Part 2 (1/2)

Friedman and Schwartz opposed government intervention on principle-especially if it was government spending a la Keynes-but they believed that a drop in the money supply could have been avoided had the Federal Reserve aggressively cut the rates at which banks could borrow from it. More important, the monetarists blamed the Federal Reserve for not acting as a lender of last resort, making lines of credit available to faltering banks and financial inst.i.tutions. Had the Federal Reserve prevented the waves of bank failures in the early 1930s, they argued, the Great Depression would not have been so great, and the nation would have suffered through an ordinary recession before recovering.

The monetarist interpretation of the Great Depression has some merit: the collapse of the money supply in the 1930s certainly exacerbated the credit crunch, and the Federal Reserve only made matters worse. But other economic historians, most notably Peter Temin, have since argued that the collapse in aggregate demand was the primary catalyst for the disaster. Keynes, they argued, was mostly right: only increased public spending could have sustained aggregate demand, even if a more aggressive monetary policy would have contributed to the eventual recovery.

Nonetheless, it was Friedman, not Keynes, who became increasingly influential in the 1970s and 1980s. One reason was that what little remained of Keynesian economics by this time was a pale imitation of the original. Significant portions of Keynes's writings-not only The General Theory but his earlier A Treatise on Money-contained plenty of other insights that the postwar generation of economists ignored in their attempt to reconcile Keynes with earlier schools of economic thought, particularly the cla.s.sical economists. That effort, which came to be known as the neocla.s.sical synthesis, was a mixed bag. (One critic called it ”b.a.s.t.a.r.d Keynesianism.”) The great economist's belief in the power of government to stimulate demand was retained, but almost everything else Keynes wrote was ignored.

Not everyone discounted the other implications of Keynes's work, however. Hyman Minsky, a professor of economics at Was.h.i.+ngton University in St. Louis, dedicated his life to building a theoretical edifice on the foundation that Keynes had laid. Minsky auth.o.r.ed an intellectual biography of Keynes and an elaboration of his own distinct interpretation, pointedly t.i.tled Stabilizing an Unstable Economy.

In these works, along with numerous articles, Minsky argued that Keynes had been misunderstood. He focused on several neglected chapters of The General Theory that dealt with banks, credit, and financial inst.i.tutions, and he synthesized them with insights from A Treatise on Money. Keynes, Minsky argued, had made a powerful argument that capitalism was by its very nature unstable and p.r.o.ne to collapse. ”Instability,” Minsky wrote, ”is an inherent and inescapable flaw of capitalism.”

According to Minsky, instability originates in the very financial inst.i.tutions that make capitalism possible. ”Implicit in [Keynes's] a.n.a.lysis,” he wrote, ”is a view that the capitalist economy is fundamentally flawed. This flaw exists because the financial system necessary for capitalist vitality and vigor-which translates entrepreneurial animal spirits into effective demand for investment-contains the potential for runaway expansion, powered by an investment boom.” This runaway expansion, Minsky explained, can readily grind to a halt because ”acc.u.mulated financial changes render the financial system fragile.”

Minsky repeatedly came back to Keynes's observation that financial intermediaries-banks, most obviously-play a critical and growing role in modern economies, binding creditors and debtors in elaborate and complex financial webs. ”The interposition of this veil of money,” wrote Keynes, ”. . . is an especially marked characteristic of the modern world.” According to Minsky, Keynes offered a ”deep a.n.a.lysis” of how financial forces interact with variables of production and consumption, on the one hand, and output, employment, and prices on the other.

All of this stood in stark contrast to the economics profession in the postwar era: the equations and models deployed by architects of the neocla.s.sical synthesis had little or no place for banks and other financial inst.i.tutions, despite the fact that their failure could wreak havoc on the larger economy. Minsky set out to change this state of affairs by showing how banks and other financial inst.i.tutions could, as they became increasingly complex and interdependent, bring the entire system cras.h.i.+ng down. The centerpiece of his a.n.a.lysis was debt: how it is acc.u.mulated, distributed, and valued. Following Keynes, he saw debt as part of a dynamic system that would necessarily evolve over time. Again, per Keynes, he recognized that this dynamism injected uncertainty into economic calculations. In good times, the promise of continuing growth and profits allayed uncertainty. But in bad times, uncertainty would prompt financial players to curtail lending, reduce risk and exposure, and h.o.a.rd capital.

