After decades in the circular file, Keynesianism is back. There are lots of economic problems that the Keynesian paradigm isn’t designed to solve, but this is precisely the situation that Keynes diagnosed. For Keynes, financial markets are driven by waves of excessive enthusiasm followed by waves of pervasive fear. Fear translates into a desire to be liquid, which means converting all risk-bearing investments into cash. With the flight to cash, all savings available for investment dries up, and eventually the real economy contracts, since companies that can’t invest sufficiently from retained earnings find they can’t buy raw materials, pay their workers, much less put money into R&D.
Keynes argued there is no natural cycle whereby this pattern gets broken—it can produce a low-level equilibrium (hysteresis), since the flight to liquidity that caused the cycle in the beginning only gets reinforced by the collapse of the real economy. Especially when households are holding a lot of debt, tax cuts don’t necessarily solve the problem, since they simply get converted into net savings (from the reduction of debt, for example), rather than increasing net demand. In such a condition, the only thing that can pull the economy out of a low-level equilibrium is direct government spending, since government borrowing (at relatively low interest rates, due to the flight to quality) can directly fund economic activity that the market is too fearful to support. As the real economy is reinflated by government spending, cash starts coming in from the sidelines and the markets recover. Crises like this are an example of a massive first-mover problem-the money to support economic activity is out there, but no one wants to be the first one to start investing again. Government has to be the first mover.
Now, I’m not an economist, but this seems very much like the situation we’re in now. There’s a massive flight to quality, which we’re seeing in the spread between short-term Treasuries and corporate bonds, and the fact that Warren Buffett has to be offered the equivalent of a convertible bond worth ten percent by GE or Goldman Sachs to be willing to give them money. This flight to quality is driven by fear. Now, part of the fear is driven by problems in the market for mortgage-backed securities, and there’s an argument that having Treasury buy, price and then resell these securities may reduce some of that fear. But fear-driven moves into liquid assets can last a long time after the original cause has disappeared, and in the meantime the consequences for the real economy can be huge. We could try to deal with the problem by cutting taxes, and there was some indication that last summer’s refund checks had some effect, but it seems as if a lot of them got pushed into reducing debt rather than spending.
The implication is that the current Treasury bailout isn’t going to be enough, and that government will have to solve the problem by providing money for investment directly. I would be shocked if this weekend passed without the Treasury agreeing on a coordinated plan with the finance ministers of the other advanced industrial countries to inject money directly into the banking sector, which is probably what they should have done two weeks ago. But I don’t think this is enough.
The papers this morning say that Congress is putting together another stimulus plan. That’s fine, but my big worry is that they’ll be too timid. The level of stimulus that the situation requires, if it’s going to fill the gap left by private sector fear, is simply enormous. The Feds are going to have to spend a ton of money just to keep state and local governments from cutting their budgets. Getting them to spend more is going to require a level of spending—and borrowing—that is simply unprecedented in our recent experience. I am frightened that Obama hasn’t really gotten this yet, and hasn’t done what he need to do to make it clear to Americans that the orthodoxies of yesterday must be thrown in the trash can.
For example, this is simply not the time to get all finicky about government spending and deficits—Obama’s attempts to sound like a fiscal hawk in the last debate were (and I know Mark will jump on me on this, but what the hell) simply irresponsible. Obama should simply say, directly, that, “John McCain is still talking about cutting spending. Someone should send a ship out to Planet Hoover to let John McCain know this is insane. The only large actor willing to invest today is the federal government. The United States has a huge backlog of productive projects with a social return well above the 4% interest we’ll have to pay for the money. Opening up the spigots on federal spending will help save the economy in the short term, and it will provide the infrastructure we need for growth in the long term. Only enslavement to the bankrupt ideas of yesterday would keep us from doing what basic logic tells us must be done. John McCain won’t do what needs to be done—and I will. And that’s what this election should be about.” Instead he talked about going through every appropriation by hand (very Carteresque).
This is the moment in which we’ll see what kind of leader Barack Obama is. He has invested his time and effort in creating an image of himself as a safe pair of hands. Now is the time for him to tell Americans that he can be trusted to do what must be done, and that what must be done is on a genuinely enormous scale. Will he do so?