Wednesday, October 22, 2008


More details of what has become a worldwide ‘bailout’ of financial institutions are emerging. Are we seeing the return of Roosevelt’s New Deal for the U.S. version, at least? Governments are actually taking ownership of many of the troubled financial entities that caused the subprime debacle. The European Union and United Kingdom recently announced that their governments would not only guarantee bank deposits and interbank lending between banks, but offer unlimited amounts of dollars to commercial banks as well!

As if to reinforce this perception, this year’s Nobel Prize in economics was just awarded to Paul Krugman, not only a ‘liberal” (his words) economist, but author of “The Great Unraveling”, which documented the attempt by conservatives to dismantle the New Deal, including privatization of social security.

The New Deal was based on a new economics of that time, formulated by Britain’s Lord Keynes, a British economist and expert on financial markets. He postulated that governments should intervene not only during wartime, but bad economic times to prime the economic pump. It should cut spending during good times, on the other hand, so that inflation and excess consumption would not take place. His most famous work was “The General Theory of Employment, Interest and Money” published in 1936.

“…there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment,” said Keynes. “Formerly there was no expenditure out of the proceeds of borrowing that it was thought proper for the State to incur except for war. In the past therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war.”

Since the Roosevelt Administration governed during the worst of times—the Great Depression and World War II—it created massive government programs to support the economy, as well as modern financial regulation, the FDIC, housing programs and social security. More than 6,000 banks were re-capitalized with government funds at that time, according to historians. It was as much as is being spent today, in real terms.

Today, we find that history is repeating itself. The U.S. government is having to push back against the excesses created by too little government, as in the 1930s—especially too little regulation of financial markets. But no one thinks we will return to the monolithic measures of the New Deal, when there were fewer private institutions to spur economic growth.

Modern economic theory reflects this mix of private and public enterprise. We now know that so-called ‘free’ markets don’t work without regulations, for instance. Financial institutions do not regulate themselves, as Alan Greenspan and other classical economists believed. But private capital markets—such as bank deposits, pension and insurance funds—are now the best providers of jobs, not governments.

We also know why the markets collapsed after the subprime and housing meltdowns. Banks and consumers took out too much debt. But few will talk about the why. Fareed Zakaria,. Newsweek’s International Editor in chief, tells us that governments wouldn’t or couldn’t raise taxes to cover their increased spending. That is why the federal government now owes $10.2 trillion, whereas it owed just $3 trillion in 1990.

And consumers continued to spend, even though ‘real’ (after inflation) household incomes have been falling for decades. Household debt ballooned from $680 billion in 1974 to $14 trillion today. The average household now has 13 credit cards, and 40 percent of these carry a balance, up from 6 percent in 1970. In fact, consumers spent $800 billion more than they earned just in 2007.

The current financial dilemma is therefore a wakeup call for both government and consumers to spend within their means.

© Harlan Green 2008

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