In itself, this view was not entirely revolutionary. But Minsky's Financial Instability Hypothesis had another dimension. He categorized the debtors in a given economy into three groups, according to the nature of the financing they used: hedge borrowers, speculative borrowers, and Ponzi borrowers. Hedge borrowers are those who can make payments on both the interest and the princ.i.p.al of their debts from their current cash flow. Speculative borrowers are those whose income will cover interest payments but not the princ.i.p.al; they have to roll over their debts, selling new debt to pay off old. Ponzi borrowers are the most unstable: their income covers neither the princ.i.p.al nor the interest payments. Their only option is to mortgage their future finances by borrowing still further, hoping for a rise in the value of the a.s.sests they purchased with borrowed money.

During a speculative boom, Minsky believed, the number of hedge borrowers declines, while the number of speculative and Ponzi borrowers grows. Hedge borrowers, now flush with cash thanks to their conservative investments, begin lending to speculative and Ponzi borrowers. The a.s.set at the center of the boom-real estate, for example-rises in price, prompting all borrowers to take on even more debt. As the amount of unserviceable debt balloons, the system becomes ever more ripe for financial disaster. In Minsky's view, the trigger is almost irrelevant: it could be the failure of a firm (much as the failure of hedge funds and major banks marked the end of the bubble in 2007 and 2008) or the revelation of a staggering fraud (like the Bernard Madoff scheme, exposed in 2008).

When pyramids of debt start to crumble and credit dries up, Minsky realized, otherwise healthy financial inst.i.tutions, corporations, and consumers may find themselves short of cash, unable to pay their debts without selling off a.s.sets at bargain-bas.e.m.e.nt prices. As more and more people rush to sell their a.s.sets, the prices of those a.s.sets spiral downward, creating a self-perpetuating cycle of fire sales, falling prices, and more fire sales. As the level of aggregate demand falls below the supply of goods, the larger economy suffers from price deflation: with every pa.s.sing day, each dollar purchases more than it did the day before.

It sounds like a blessing, but for debtors it's a curse. Irving Fisher, a Great Depression economist who coined the term ”debt deflation” (see chapter 6) to describe this process, observed that if the price of goods falls faster than debts are reduced, the real value of private debts will rise over time. For example, imagine that someone borrows a million dollars to buy a house with no money down. The house is worth a million dollars; the owner owes a million dollars. Then deflation kicks in, and prices fall across the economy; everything from the price of the house to the salary of the owner declines. Everything costs less, but everyone has less money. Unfortunately, the real size of that mortgage has increased: a million dollars' worth of debt is now a bigger burden than it was previously.

Because deflation increases people's debt burden, it also increases the probability of default and bankruptcy. As defaults and bankruptcies soar, the downward spiral continues, dragging the economy into a depression. Between October 1929 and March 1933, for example, the liquidations of a.s.sets reduced the nominal value of private debts by 20 percent. But thanks to deflation, the real burden of those debts increased by a whopping 40 percent.

In order to avoid a repeat of the Great Depression, Fisher (and for that matter, Friedman and Minsky) counseled that a central bank-the Federal Reserve, in the case of the United States-should step in to play the role of lender of last resort, providing the necessary financing for banks and even for corporations and individuals. In extreme cases, Fisher argued that the government should pursue ”reflation,” reviving the economy by flooding it with easy money.

That's exactly what has been done in our own time. Over the course of 2007 and 2008, as the financial crisis deepened, American policy makers looked to the lessons of the Great Depression and acted accordingly. Rather than let thousands of banks and corporations go under, as Hoover had done in the early 1930s, the Federal Reserve made available unprecedented lines of credit. That enabled investment banks, insurers, hedge funds, money market funds, and others to avoid insolvency and eventually halted the vicious cycle of fire sales, falling prices, and more fire sales. Likewise, major firms like Chrysler and General Motors were given lines of credit to prevent them from falling into Chapter 7 bankruptcy proceedings, where their a.s.sets would have been liquidated. Instead, the government steered them into Chapter 11, where they could be reorganized and reborn. It was all a far cry from the ”leave-it-alone liquidationists” of the Hoover administration.

The policy response on the fiscal level also starkly contrasts with what happened during the Great Depression. As the early 1930s crisis spiraled out of control, the idea of using government spending to take up the slack in demand was still a glimmer in Keynes's eyes. Instead, governments across the world insisted on balancing the budget, which prompted cuts in government spending and tax hikes, both of which arrived at the worst possible time. But in 2009 the Obama administration pa.s.sed the biggest stimulus bill in the nation's history, which included plentiful tax breaks. Between monetary policy (the government's various levers of control over the money supply) and fiscal policy (the government's means of taxing and spending), everything that should have been done was done, however imperfectly.

