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As the global financial crisis deepens, leaders and policy makers are urgently debating why our financial system deteriorated so quickly and how best to get the economy moving again.
Richard Parker, lecturer in public policy and senior fellow at the Harvard Kennedy School’s Shorenstein Center, brings an historical perspective as well as keen analysis to the current crisis. His most recent book is the biography, “John Kenneth Galbraith: His Life, His Politics, His Economics.”
Q: As the U.S. banking crisis has spread to other industries and other countries, many economists are saying that deregulation may have been the culprit. Do you agree, and can you provide a brief historical perspective on how we have ended up in so dire a crisis?
Parker: Yes, I do agree. In 1971 Richard Nixon destroyed the Bretton Woods agreement that had been put into effect after the Second World War, and which had stabilized currencies and foreign exchange markets for 35 years. Once that happened, the conflict between the interests of European, Japanese, and American businesses became paramount.
This led to a huge oil price hike in 1973 as OPEC producers tried to re-coup the value of oil prices that were declining in dollars, which then led to the great global debt crisis as American banks loaned out all the money that the OPEC producers had deposited with them. Then came the so-called “Washington Consensus,” which imposed neo-liberalism on the third world in an attempt to prevent another bank crisis similar to the one in the early 1980s. This all resulted in the savings and loan crisis, also in the 1980s, which was the first “canary in the coal mine” of the dangers of deregulation of this sort.
What we’ve learned – or at least what is a growing consensus among economists –is that deregulation went too far. It went forward unevenly, and it went forward without a full understanding of the ability of actors – particularly actors operating outside the regulatory apparatus – to game the system. And as a consequence, because they were unregulated, highly risky bets were made in such a way that when markets started to decline, the value of their underlying holdings collapsed.
Far more than the housing market itself, it was the leveraging of the bets on the movement of the housing market that sparked the global financial crisis we have today. And had it not been precipitated by Richard Nixon’s destruction of the global monetary system, I don’t think we would be in this deep of a crisis.
Q. What are some of the significant ways in which this current crisis differs from the Great Depression in the 1930s?
Parker: There are several differences. First of all, today there is a level of protection for depositors – the great majority of the American people – for their bank accounts. President Franklin Roosevelt had put the Federal Deposit Insurance Corporation (FDIC) in place in the 1930s, and if it were not in place today, millions of American families would have seen their life savings devastated.
Another significant difference is that the complexity of the financial instruments – the collateralized debt obligations, the credit-default swaps, and others – are far beyond the kind of complexity that was being used in the 1920s. The third is our standard of living. The American people today are not in danger of literally falling into starvation and death like millions of Americans were in the early 1930s. You had massive malnutrition affecting at least a quarter of the American population, and hundreds of thousands of premature deaths caused by the conditions of the Great Depression. We are nowhere near that level of material suffering that our grandparents endured in the 1930s.
Q. The Obama administration has taken several steps to address the economic crisis through a combination of fiscal and monetary policies. How do you assess the efforts thus far?
Parker: Well, it’s a complex set of programs that is being initiated. In broad measure I’m concerned about the level of emphasis placed on tax rebates in President Obama’s budget. We know quite well that there’s a difference between tax rebates and actual public spending on things like infrastructure, education, and the like. That is, in times like these, when people get tax rebates, they tend to save that money so that it doesn’t get invested in the economy, and in effect it becomes substantially sterilized in terms of its usefulness for re-stimulating the economy. Of course Obama had to create that balance in order to get critical votes, particularly in the Senate, since no members of the Republican Party would vote for the stimulus package in the House.
The announcement by Treasury Secretary Geithner of plans to have hedge funds essentially soak up a lot of the “cleaned-up” toxic assets that banks are holding today is a very risky strategy. The hedge funds are already holding hundreds of billions of dollars of the same toxic assets that the banks are holding, but because the hedge funds are basically unregulated, they haven’t had to report just how bad those underlying assets really are. So what we’re asking them to do is double-up their bets, this time on a whole new round of toxic assets, on the premise that the government will put 85% of the money that the hedge fund uses to make the purchase of these toxic assets from the banks. And of course the danger here is that if those assets in fact deteriorate further, if the banks and the FDIC have not cleaned them up enough before they’re sold off, the taxpayers are going to be stuck with an enormous new bill while the hedge funds will be able to walk away.
Q: Moving forward, what reforms are being considered in order to prevent this type of financial meltdown from happening again?
Parker: In late March Secretary Geithner and the White House announced a set of programs that looks very encouraging, but remain rather vague in the details, so I’m not sure they meet all of the concerns that many economists have about just what to do.
For example, Geithner indicates that the administration wants to extend federal supervision to the hedge funds themselves. I think this is absolutely necessary. He also has said that they want to strengthen oversight, through the Commodities Futures Trading Commission, of derivatives and over-the-counter markets and things like collateralized debt obligations. Again, I think this is extremely important to do, but there are some potential loopholes because the plan doesn’t spell out how the regulations will be created. One can assume that K-Street lobbyists will be all over any legislation that is initiated, so I’m still unsure how the different parts will fit together.
Geithner has floated the concept of a giant superagency for regulation, and I think a lot of economists are very concerned that concentrating that much power in a single agency creates an agency that’s too big to fail. And that’s probably not a good thing. One of the features of the New Deal regulatory system was that responsibility was dispersed with the Securities and Exchange Commission (SEC) basically covering the stock market, the Fed covering the banks, and later the Commodities Futures Trading Commission covering commodities. And while each of those agencies has its flaws, and the system of coordination among those agencies has not been the best, it’s probably better to have more eyes and more agencies watching than fewer eyes concentrated in one agency trying to watch so much.
Q: Are you surprised, and would John Kenneth Galbraith be surprised, with how quickly this situation morphed from a crisis within the mortgage industry to a worldwide economic crisis?
Parker: I don’t think Professor Galbraith would be at all surprised. He wrote a sterling little book called “The Great Crash, 1929” in the 1950s that remains the best introductory read on what led up to the crash that began the Great Depression. You saw the same transmission mechanism at work in the late 1920s and the early 1930s, where what happens is that the financial markets transmit those crises through the banking system and secondarily through the stock market system into the real economy, which then sparks a panic. Businesses layoff workers, workers cutback purchases, and you have an authentic extensive depression in one country.
And the fact of the matter was that in the 1920s there were plenty of global interconnections. American banks, JP Morgan and others, were heavily involved in lending to the Weimar German Republic. And so, fluctuations in Germany affected America; fluctuations in France affected Britain; and each was deeply intertwined. So Galbraith was fully aware of all of this and would have seen nothing surprising about the rate at which this unfolded internationally, and was transmitted from the financial sector into the real economy.
Q: The Obama administration is under tremendous pressure to craft policy quickly, with some critics claiming it's not doing enough and others saying it is doing too much. Is this a Catch-22 for the administration?
Parker: I think a couple of things. I don’t think it’s a question of trying to steer a middle course between the left and the right; I think it’s a question of steering the wisest course that balances long-term needs against short-term needs. So rather than left and right, I think now and then are the two poles that we need to be paying attention to. But the rule of thumb that I’d be guided by is that we need to act swiftly to contain both the current damage and restore the current economy, and build in the kinds of protections that generations are going to need after this. Because the window for significant legislative activity in this area always closes quickly after a moment in which the gates are wide open. And so, I’m not particularly worried about [New York Times columnist] Paul Krugman being on one side of it, and the Republicans being on the other. What I worry about is whether Sec. Geithner and Chairman Summers are in fact as attuned to the politics of Main Street as they are to the mechanics of Wall Street, and that we will see over the next several months and years.