The Administration’s Current Policy Approach is Not Working

In the minds of many the global financial crisis was caused by a collapse in the U.S. housing market and the disastrous effects it had on the financial sector here and abroad as packages of toxic American mortgages were sold far and wide. The story goes as follows: Once the housing bubble burst, a credit crisis unfolded, the worst since the 1930s, and in the uncertainty of the situation banks across the world refused to lend at all, even to qualified borrowers who had been customers for years. A sharp drop in the demand for goods and services and in capital investment and international trade resulted, leading to a severe worldwide recession.

In the U.S., the policy response has been twofold: First, restore liquidity to the financial system through monetary measures designed to move non-performing loans onto the balance sheet of the government while simultaneously injecting massive amounts of reserves into the banking system to promote lending; and Second, stimulate the demand for goods and services by ramping up government spending and running massive deficits, reaching to some 12 per cent of the GDP.

The inherent contradiction in these measures -- one aimed at keeping liquidity high and interest rates low and the other spiking demand, soaking up liquidity and driving interest rates up with heavy borrowing -- has been overcome by the Fed purchasing Treasuries by the carload. To date, however, these policies have not fundamentally changed the outlook, and the U.S. and the world remain mired in a deep and on-going recession. Moreover, by greatly expanding the monetary base, the Fed increased considerably the risk of inflation once a recovery gets underway.

Perhaps the reason the current policy stance has not been successful is the narrative related above about the cause of the crisis, and hence the appropriate policy response, is wrong. While it is true that a housing bubble burst and the financial sector froze, this may only be the proximate cause of the crisis, the trigger that initiated a more widespread breakdown as it exposed deeper problems.

As we have seen in recent months, the economy’s problems extend far beyond sour mortgages and disarray in credit markets. The auto industry, as one example, has been in desperate straits for many years and may well follow the American steel and electronics industries in a steep decline. The country has also been running a huge deficit on its trade account for decades, at times amounting to 6 per cent of its gross product; this deficit is reflective of massive global imbalances -- insufficient saving in the U.S. and surplus saving in Asia and elsewhere -- that must be eliminated if global growth is to be restored. Many states and localities have been running enormous deficits for years. And many public and private pension and health care finance systems are actuarially bankrupt, and not by a small amount. Similar problems plague other countries.

These latter problems are structural in nature and are not only far more persistent and difficult to overcome than those of the financial system but are the underlying reason for the disorder in financial markets. Given the country’s weak productive structure and unsustainable entitlements, no one should be surprised that current policies, focused as they are on short-term concerns, have yet to achieve results. More importantly, these short-term policies aggravate the longer-term structural imbalances that must be overcome to restore sustainable growth to the economy.

A more realistic narrative of the crisis would focus on the huge imbalances in the American economy and the need for the country to restructure its productive base, match incomes and outlays in its government and trade accounts, and reform its entitlements to sustainable levels. It will take many years to do this. If anything, the present policy stance pursued by the Administration makes overcoming structural problems much more difficult by raising taxes on the productive, implementing huge increases in government spending and entitlements, and introducing far-reaching governmental controls over private economic activity.

If the Obama Administration insists on its present policy course it will neither restore stability to the financial sector nor set the stage for a return to the rapid pace of economic advance the country enjoyed for decades.

A comment by Doug Walker.