So regardless of their theoretical inclinations, economists of all stripes should be happy with the handling of the recent crisis, right? Wrong. There's another way of looking at financial crises, one that points to an entirely different understanding of the Great Depression of the 1930s, the j.a.panese near depression and Lost Decade of the 1990s, and the Great Recession of our own time.

To Austria and Back.

The Austrian School originated in the late nineteenth and early twentieth centuries with a loosely affiliated group of Austrian economists: Carl Menger, Ludwig von Mises, Eugen von Bohm-Bawerk, and Friedrich Hayek. These economists and their many students, including Joseph Schumpeter, were a fractious bunch and are next to impossible to categorize. The same can be said of those twenty-first-century economists who consider themselves heirs to the Austrians.

Nonetheless, a few generalizations are possible. Being an Austrian economist today is tantamount to holding libertarian economic beliefs. Indeed, a deep skepticism of government intervention in the economy-especially in the monetary system-is a pillar of the Austrian School. For example, most Austrians make a strong distinction between sustainable economic expansion financed by private savings and unstable, ill-fated expansion financed by credit from a central bank. While they would agree with Keynes and Minsky that excessive a.s.set and credit bubbles lead to dangerous crises, they don't blame capitalism for that problem. Instead, they point to government policies, namely easy monetary policy, along with regulations and interventions that allegedly interfere with the workings of the free market.

This skepticism toward government intervention goes hand in hand with another hallmark of the Austrian approach: a focus on individual entrepreneurs as the unit of economic a.n.a.lysis. Though he was hardly a libertarian, Joseph Schumpeter developed a powerful theory of entrepreneurs.h.i.+p that is often distilled down to a pair of powerful words: creative destruction. In Schumpeter's worldview, capitalism consists of waves of innovation in prosperous times, followed by a brutal winnowing in times of depression. This winnowing is to be neither avoided nor minimized: it is a painful but positive adjustment, whose survivors will create a new economic order.

For those who embrace the Austrian point of view, the Great Depression is an object lesson in the perils not of doing too little in the face of a crisis but of doing too much. According to some Austrian economists, Roosevelt prolonged the Great Depression by intervening in the economy. The Austrians even criticize Herbert Hoover, arguing that by overseeing the Reconstruction Finance Corporation, a government agency that made loans to beleaguered banks and local governments, he too stood in the way of the necessary but painful process of ”creative destruction.”

This dispute over distant crises may seem academic, but it's not: Austrian School economists make a historical case that the policy response to the recent crisis will eventually give us the worst of all worlds. Instead of letting weak, overleveraged banks, corporations, and even households perish in a burst of creative destruction, thereby allowing the strong to survive and thrive, governments around the world have meddled, creating an economy of the living dead: zombie banks that cling to life with endless lines of credit from central banks; zombie firms like General Motors and Chrysler that depend on government owners.h.i.+p for their continued survival; and zombie households across the United States, kept alive by legislation that keeps creditors at bay and that spares them from losing homes they could not afford in the first place.

In the process, private losses are socialized: they become the burden of society at large and, by implication, of the national government, as budget deficits lead to unsustainable increases in public debt. In time, the a.s.sumption of these crus.h.i.+ng debts can strain government finances and reduce long-term economic growth. In extreme cases, this kind of burden will lead the government to default on its debt, or alternatively, to start printing money to buy back its debt, a maneuver that can swiftly trigger bouts of dangerously high inflation. In either case, the Austrians argue, the best course of action would have been to let the inevitable liquidations take place as quickly as possible. If Andrew Mellon were alive today, he would find friends in the Austrian camp.

Economists of the Austrian persuasion are also deeply skeptical of the rush to regulate that so often occurs in the wake of a crisis. In their view, too much regulation was the cause of the crisis in the first place, and adding more will only make future crises worse. This seems counterintuitive: how can regulation cause a crisis? The Austrians would respond that innovations like deposit insurance and lender-of-last-resort support, while offering security to anyone with a savings account, have nonetheless increased bankers' appet.i.te for risk. Much as someone who wears a seat belt may be tempted to drive faster, banks a.s.sumed greater risks-and the potential for accruing greater profits-secure in the knowledge that if they failed, the federal government would make things right with their depositors.

