. Markets do not always move towards an equilibrium.

Last year, the price of crude oil soared to an all time high of $147 per barrel, more than a 200% increase in less than a year.  The sustained rise in crude price was unexpected but convincing.  Numerous industry experts and economists concluded that price spike was indicative of fundamental changes in market demand and supply, and not caused primarily by self-fulfilling expectations of higher prices otherwise called a bubble. Factors such as high demand in India and China were mentioned.  Even top notch economists like the Nobel Laureate Paul Krugman ruled out the existence of a bubble, given the low inventory levels in crude oil.

The consequences of the sustained rise in crude oil prices were harsh on the global economy. Since crude oil and energy is a crucial ingredient in the production of agriculture products, the impact on food prices was predictable and debilitating.  Food riots broke out in many developing nations with millions of low income families squeezed in a vicious crisis from escalating price of rice and other essentials.

Fortunately, most experts were wrong.  The spectacular increase in crude oil price was in fact caused by excessive speculation, or a price bubble.  Fundamentals such as a sustained increase in demand from economic growth in India and China played a relatively minor role. A market bubble is created and sustained by easy money and excessive speculation from an influx of unsophisticated traders.  Traders who take long positions in markets infected by a price bubble are not acting irrationally, but the market outcome is highly inefficient.  Rational traders can behave with a herd mentality, causing irrational outcomes. A bubble is not sustainable, and when conditions are right it collapses. Once the crude oil price bubble popped in 2008, in a classic manner prices fell rapidly until they were below $35 a barrel, a dizzying collapse of more than $111 dollars per barrel in a few months.  Typically, a collapsing bubble overshoots before reaching the true equilibrium.

Those who oppose the proposed CFTC legislation have presented various arguments.  First, some argue that it is a mistake to try to separate the two types of traders – speculators from hedgers, since both add liquidity.  Second, some state that since speculation is a market force, it must be allowed unimpeded.  Third, the argument is made that speculation is harmless.  Fourth, an argument is heard that regulation impedes markets and is anti-capitalistic, and harmful. One hears that yes, market gyrations can be painful, but attempts to control the fluctuations can be even more harmful.

None of these arguments stand up to close scrutiny.  The case for judicious regulations can be made relatively easily. First, it is relatively easy to separate and regulate trading motivated by a desire to spread the risk, and trading for profit motive only. This is already done in other countries and in US agricultural markets. Second, economists who have studied speculative price bubbles realize that at some point retail investors who are generally unsophisticated wade in creating greater instability. Third, even though normally speculative forces, through arbitrage, lead to improved market efficiency, these markets can spin out of control if excessive speculative funds come in.  According to estimates, at the peak of the crude oil bubble, demand was several times what could be justified by fundamentals. Contrary to the common view, speculation can be destabilizing eventually creating millions of victims including small businesses and retail traders.

Free markets were never meant to be free of all rules.  Good regulations play the same role in markets, as good traffic laws play in transportation.  They ensure efficiency and safety of all participants.  It makes little sense to allow price bubbles to grow unimpeded and wait to clean up the mess after the bubble pops.  Good regulations can prevent bubbles from forming, and can pop these before they grow too big.

In case of the recent run up in the crude oil markets, by intelligently using the Strategic Oil Reserves, policy makers could have intervened to prevent the rise and fall of the 2007-2008 crude oil bubble.  This would have been justified on national security grounds, and would have been good for consumers and investors in America and globally.  A bubble creates and feeds on artificial scarcity – by giving appropriate signals can influence expectations and puncture a growing bubble. As a result of cutting edge research, policymakers now have a number of additional tools in their arsenal to identify and stamp out bubbles. This includes reducing leverage by raising margin requirements, raising interest rates to reduce excessive liquidity, making fundamentals more transparent, and warning against the dangers of irrational exuberance.

By moving to curb excessive speculation, while preserving the ability of traders to conduct the normal transactions for risk sharing, CFTC and other Federal regulators are moving in the right direction.  Excessive speculation leading up to a price bubble can be absolutely toxic to the long term safety and health of markets.  To prevent the next bubble, it is crucial that regulators and politicians learn the right lessons from recent business history such as the dot.com bubble, and the more recent housing and financial markets (derivative) bubbles.  Clearly, these regulations must be placed in a coordinated fashion to close potential loopholes.

