A Crisis Resists the Usual Remedies

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What we are witnessing, in the broadest sense, is the bankruptcy of modern economics. Its conceit has been that we had solved the problem of stability. Oh, there would be periodic recessions, but the prospects of a major economic collapse were negligible because we knew how the system worked and could take steps to prevent it. What's been so unsettling about the present crisis is that it has not conformed to the standard model of business cycles and has not submitted to familiar textbook solutions.

A hallmark of the crisis has been the stark contrast between the "real economy" of production and jobs and the tumultuous financial markets of stocks, bonds, banks, money funds and the like. Even with the 60 percent drop in housing construction since early 2006, the real economy has so far suffered only modest setbacks. Yes, there are 605,000 fewer payroll jobs than there were in December; still, 137.5 million jobs remain. Meanwhile, financial markets verge on hysteria. The question is whether this hysteria will drive the real economy into a deep recession or worse -- and what we can do to prevent that.

The word that best epitomizes mainstream "macroeconomics" (the study of the entire economy, not individual markets) is demand. If weak demand left the economy in a slump, government could rectify the situation by stimulating more demand through tax cuts, higher spending or lower interest rates. If excess demand created inflation, government could suppress it by cutting demand through more taxes, less spending or higher interest rates.

Economists of this tradition watch consumer and business behavior. Are car sales soft? How much are companies raising prices? What about profits? The $152 billion "stimulus" program earlier this year was a classic exercise in "demand management." It didn't work well mainly because this crisis originated in frightened financial markets. Massive losses on mortgage-related securities caused some financial institutions to fail. As fear spread, financial institutions grew wary of dealing with each other because no one knew who was solvent and who wasn't.

To Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, this financial breakdown now threatens the real economy. Companies depend on bank borrowings and sales of commercial paper (in effect, short-term bonds) to conduct everyday business -- to buy inventories, to pay suppliers and workers before cash arrives from sales. Credit markets were freezing, Paulson and Bernanke decided. Panicky investors were shifting from commercial paper to Treasury bills; banks weren't lending to each other. If it continued, consumers and firms wouldn't get essential credit.

If you reject that conclusion, then the whole crisis has been a contrived farce. Some economists do; they note that downturns always involve losses and disruptions. This one isn't so different. But many economists agree with Paulson and Bernanke. "If we can't calm down short-term credit markets, we're looking at a pretty severe recession," says Michael Mussa of the Peterson Institute for International Economics. "If businesses can't roll over their short-term debt, [they] ask where can we cut back" -- firing workers, reducing spending -- "to avoid bankruptcy."

Unfortunately, we lack experience with stabilizing financial markets, and the issue has been at the fringes of economics. Mostly, markets should operate freely. When is intervention justified? How?

Of course, economists recognized that the Federal Reserve should act as a "lender of last resort" and that permitting two-fifths of banks to fail in the 1930s aggravated the Depression. But the creation in 1933 of deposit insurance (now up to $100,000) was thought to prevent most bank runs, and the "lender of last resort" role never anticipated a worldwide financial system that mediated credit not just through banks but also through hedge funds, private equity funds, investment banks and many other channels. In congressional testimony last week, Bernanke admitted the Fed has been "shocked" at how elastic the "lender of last resort" role has become.

The resulting intellectual vacuum has spawned political chaos. Unpleasant and untested ideas invite opposition. Paulson's plan to buy up to $700 billion of impaired securities is wildly unpopular. It may not work and raises many problems. If the government pays too little for the securities, financial failures may mount; if it pays too much, it may create windfall profits for some investors and losses for taxpayers. But Paulson's plan has better prospects for restoring confidence by removing suspect securities from balance sheets than suggested alternatives would. Selective injections of capital into banks, for instance, might involve favoritism and operate too slowly to improve confidence. Psychology matters.

The economy will get worse. Mussa thinks unemployment (now 6.1 percent) could peak near 7 percent; other projections are higher. The harder question is whether financial turmoil heralds an era of instability. Our leaders are making up their responses from day to day because old ideas of how the economy works have failed them. These ideas were not necessarily wrong, but they're grievously inadequate at the moment.

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