This same logic extends to any number of other government interventions in the economy. Earlier this decade, Wall Street a.n.a.lysts spoke of the ”Greenspan put”-the belief that the Federal Reserve would rescue financial firms with easy money, special lines of credit, and lender-of-last-resort support. (A put is an option that an investor can purchase to hedge against a sharp market downturn.) The Greenspan put is precisely what happened when the crisis. .h.i.t: the Federal Reserve stepped into the breach, rewarding incompetent risk taking with monetary largesse-or at least, that is how the Austrians would interpret it. In the process, they argue, it only fostered a bigger and more disastrous boom-and-bust cycle down the line.

Austrians argue that many of the common cures for financial disasters are worse than the disease. On the one hand, if governments run fiscal deficits in order to keep the economy afloat, levels of public debt become unsustainable. Eventually, governments are forced to raise interest rates, killing off whatever recovery may be under way. The Austrians are equally critical of the easy solution to this problem: printing money to ”monetize” deficits. Doing so, they argue, will invariably lead to inflation and anemic economic growth comparable to the stagflation that crippled the United States in the 1970s. Either way, the Austrians believe, government can only make a bad situation worse and plant the seeds of a bigger bubble down the line, as everyone comes to believe that in the event of a future financial crisis, a bailout will be forthcoming.

Much of the Austrian vision seems extreme, or at the very least heartless. It is the ant.i.thesis of Keynesian thinking, much as Joseph Schumpeter was the most significant rival of Keynes when both were alive. If Keynes advanced a vision of capitalism that might occasionally become imbalanced (but could readily be stabilized with government intervention), Schumpeter believed instability to be the necessary consequence of the kind of innovation that made capitalism possible in the first place.

From the Austrian perspective, the fear now is that the United States is heading down the road that j.a.pan paved in the 1990s, when it responded to its own slow-motion financial crisis by propping up zombie banks and corporate firms and by dropping interest rates down to zero, flooding the economy with yet more easy money. The government also ran enormous fiscal deficits to finance the kind of stimulus spending that Keynes prescribed. Instead of allowing ”creative destruction,” the j.a.panese built bridges to nowhere that merely put enormous amounts of debt on the shoulders of the national government. The result, the Austrians maintain, was j.a.pan's Lost Decade.

Does the Austrian view have any merit? Economists who swear fealty to Keynes argue that j.a.pan failed to implement the appropriate fiscal stimulus and monetary policy in time. They point out that the government waited two years after the collapse of the bubble to start its stimulus spending. Even worse, the Bank of j.a.pan took eight years to cut interest rates from 8 percent to 0 percent. Then it moved away from this zero-interest-rate policy (better known as ZIRP) too soon. Just as FDR curtailed fiscal and monetary policies in 1937, ushering in a severe recession, j.a.pan triggered a recession that lasted from 1998 to 2000. By the same logic, the United States, should it curtail stimulus spending or tighten the monetary reins while the recovery has barely started, risks repeating this mistake today.

In short, the Austrian approach is misguided when it comes to short-term policies. As Keynes and Minsky recognized, in the absence of government intervention, a crisis caused by financial excesses can become an outright depression, and what begins as a reasonable retreat from risk can turn into a rout. When the ”animal spirits” of capitalism vanish, the ”creative destruction” hailed by the Austrians can swiftly turn into a self-fulfilling collapse of private aggregate demand. As a consequence, distressed but still-solvent firms, banks, and households can no longer gain access to the credit necessary for their continued survival. It's one thing if truly insolvent banks, firms, and individual households go under; it's another altogether when innocent bystanders to an economic crisis are forced into bankruptcy because credit dries up.

In order to prevent this kind of collateral damage, it makes sense to follow the playbook devised by Keynes in the short term, even when the underlying fundamentals suggest that significant portions of the economy are not only illiquid but insolvent. In the short term, it's best to prevent a disorderly collapse of the entire financial system via monetary easing and the creation of bulwarks: via lender-of-last-resort support, for example, or capital injections into ailing banks. It's also best to prop up aggregate demand through stimulus spending and tax cuts. Doing so will prevent a financial crisis from turning into something comparable to j.a.pan's Lost Decade or, worse, the Great Depression.

But when it comes to the medium term and long term, the Austrians have something to teach us. Even Minsky correctly pointed out that resolving a financial crisis over the medium and long term requires that everyone from households to corporations to banks reduce their level of debt. Putting this off is always a serious mistake. By failing to reduce private leverage, banks, firms, and households drown in debt, unable to lend, spend, consume, or invest. Likewise, socializing these losses-via unending government bailouts-is untenable. So too is the impulse to get rid of these debts by trying to inflate the currency. These actions merely move the problem from one part of the economy to another. In the long term, it is absolutely necessary for insolvent banks, firms, and households to go bankrupt and emerge anew; keeping them alive indefinitely only prolongs the problem.