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Alan Greenspan’s Mea culpa – Too Little, Too Late

Munir Quddus
muquddus@pvamu.edu
November 3, 2008

On October 23, Alan Greenspan, the nation’s most celebrated Central Banker, affectionately called the “maestro” for his skillful handling of the economy over 18 years as the Nation’s Chief Central Banker, finally faced the music.  One must give credit to Mr. Greenspan for showing up more than two years after his retirement as the Chairman of the Federal Reserve Bank.  Certainly, not showing up at the Congressional testimony would have been even more damaging to his carefully nurtured image as the nation’s foremost economic seer.

Mr. Greenspan, a Republican and self proclaimed admirer of Ayan Ryan’s somewhat extreme economic views that markets are always correct, has been a fixture in the Washington policy circles since the days of President Nixon.  During much of his tenure at the FED, Greenspan enjoyed a “large than life” persona, a celebrity who led a charmed life at the highest echelons of power.  The Chairman of the Fed is often called the most powerful man in the country, ahead of the President given the impact of monetary policy on the every day life of each American.

The questions from Congressman Henry Waxman, Chair of the House Banking Committee were direct and rough:  “You had the authority to prevent irresponsible lending practices that led to the sub-prime mortgage crisis. You were advised to do so by many others. Do you feel that your ideology pushed you to make decisions that you wish you had not made?” The Congressman reminded the former Fed chairman that he had been one of the nation’s leading defenders of deregulation, reading past statements in which Mr. Greenspan had argued forcefully that government regulators were no better than markets at imposing discipline.

What Congressmen Waxman and others should have asked was: How much did Mr. Greenspan personally benefit from his persistent opposition to regulations of the hedge funds and the derivatives? Why did the former Chairman of the FED, in his role as the regulator in chief of all financial markets, fail to take steps to stop the bubble when he was fully aware that one was growing? Why did he not adequately assess the risks to the financial system of the credit swaps and other derivatives and in banks getting ever larger? Why did Mr. Greenspan not learn from the real world crisis during his tenure – the collapse of the dot.com bubble, and the meltdown of the hedge fund Long Term Capital Management, when excessive leverage from the use of derivatives nearly brought down the financial system? Has he not read economic history to realize that time and again markets are disrupted by excessive greed and deceit leading to much misery? Why did he actively undermine the New Deal regulatory infrastructure put into place seventy years ago to prevent precisely this type of speculative excesses?

Mr. Greenspan, the high priest of unregulated capitalism, chastened by the unprecedented crisis was measured in his responses during his testimony: He said he was shocked that financial markets had failed to respond as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”  Under intense questioning he conceded that he had “found a flaw” in his bedrock believe of “40 years or more” that markets tend to self-regulate. “I made a mistake” a somewhat contrite Greenspan explained. “It has been painful to realize that I had put too much faith in the ability of the markets to self-correct.” “My view is that same as that of many in the academic profession including Nobel prize winning professors.” Finally he confided that while in office he had no clue that a financial catastrophe was in the making.  Besides, the best computerized economic models in the country that are used by the FED, also failed to anticipate the financial tsunami.

Shocked and surprised?  This is incredulous.  Mr. Greenspan with a doctorate in economics is an expert on financial and economic history.  He should be fully aware of the long history of manias panics and speculative binges that have from time to time turned the financial markets into gambling casinos.  He has lived through and perhaps contributed to some of crises, from the 1987 stock market crash to the LTCM debacle; from the growth to the crash of the dot.com bubble.  These are enough to teach several lifetimes worth of lessons.

Mr. Greenspan’s Mea culpa is too little and too late.  First his statements do not sound like an apology.  He sounds as if he is still passing the buck instead of taking responsibility for his role in leading the nation into an economic debacle.  Second, the expression of regret is late.  As the economy spun out of control, he remained quiet.  In his recently published book for which he received an advance of $3 million, he failed to mention any of this. Finally, he cannot say that he did not have full information of the extent of the rot and the growing bubble.

The basic lessons are few: Do not put blind faith in the markets.  Prudent regulations are best for productive capitalism.  Look out for greed and excessive speculation.  Make sure the ability to leverage is constrained and transparency rules.  Keep an eye for any asset bubbles, and defuse these before they become “too big to fail.” As Adam Smith, the father of modern capitalism said, do not trust big business.  Power always corrupts.  Make sure the regulators identify and crush market power before it is too late.

