Saturday, December 13, 2008

Where next? First in an occasional series.

The global financial and economic crisis is only one of the developments that make 2008 appear to be a bit of a watershed. There's clearly a lot of thinking internationally about this new era and I'm just going to link to some of it.

In the realm of ideas, things are up for grabs in a way they haven’t been for several decades now. That is what makes the present both an anxious and an exhilarating time.

That from Francis Fukuyama, courtesy of The Washington Note.

Fukuyama is among those who see a possible end to the Reagan era in US politics. Specifically on financial deregulation, tax cuts and foreign policy. The first two aspects might be relevant to other countries.

There are three core Reaganite ideas that need to be reformulated or discarded altogether if the United States is to navigate the current crisis and restore its credibility in the new era. The first has to do with deregulation and the role of the government in the economy more broadly. The Wall Street collapse and the big recession we are heading into occurred for reasons intrinsic to the Reagan model, that is, because the government had permitted the emergence of an enormous, wholly unregulated shadow finance sector under the belief that this sector would be self-correcting. Financial market liberalization had proven highly dangerous in any number of earlier cases, most notably the Asian economic crisis of 1997-98 and the Swedish banking collapse of the early 1990s, but these warning signs were not heeded and no one imagined that this could happen to the United States itself. In this the Democrats were fully complicit, not just in their support for loan expansion by Fannie Mae and Freddie Mac, but in Clinton Treasury Secretaries who pushed financial market liberalization on the developing world. The current crisis of course has many other causes, such as the more than $5 trillion of excess savings pouring into the country from China and other Asian countries after 2002, but the idea that history was on the side of ever-expanding deregulation was ultimately an important cause of the collapse. The Reagan-era joke, “Hi, I’m from the government and I want to help” doesn’t sound so ironic in light of the Fed and Treasury’s heroic efforts to keep the economy from walking further off a cliff.

The trick in redefining the model is not to overdo it on the regulatory side. The financial sector is very different from other parts of the economy because failure there imposes enormous spillover costs on everyone else, and is why Congress ended up having to vote for the $700 billion bank bailout in September. Labor market deregulation, by contrast, has had very beneficial effects in driving down unemployment rates and permitting much more rapid adjustment to changing conditions. American income distribution has gotten excessively skewed towards the wealthy, but we don’t want to fix that problem by returning to a trade union dominated labor market.

The second big Reaganite idea that needs to be rethought concerns taxes and spending—i.e., fiscal policy. Reagan introduced the notion that tax cuts would be self-financing because all taxes smothered growth; he was also responsible for promoting the idea that virtually all new government spending outside of defense would necessarily be wasteful. While there is some rate of taxation for which this is true, the actual tax cuts enacted both in the 1980s and in the early 21st century have simply served to deepen fiscal deficits and further skew income distribution to the wealthy. The impact of these deficits was for many years masked, however, by the fact that foreigners were wanted to hold their ever-mounting reserves in dollars, a phenomenon that put off the final reckoning but ensured that the fiscal crisis would be much more severe when it finally arrived.

This attitude towards taxes and spending has rendered the American political system incapable of confronting, first, the huge looming entitlement crisis over social security and Medicare, and second, energy. The single best thing we could have done for ourselves in the past generation was to impose a stiff carbon tax in periods when energy prices were relatively low; it was also something that no politician had the courage to take on. No one is going to be talking about increasing taxes until we are out from under the current recession, but in the long run Americans will have to learn to pay their own way.

Secondly, take a look at Ian Macfarlane's lecture to the Lowy Institute last week. Macfarlane was for a decade the Governor of the Reserve Bank of Australia. He reviewed the financial crisis and its effect on Australia before discussing possible regulatory developments.

When it is time to rebuild the regulatory system, I have no doubt that it will have to be more all-encompassing than formerly, but I don't see any likelihood of us returning to the old price-control type system that we had 30 years ago. To me the major challenges will be to:

- rein in what is left of the "shadow banking system";
- be able to measure the aggregate gearing ratio of the financial system and use this as a guide to policy;
- incorporate the risks arising from the reward structure of management into the regulatory framework;
- do something to address the inherent pro-cyclicality of conventional risk management frameworks and systems of bank supervision;
- resist the calls for self-regulation. As one astute commentator observed -- "self-regulation is to regulation as self-importance is to importance";
- bring some of the derivative instruments, particularly credit default swaps back onto an exchange so we can at least measrue their extent and the risks embedded in them, as well as reduce counterparty risk.

1 comment:

Steve Withers said...

I'm glad Fukuyama is rediscovering what other have been saying for years: tax cuts were dumb. I took him long enough!

It's a bit sad that here in NZ we are now emarking on the same siliness GW Bush kicked off in 2001 when he insisted on introducing tax cuts in downturn, leading to (predicted) monster deficits and making the great interest rate wheel start to turn in a way that lead to the current crash.

All the ideologues on the Right appar to be utterly unaware than the prosperous civilisation we currently enjoy began in earnest with the introduction of redistributive taxation and benefits. To the extent Reagan began winding these back, he began to return us to the days of wealth disparity and boom / bust....which Fukuyama alludes to.

I like much of the Aussie's advice. Very sensible.

But as to where we are headed...It doesn't add up to me. Right now, we are "fixing" the problem of falling demand by lighting a new fire under the underlying debt problem by making and cheaper debt available.

That won't go anywhere in the long run but dark, unpleasnant places. We aren't there yet...but the clock is ticking.