Hindsight is occasionally blurry

ProSense

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Wed Nov-18-09 10:22 PM
Original message

Hindsight is occasionally blurry

Posted by: Economist.com | WASHINGTON

BRAD DELONG got himself a lot of links yesterday by writing that efforts to save the banking industry last fall, by eroding public trust in government, increased the odds of a replay of the Great Depression from virtually nothing to 5%. Paul Krugman takes it from there:

Brad DeLong says that the loss of public trust due to the kid-gloves treatment of bankers has raised the probability of another Great Depression, because the public won’t support another round of bailouts even if it becomes desperately necessary. I agree — but I think the bigger cost is that we’ve greatly increased the chance of a Japanese-style lost decade, with I would now give roughly even odds of happening. Why? Because bank-friendly policies have squandered public trust in all government action: try talking to the general public about stimulus, and it’s all confounded in their minds with the deeply unpopular bailouts.

One side of this discussion is whether the government was actually able to handle things differently. Mr Krugman says yes; Economics of Contempt says no. I'm sympathetic to Mr Contempt's view, but I also think that—as with Lehman—the government could have come with something if it had wanted to. And I agree with Felix Salmon:

(T)he government owned AIG, which created the situation that Germans call Anstaltslast: the fact that state-owned companies simply don’t default on their obligations. The government was also battling a major crisis using the only weapon at its disposal: enormous amounts of liquidity. When you’re putting out a fire, you don’t stop to worry that large amounts of liquidity are going to end up where you don’t particularly want them — the important thing is putting out the fire.

So yes, given a bit more aggression and foresight, the Fed could have tried to cram down a haircut onto AIG’s counterparties. But at the time, no one was particularly interested in being harsh to the global financial sector; instead, they were trying to rescue it. With hindsight, it now seems that companies like Goldman Sachs have turned out to be the biggest winners, paying out billions of dollars in bonuses even as the rest of the country struggles with an extremely nasty recession. But that wasn’t particularly foreseeable. And so although I agree with Barofsky that the Fed and Treasury should have been harsher on the counterparties, I do understand why they weren’t.

Perhaps Mr DeLong is right, and America now faces a 5% probability of Depression. On the other hand, if you swapped out the folks who were in charge last fall with a group inclined to drive a hard bargain with the banks, you might find yourself in a world in which the Fed and the Treasury fail to convince markets that they'll do whatever they have to do save the financial system, in which a nasty cycle of deleveraging continues to drive important institutions into the ground, and in which the odds of Depression rise to 5%, or higher.

That's the nature of many of these interventions—we all live to whine another day. If an overwhelming stimulus prevents the economy from experiencing a major contraction, then many people will feel as though the situation probably wasn't that bad to begin with, that stimulus wasn't necessary, and that now they're saddled with a bunch of debt they didn't need to take on. Successful stimulus may well undermine the ability of governments to deploy successful stimulus in the future.

I do think the Obama administration is learning the lesson that public confidence is key. While I believe that administration officials are well aware of the potential long-term costs of a failure to address the deficit, I think they're making deficit-reduction a near-term priority precisely because increased fiscal credibility will allow the government more flexibility to address economic weakness now.

Brad DeLong responds

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Ummm... With respect to Felix, the key issue is not making AIG creditors take a haircut but rather making them share the upside with the government--as Chrysler shared the upside with the government with its loan guarantee program, as Al Gore was able to stand up there at the VP debate in 1996 and say that the U.S. had made money out of its bailout of Mexico.

If Free Exchange wants to ignore the fact that we are now out of macroeconomic running room, they are of course free to do so. But it might be more constructive for Free Exchange to help me think how we can get some of that running room back. We might need it. We might need it real bad.