For more than 18 years as the Chairman of the FED working with several administrations, Mr. Greenspan enjoyed vast powers. During this period, he was a fearless advocate of Laissez-faire capitalism and defender of deregulation.  He worked aggressively to block sensible regulations proposed to monitor and manage the derivative market, now considered a $65 trillion cloud casting a long shadow over the economy.

His intellectual and moral stature in the nation’s capital and on Wall Street was unique.  He was widely respected and admired, even feared.  He was considered the nation’s foremost authority over all things relating to the economy. He could have given a siren call for restrain and for regulating the secretive hedge funds. He could have single handedly called for new regulations.  He could have directed the Fed to use if vast powers to regulate to penalize some of the worst offenders of speculative excesses and send a clear message.

Clearly he was not an independent observer.  His politics has long been known.  He is a Republican, but as the chief of nation’s central bank, he was expected to serve as a unbiased public servant.  He did not do so.  He constantly opposed taxes. He always supported President Bush’s tax cuts when these cuts threatened to greatly explode the annual deficits and add to the national debt.  He is also much overrated as a economic forecaster.  In 2004, he said, “Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”

In the case of the LTCM, he successfully engineered a bailout.  He was in the room with the big bank CEOs and had information the rest of us did not.  He knew how close the system came to a meltdown. Did he not learn any lessons from this experience that the best and brightest can get caught in greed and indulge in irresponsible investments? Did he not learn how fragile and interdependent the system has grown? Was he not aware of the awful power of leverage from derivatives and the comments made by Warren Buffet that these were “(financial) weapons of mass destruction,” and must be monitored and controlled? Why did he used the full weight of his authority to unambiguously stop attempts to regulate the derivative markets? Why did he and his colleagues on the FDIC not seriously warnings from seasoned market participants like Warren Buffet who in 2004 called derivatives, “financial weapons of mass destruction.”

Unfortunately for America, Mr. Greenspan was overrated as an economic guru and as a sage.  He is an ideologue and not a moderate.  He is opposed to regulations, even good ones, as a core principle of his thinking. Is there a single regulation he has proposed, defended or strengthened? Can he point to any attempt on his part to restrain the excesses in the market (beside the lonely comment on irrational exuberance)? Can he claim in good faith that he and his colleagues did not have all the facts about the bubble in the nation’s housing market?

The real danger from this tragic episode is that Mr. Greenspan and other ideologues are far from convinced that markets are an imperfect device for creating wealth.  The blind faith in free markets – the mantra that markets are always efficient and right and never mistaken- are deeply embedded in the psyche of this nation.  Common sense and a cursory reading of financial history eloquently make the case for market imperfections and judicious regulations.  Yet ideology is powerful.  It can dazzle and spell bound the most analytical mind as well as the average citizen.  In this environment, Senator McCain’s attempt to raise the bogeyman of socialism makes perfect sense. The dreaded socialism – redistribution of wealth is as un-American as one can go.  Any attempt to reform or improve market performance is immediately labeled as an attempt to “regulate” the market, will increase inefficiencies, eliminate liberty and competition, and will be a step towards a complete control of markets – socialism.  According to this mindset, either you are for free unregulated markets or against it.  There is no middle ground in this debate.  Absurd as this view is, it has had considerable influence on the US economic policy and political arena.

The leaders of the unfettered or unregulated capitalism movement have invested too much in buying and selling the snake oil equivalent of the mantra that markets are the best mechanisms for self-discipline.  They refuse to learn from economic history and modern economic research that demonstrates that markets are never perfect, have lopsided information and participants often behave irrationally overcome by greed and hubris.  Just as in government, power corrupts.  Therefore, a system of checks and balances is good for the markets.  We need regulators to play cops in the financial streets just as we depend on cops to stop the criminals and protect the good citizens.  Just as we need fences for good neighbors, or the sprinkler for the remote possibility of a fire, we need regulations for all the parties to know the limits of what is allowed and what is not, and institutions that play that play the role of lender of the last resort.

Given this dismal conclusion, the cycle of boom and bust will continue in the future, and may even get worse.  This loss from the 2008 bust of $8 trillion may look like peanuts when ten years from now we run into the bursting of another bubble that may wipe out $20 trillion or more.  We must educate citizens, regulators, and politicians on the basics of capitalism.  We should make it mandatory that regulators read financial history to understand the power of human psychology in affecting markets to create as well as to destroy great wealth.

