Baseline Scenario

Very, very good today, with some points we should never forget:

The Baseline Scenario


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Firefighter Arson And Our Macroeconomic Policymakers

Posted: 27 Aug 2009 04:49 AM PDT



Firefighter arson is a serious problem. The U.S. Fire Administration, part of Homeland Security, concluded in 2003, “A very small percentage of otherwise trustworthy firefighters cause the very flames they are dispatched to put out” (p.1). Illustrative and shocking anecdotes are on pp. 9-15 of that report, as well as here and here.

Macroeconomic policy making now has a similar issue to confront.

As the economy begins to stabilize and the financial system shows signs of recovery, accolades start to shower down on various officials, including most recently Ben Bernanke, who was rewarded this week with renomination – and almost certain confirmation – to a second term as chairman of the Federal Reserve Board of Governors.

Bernanke is widely seen as our financial firefighter in chief (BusinessWeek; USA Today) Similar terms are used to describe Treasury Secretary Tim Geithner and the entire gigantic financial rescue effort. Larry Summers, head of the White House National Economic Council and administration economic guru-at-large, is applauded as an “experienced crisis manager”, which amounts to the same thing in this context.

If any of this sounds familiar, you’re probably remembering the famous cover of Time magazine from November 1999, which depicted Alan Greenspan, Robert Rubin, and Summers as “The Committee To Save The World.” The idea then was that crises in Asia, Latin America, and Russia had spilled over to US financial markets, most notably in the near failure of Long Term Capital Management, but disaster had been averted by – essentially – the financial firefighting abilities of this troika.

But what if the financial crises in recent decades – you can add the dotcom bubble, the S&Ls fiasco, and various emerging market debt crises to our recent housing and banking disaster – is not a sequence of random unfortunate events, but rather the product of a dangerous financial system? Given that today’s firefighters also previously held responsibility for overseeing this system, both recently and as long ago as the early 1990s, this question is relevant – particularly as the very same team, in various combinations, repeatedly pronounced on the system’s fundamental soundness.

Some of today’s firefighters pushed hard for deregulation of derivatives markets in the 1990s, and this now proves to have been an important cause of the crisis (Summers and others). Others had responsibility for the solvency of Wall Street over the past half decade, yet disguised all potential warnings in layers of impenetrable opaqueness (e.g., Geithner; see p.91 in David Wessel’s bestselling In Fed We Trust, Crown Business, 2009). Still others pronounced that there was no housing bubble exactly as things spiraled out of control and the potential costs to taxpayers rose (Bernanke and his colleagues at the Fed; again, pick up Wessel’s book, p.93 is among the most damaging).

No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis. But, for over two decades, they and their close mentors oversaw the operation and development of a banking and securities system with profound instability hard wired into its DNA. Don’t take my word for it; review this speech by Summers in April 2009, or – in the light of what we know now – look at his talk on crises to the American Economic Association in 2000.

Perhaps that was all a legitimate mistake on their parts and they have now learned the right lessons. But how then do you explain their amazing reluctance to reform the financial system today?

President Obama said on Tuesday that Ben Bernanke helped avert a second Great Depression. That is a considerable achievement, but why then are this administration and the Federal Reserve proposing only minor adjustments in oversight and governance for the financial system that ran amok – producing “financial innovation” that harms consumers and destabilizes everything?

It makes no sense at all. Unless, of course, they are not afraid of future financial fires – despite the enormous fiscal cost (likely 40% of GDP from this round alone), the unemployment (heading to and lingering at 10%, by the administration’s own revised estimates), and the millions of people hammered hard by lender abuse, house price collapse, and job losses.

You may not like the implications, but keep in mind this advice: “To ignore the problem or suggest that it does not exist will only increase the damage caused by the arson firefighters involved, as well as destroy the morale of the other firefighters in their departments” (Minnesota Fire Chief, March/April 1995 issue, quoted on p.1 of above cited report).

By Simon Johnson

A slightly edited version of this post originally appeared on NYT.com’s Economix, and from that version you can link directly to the referenced pages in David Wessel’s book.

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