In general, the followers of Keynes and the followers of Schumpeter don't talk to each other. That's unfortunate, because both thinkers-and the larger schools of economic thinking they represent-have something to say about what should be done. The insights of both schools can be synthesized and brought to bear on the problems we face now; indeed, the successful resolution of the recent crisis depends on a pragmatic approach that takes the best of both camps, recognizing that while stimulus spending, bailouts, lender-of-last-resort support, and monetary policy may help in the short term, a necessary reckoning must take place over the longer term in order to achieve a return to prosperity.

What we counsel is a kind of controlled ”creative destruction.” Financial crises are a bit like nuclear energy: they are enormously destructive if all the energy is released at once, but much less so if channeled and controlled. The ma.s.sive interventions by the Federal Reserve and governments around the globe brought the financial crisis under control. But much remains to be done: radioactive a.s.sets the world over must be acknowledged, contained, and disposed of. Regulations must be written, and international financial inst.i.tutions reborn.

How to manage that task is the pressing question of our time. Keynes once observed that ”economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” The waters will eventually stop churning, but how long it takes them to subside depends on how economists approach the problem, craft solutions, and make difficult decisions.

In facing these challenges, it's worth adding one more arrow to the quiver of crisis economics. The study of crises cannot be confined to economic theories alone. A final perspective is necessary, one that is not easily distilled to a school of thought, a model, or an equation: the study of the past.

The Uses of History.

In June 2009 the legendary economist Paul Samuelson sat down with an interviewer. Samuelson, who remained as productive as ever into his nineties, is widely considered the greatest economist of the last half century. A founder and codifier of the neocla.s.sical school, he oversaw his profession's embrace of esoteric mathematical models as a way of describing timeless economic phenomena. But when the interviewer innocently asked, ”What would you say to someone starting graduate study in economics?” Samuelson gave an unexpected answer. ”Well,” he said, ”this is probably a change from what I would have said when I was younger. Have a very healthy respect for the study of economic history, because that's the raw material out of which any of your conjectures or testings will come.”

Samuelson is right-economic history is important, far more than theories of efficient markets and rational investors would lead one to believe. That's not because history repeats itself in some simplistic, cyclical way, though parallels between past and present are plentiful. Rather, history is useful precisely because its raw material can inform and inflect economic theories. It injects gritty, real-life detail into elegant mathematical models, like those devised by Samuelson and his peers. That's a good thing: an almost religious faith in models helped create the conditions for the crisis in the first place, blinding traders and market players to the very real risks that had been acc.u.mulating for years. History promotes humility, a quality that comes in handy when a.s.sessing crises, which so often come on the heels of arrogant proclamations that ordinary economic rules no longer apply.

We are hardly alone in our desire to harness history. As long as there have been crises, there have been attempts to put them in historical context. Amateurs like the Scottish journalist Charles Mackay, whose Extraordinary Popular Delusions and the Madness of Crowds was published in 1841, began the effort. Though only partially concerned with economic crises (and chock-full of inaccuracies), Mackay's book may have been the first attempt to draw lessons from the history of economic crises. His main conclusion-that human beings are an irrational lot, p.r.o.ne to fits of economic exuberance and euphoria-antic.i.p.ated both behavioral economics and the thrust of much historical writing on crises.

Several professional historians and economists followed in Mackay's footsteps, but not until the economist Charles P. Kindleberger wrote Manias, Panics, and Crashes in 1978 did someone try to articulate an overarching historical theory of crises. It became a cult cla.s.sic, and though its conclusions were evidently ignored in the years leading up to the recent disaster, its spirit of inquiry animates much of our thinking. So too does it animate the systematic and rigorous work of Carmen Reinhart and Kenneth Rogoff. In This Time Is Different: Eight Centuries of Financial Folly (2009), these two economists a.s.sembled a ma.s.sive collection of historical data on crises, showing that while the details of currency crashes, banking panics, and debt defaults change, the broader trajectory of crises varies little from decade to decade, century to century.

This work, along with the work of numerous other historians and economists of a historical bent, helps us understand the deep origins of crises as well as their lingering aftereffects. Clearly the best way to understand crises is to see them as part of a broader continuum of causes and effects, extending long before and long after the acute phase of the crisis. In this spirit, we turn next to tracking some of those deeper structural forces that over many years set the stage for a crisis.