WHAT IS ‘THE SOLUTION' TO BANKING CRISIS?

The critics of the new $814 Billion stimulus have got it wrong. Lowering taxes helps the few, but spending monies on infrastructure, education, health care and state governments aids the many. The problem is that businesses are hurting because there is a lack of demand for their products. And demand comes mainly from consumers who are tapped out at present. So any programs that directly create more jobs—especially in the private sector—give the most bang for the stimulus buck.

The demand slack is now worldwide, so that even our exports are down, which has hurt many domestic industries. This is puzzling many of the 2500 economists, business and political leaders attending the annual Davos, Switzerland economic summit, according to New York Times columnist Thomas Friedman. They seem to be at a loss to find a solution to the current worldwide economic malaise.

Part of the puzzlement is due to the nature of the malaise. Such a complete breakdown in consumer spending hasn’t happened since World War II. And that is due to both the housing and credit crunches, which caused the soaring jobless rate. So any solution must also envision how to get banks lending again. But banks won’t lend, until they see a pickup in demand for products and services.

This recession is also puzzling because the old solutions aren’t working. The first half of the TARP funds went to shore up financial institutions, on the theory that they would begin to lend again. For the past 28 years the answer to any economic problem was what is called supply-side economics, which meant giving more breaks to businesses such as banks or cutting taxes of the investor class.

But that program didn’t work over the past 8 years. Only 5 million jobs were created, in spite of record corporate profits and incomes of the top 1 percent of income earners; whereas 20 million jobs were created in the prior 8 years. The result is that wages and salaries of most consumers haven’t risen at all when inflation is taken into account. And so consumers could only spend what they could borrow, and borrowing collapsed when housing values plunged.

Therefore, any solution has to boost the incomes of ordinary Americans. This was understood by British economist John Maynard Keynes during Roosevelt’s New Deal, and his theories helped the U.S. and Europe recover from the Great Depression. So what was forgotten is being resurrected, given the severity of the current recession.

There is a new twist to the solution that is missed by many economists, even, because Lord John Maynard Keynes’ economic theories continue to be misunderstood. He advocated more government spending only during the bad times. His real contribution was in the new field of behavioral economics. He was the first to take psychological factors into account to explain the behavior of individuals and the financial markets.

Keynes maintained that the Great Depression was caused primarily by a psychological depression in “animal spirits” that caused Americans to retreat into themselves, and so cease most economic activity. His most famous conclusion was that since governments already knew how to stimulate economies during wartime, they should also be able to do so during peacetime.

Many of his followers have been behavioral economists whose research has led to a greater understanding of what financial stimulus works and what doesn’t. For instance, the irrational exuberance that caused the housing bubble (and dot-com bubble before that) was predictable, since research has shown that investors and consumers are easily fooled by past history. Once home prices started climbing, for instance, there was a tendency to believe they would continue to climb.

And so part of the solution is create measures that prevent such bubbles from re-occurring. Hence the emphasis should be on better regulatory oversight of the financial markets. Such oversight not only fights fraud, but helps to establish programs that educate investors and consumers in the pitfalls of irrational exuberance.

Harlan Green © 2009