First Bank of the Living Dead

First Bank of the Living Dead

Mini Teaser: As the Great Recession gnaws at our very belief in the ability of capitalism to raise us to ever-escalating levels of wealth and prosperity, Keynes's no-longer-viable financial prescriptions are being resurrected.

by Author(s): Daniel W. Drezner

BUT THE folks who really come out worst in all of this are the politicians, economists and financial actors that had faith in the idea of the Great Moderation; the observation that nimble monetary and exchange-rate policies could diminish any severe economic downturns should our ever-so-efficient markets momentarily fail us. This faith was most religiously held in the United States, and with some justification. Over the twenty-five years prior to the Great Recession, each American slump had been milder in its effects on GDP than the one before. Faith in the Federal Reserve’s ability to cushion the force of downward shocks was often referred to as the “Greenspan put.”

With unmitigated glee, Reich argues that the boom of the Great Moderation masked the underlying fragilities of asset bubble piled upon asset bubble. Both Crisis Economics and Zombie Economics go further on this front, detailing the ways in which Fed Chairmen Alan Greenspan and Ben Bernanke made the asset bubbles worse through easy monetary policies. Indeed, Greenspan is cuffed around for twin failures: though his infamous 1996 “irrational exuberance” speech popped one asset bubble before it expanded, he failed to heed his own warning by keeping interest rates after 9/11 so low for so long. We should not be surprised by the outcome. Bernanke gets it on the chin for maintaining that the subprime-mortgage crisis was containable.

Considering that by 2005 many economists were cognizant that housing prices were rising at an unsustainable rate, why wasn’t preventive action taken sooner? The first rule for policy makers in an asset bubble is that they can’t talk about the existence of an asset bubble. The reason for this is simple: pricking an asset bubble requires pursuing policies that, in one way or another, tell people that the good times have come to an end. Any effort by the Fed or the SEC to contain the housing bubble would have met fierce congressional and executive-branch resistance. So long as asset prices continued to rise, it was difficult to expose the flaws in the financial system.

While these books occasionally discuss these politics of bubbles, they tend to elide all that is political. For them, it’s strictly about the power of the financial lobby, which is not an entirely fair assessment. In this narrative, interest groups with a powerful stake in maintaining the status quo blocked any serious efforts at reforming the financial system. Domestically, this came in the form of lobbying by Big Finance, whether one refers to Fannie Mae, Freddie Mac or Wall Street more generally. Globally, it was the princelings who dominated China’s export sector, the sheikhs who set up sovereign-wealth funds in the Gulf emirates and the hedge funds ensconced in America that all bitterly resisted any effort to prick the bubble.

Yet beyond interest-group politics, no politician likes to hear that contractionary policies are on the horizon, regardless of their ties to Wall Street. Plenty of incumbent Democrats were plenty comfortable with Greenspan’s easy-money policies when the alternative seemed like a more severe recession. The asserted power of Wall Street also does not square with the events of the past few months. Despite fierce lobbying by the financial sector, Dodd-Frank regulates derivative markets, toughens consumer finance, enhances the Fed’s oversight powers and creates an authority to wind down big financial firms. The SEC’s lawsuit and settlement with Goldman Sachs eroded that firm’s share price considerably. Yes, financial firms still possess political clout—but the attempt in these books to stoke populist resentment does not work all that well.

IN THE end, the big question that these books wrestle with is how to reintegrate John Maynard Keynes’s ideas about finance into a world of instantaneous, complex and globalized capital markets. Keynes distrusted the financial sector, seeing it as an arena combining greed with bouts of irrationality. Thus he wanted it heavily segmented, subordinated to full employment policies and embedded in a tight web of regulation. But though market fundamentalism might be mortally wounded, it’s not clear how much room there is for Keynesian macroeconomic policies. And if one is looking for answers they aren’t to be found with Sebastian Mallaby. His hedge-fund-formed recommendations of a light regulatory touch make some sense but extrapolation to larger prescriptions is difficult; as he notes, hedge funds are only a small sliver of the financial sector, and More Money Than God is mum on big-think policies.

And if Mallaby’s focus is too narrow, Reich’s is too inchoate. Aftershock tries to scare moderates into redistribution policies, arguing that otherwise a political revolution will take place that makes the Tea Party activists look like a sewing circle. Yet he does not persuade. At one point he allows that “opulence has provoked more ambition than hostility” and that “economic resentments have not yet propelled anyone into the White House.” Reich clearly yearns for a return to the policies of the Bretton Woods era. But he never wrestles with the ways in which the world has changed since the 1950s. Nor does he even mention the reasons why the Keynesian policies failed during the 1970s.

Unlike Reich, Quiggin is clear-eyed about Keynesianism’s failures as well as its successes, but he believes that:

The failures of the 1970s were the result of mistakes that could have been avoided with a better understanding of the economy and stronger social institutions. If so, the current crisis may mark a return to successful Keynesian policies that take account of the errors of the past.

He might be right, but if so it would contradict everything else contained in Zombie Economics. Quiggin thinks he’s only writing about the failure of free-market ideas, but he’s actually describing the intellectual life cycle of most ideas in political economy. All intellectual movements start with trenchant ways of understanding the world. As these ideas gain currency, they are used to explain more and more disparate phenomena, until the explanation starts to lose its predictive power. As time passes, the original ideas become obscured by ideology, caricature and ad hoc efforts to explain away emerging anomalies. Finally, enough contradictions build up to crash the paradigm, although current adherents often continue to advance the ideas in zombielike form. Quiggin demonstrates with great clarity how this happened to the Chicago school of economics. How he can think it won’t happen with whatever neo-Keynesian model emerges is truly puzzling.

In the end the best Keynesian-like proposals come from Roubini and Mihm, even if they do not develop a grand theoretical paradigm. Instead, Roubini and Mihm outline a plan for reform with ideas like “Glass-Steagall on steroids,” and countercyclical rules on capital adequacy for banks (holding more capital on reserve during boom times but relaxing those rules during downturns). Some of these ideas make a great deal of sense. Others, such as transitioning away from the dollar toward multiple reserve currencies, are unlikely to take place. Certainly parts of their conclusions read less like a summing-up and more like an investment newsletter. Still, as the book that does the best job of explaining where we have been, it would behoove policy makers to read Roubini and Mihm’s thoughts on where we should be going.

In 1933, Keynes wrote:

The decadent international but individualistic capitalism, in the hands of which we found ourselves after the [First World W]ar, is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous—and it doesn’t deliver the goods. In short we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed.

Regretfully, eight decades later, there is not much more to offer in the way of clarity.

Daniel W. Drezner is a professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University and a senior editor at The National Interest.

Pullquote: The trouble is that finance now permeates not only the economic but also the political and social fabric of our world. No one can talk about Big Finance without talking about the power of capital in politics.Image: Essay Types: Book Review