Market failure – economists call cases where markets fail to deliver the most efficient outcome as market failure.  This can happen if there is monopoly power in the hand of one large player preventing competition.  This can also happen if there are externalities so that the action of the buyer or seller has indirect implications for others.  For example, your education has positive implication for your neighbors since educated people are less likely to commit crimes.  If this is taken into consideration, the society or community should invest more into education (perhaps subsidize your college education) but it is often not.  A bubble will be yet another example of market failure since a bubble outcome – price or output – is far from optimal or efficient.  The aftermath is always wasteful and painful.  Whenever, possible a bubble must be prevented and controlled.  Some have hypothesized that the FED under Greenspan deliberately created the Housing bubble, or failed to prevent its growth, given they had other more important considerations (wanted to prevent a Japan style long recession).  From their perspective, the bubble would be the lesser evil.  Now we know how foolish this notion is.

 

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The Clash of Ideologies – Economic Policy in Dismal Times

April 6, 2009

During the debate on the Senate floor on The American Recovery and Reinvestment Act of 2009, Senator McCain said, “This is not a stimulus bill; it is a spending bill.” Was he correct in making a distinction? By definition, a stimulus package is a spending package.  It is meant to add to the demand in the economy.  John Maynard Keynes, founder of the school of thought that prescribes aggressive government intervention to energize a slowing economy used an interesting metaphor to make his point – suppose the government would employ workers to dig ditches and subsequently fill these up, even though this would be unproductive use of labor, it will indeed benefit the economy through a process of secondary spending and re-spending – the multiplier effect – which will help create new incomes and productive jobs.

If the outcome of the Obama administration’s $787 billion Stimulus Package is a lasting improvement in the physical infrastructure, in the schools and bridges, in new energies, in the development of the first high speed train in the country, and the education of the young – this not only adds to demand in the short run but also creates conditions for a boost in productivity when the recovery gets underway.  These spending are not consumption or wasteful – they are investment in the future of the nation.  Over the years, both Democrat and Republican administrations have used the idea of fiscal stimulus to rescue a slowing economy.  In 1971, Richard Nixon, no liberal, famously remarked, “We are all Keynesians now.”

Yes, it is the entrepreneurs and the small businesses whose ingenuity and hard work create most of the jobs, but even the entrepreneurs need a framework to be successful.  This includes a healthy banking system, availability of credit, and customer confidence.  Both the House and the Senate versions of the Stimulus package include tax cuts that would result in higher disposable income for low income household to spend.

Tax cuts by themselves are seldom a cure-all for a slowing economy.  Consider the $168 billion Bush tax rebate introduced in February 2008 as part of the $300 billion Bush stimulus package. By most accounts, the impact was minimal. Most economists believe that tax cuts have a smaller bang for the buck due to our propensity to save a chunk of the tax check and the fact that some of the spending is on imported goods.  The supply side benefits of a tax cut popularized by A. Laffer have been found to be wanting.

Jesse H. Jones, the legendary Houston banker appointed as the Federal Loan Administrator by President Roosevelt, wrote, “Old and deliberate methods, dear to many, were necessarily brushed aside in order the people may have food, clothing and shelter, and that their homes and savings may not be taken from them. Fighting a depression is no different than from fighting a war.  In either case the entire resources of a nation must be used in necessary.”

If there was a time to set aside ideological differences, this is the time.  The Republicans should check save their mantra that free market does best when left alone for normal times. We are facing a crisis of historical proportions. A lot of factors cause and sustain an economic slowdown.  Not the least is the fear of failure.  Consumers and businesses pull back and the fear is infectious.  It will help dispel this fear, if the politicians act in a united manner to show their intent and determination to meet the challenge.  A house divided is a house weakened.

There is a clear and present danger that the nation’s economy could get much worse before eventually recovering.  By voting into law a bold stimulus package, the Congress has conveyed a strong message to the rest of the world that America is serious not only about defeating terrorism, but also in once again leading the world as the world’s largest and most dynamic economy.

As President Obama recently said China and other creditor worldwide should feel their investments in America is safe. The American economy is by far the largest in the world and has been a growth engine pulling the global economy.  It is incumbent on the politicians and policymakers to act decisively and responsibly to restore confidence at home and abroad so that America emerges from the recession stronger than before.

Munir Quddus is a Professor of Economics and Dean of the Business School at Prairie View A&M University, Texas. He writes on the history of economic ideas. He can be reached at

email: muquddus@pvamu.edu.

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Why Government Intervention? The Promise and the Pitfalls

March 30, 2009

The American economy is in the middle of a ferocious retrenchment.  The statistics are not in dispute. The economy shed more than 651,000 jobs in February 2009, on top of more than 500,000 lost in January, bringing the total number of Americans looking for work unsuccessfully to a staggering 12.5 million. The national unemployment rate is a record 8.1%, a thirty year high.  Drilling down below the national averages the numbers are much worse for some groups. The unemployment rate last month was 13.4% for African Americans and a whopping 21.6% for teenage workers. A distressing 15 % of the unemployed have a college degree.  This is a huge waste of precious national resources, and a personal tragedy for those unemployed, and their families.

According to the most recent estimates from the Bureau of Economic Analysis, in the 4th quarter of 2008, the total economic pie or the Gross Domestic Product contracted a stunning 6.2% on annualized basis. The declines were deep and cut across all sectors of the economy.  The only sector where demand increased was government spending and net exports since imports were down. Warren Buffet, the world’s most famous investor and a shrewd student of the economy, appropriately described the situation as “an economic Pearl Harbor.”

It is not surprising that the average citizen is confused and scared.  There are many unanswered questions.  What happened? How did we get here? How could some of the world’s most profitable businesses make such bad decisions? Why were so many analysts wrong? How could politicians, government officials, and regulators create this mess?  Did institutions of democracy and capitalism fail the people of America?

There is plenty of blame to go around.  Clearly as some of those responsible have paid a price for poor judgment, many have not and will repeat these errors. According to most unbiased analysts, the current economic malaise originated in the growth and eventual collapse of a massive housing bubble; subsequent meltdown of several large firms in the bloated financial sector, that led to a freezing of the credit markets for important segments of the private economy.

The cumulative impact of greed, excesses, and hubris in Wall Street and Government’s halls of power was a catastrophic meltdown in the financial heart of the nation, and a collapse in the real economy that has cascaded to the rest of the world. In a blink of the eye, a staggering $8 trillion dollars in wealth has disappeared, mostly in equity markets and business bankruptcies.  Despite a massive $700 billion bailout of the rogue financial companies, and an equally big stimulus package, the economy is yet to stabilize from its downward spiral.

Thanks to globalization, the crisis in the US economy has rapidly spread throughout the global economy, infecting one nation after another. Historians have to go all the way back to the stock market collapse of 1929 and the ensuing Great Depression of 1930s to find a crisis of similar depth and proportions; the Great Depression was also caused by the collapse of an overly bloated economy and stock market from excessive destabilizing speculation that eventually spread to shutter down thousands of banks sending the economy into a tailspin.

The trillion dollar question is, should the Federal government wait for the economy to self-correct, or urgently intervene to prop up the economy? Consider some numbers.  If the economic decline continues at this pace, unemployment rate could be at double digits by summer of 2009.  For a $14.3 trillion economy, a one percent negative growth in the GDP results in the potential income loss of roughly $143 billion on an annualized basis. If the fiscal stimulus can be a catalyst for even a few points of GDP growth, it will pay for itself in greater incomes and output.

If nothing is done, no one knows how long it will take the economy to recover on its own.  Analysts point to almost ten lost years in Japan once it real estate bubble burst in the early 1990s.  Fortunately, we can learn from Japan’s experience and not repeat errors made by their policymakers.  It is unnecessary that American workers and businesses suffer through years of a painful recession which would erode the nation’s competitive position in the global economy.  Most economists agree on what ails the economy, and time tested remedies are available.  A sufficiently large stimulus in the form of a combination of direct government expenditure and tax cuts should jolt the economy back to path to full recovery.  Like a bitter medicine given to a sick patient, the stimulus may take time to work, and there would be some unpleasant side effects, but it eventually it would work.  It is a small down payment for more robust growth in the long run.

Munir Quddus is a Professor of Economics and Dean of the Business School at Prairie View A&M University, Texas. He writes on the history of economic ideas. He can be reached at

e-mail: muquddus@pvamu.edu.

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