The Newest New Deal

It looks like Obamanomics will include another return to Keynes.

Once upon a housing boom in the Bay Area, million-dollar studios seemed cheap. Short-order cooks were flipping condos instead of hamburgers. Every other cab driver seemed to be moonlighting as a mortgage broker. The proverbial investment-savvy shoe-shine boy—grandson, maybe, of the one whose financial advice gave Joe Kennedy the signal to put his money in the mattress just before the 1929 market crash—was way long on South of Market lofts.

Maybe we could have seen this coming? In 2006, after all, Donald Trump headlined San Francisco’s first Real Estate Wealth Expo at Moscone Center, and 61,500 people showed up. That event was described by a local newspaper as a kind of “Woodstock for the equity generation.” But this time, the drug of choice has sent Wall Street to rehab.

Now Barack Obama is vowing we won’t be fooled again, and a new generation of deep thinkers is stepping forward, hoping to guide the administration through the coming weird times. It got weird enough during the presidential campaign, with Obama deflecting charges of being a closet socialist at a time when Republicans were proposing wholesale nationalization of the financial system. The depths of the possible downturn, and truly global scale of the market panic, forced even the most conservative defenders of free enterprise into calling for government to step in and do something.

Leading economists are harkening back to the founders of “the dismal science.” The graybeards sound a bit of out of tune with the iPod Generation. But in the current environment, a return to some of the last century’s core economic guideposts, if not the fedoras and bread lines, seems inevitable. “We’re back to Keynes,” declared Gérard Roland, chair of the Berkeley economics faculty, during an interview in Evans Hall as Congress and the Treasury were completing a $700 billion Wall Street bailout plan.

John Maynard Keynes, of course, was the guy who described how a market economy could get stuck at far less than its peak-employment, low-inflation optimum, and never really get unstuck without active government help. Keynes and his followers made the case for therapeutic bursts of deficit spending, public works programs, and credit expansion—a direct challenge to the idea that the free market can fix its own messes. Herbert Hoover wasn’t nearly as clueless as he typically is portrayed—unwise Federal Reserve policies during the 1920s, more than anything Hoover did or didn’t do, get much of the blame for starting the mess that became the Great Depression. But he did sign into law a whopping tax increase in 1932 and continued preaching the virtues of volunteerism even when one in four U.S. workers was unemployed.

The Keynes classic, The General Theory of Employment, Interest and Money, came out in 1936 and helped set a theoretical foundation under Roosevelt’s New Deal. The idea was to boost consumer demand and public works spending, reign in financial speculators and big business, encourage unions, and do everything possible to generate a mood of optimism. Wartime production, more than any particular New Deal project, deserves much of the credit for finally ending the Great Depression.

One lasting impact of the 1930s was an expectation that government would have to manage the ups and downs of the business cycle. A U.S.-style corporate capitalism came to accept regulation as though the system’s life depended on it—which of course it did. Deficit spending was no longer the sin it was in classical economics. To the Keynesians, it was the core of countercyclical fiscal policy, a way to keep a no-longer-quite-free free-market system in high gear, or at least a high enough gear to outrun the ghost of Herbert Hoover.

Two generations of economists have spent their careers testing, expanding upon, and arguing over some of the central arguments laid out in response to the Great Depression. Economics may be a dismal science, but it’s also a branch of philosophy, wonderfully complicated by politics and social values. There may never be a true consensus. Still, the idea that taxes and spending do matter would be virtually unchallenged during the lead-up to 1970s stagflation. “We are all Keynesians now,” Richard Nixon declared in 1971.

Ronald Reagan’s supply-side revolution flipped this around. Reaganites championed small government, rolled back regulation, and placed an emphasis on free trade that extended into the Clinton era. Monetarism and fiscal conservatism were ascendant inside the Beltway, while busting unions and driving Toyotas became cool even in Michigan. Cheap imports and the boom in home equity values provided ample distraction from such issues as the hollowing-out of industry, and a widening chasm between rich and poor. The financial crack-up in the fall of 2008 exposed a web of deceptive credit practices and set the stage for a historic wipeout for the Republicans.

Gross domestic product slipped into negative territory about the same time John McCain was telling voters that “the fundamentals of the economy are strong.” On election day, General Motors reported the worst monthly decline in auto sales since the invention of the automatic transmission. Unemployment claims soared, consumer confidence took a dive, and the trade deficit pointed somewhere close to a zillion dollars.

And Trump? Still rich, but no longer the rock star of the nouveau riche. The Donald had to take on conservationists and a small landholder in Scotland before winning approval for a giant golf-course development in the dunes of Aberdeenshire. Although the $1.56 billion project appears to be moving ahead, the bird lovers may win in the end if asset values keep eroding.

It’s easy to underestimate an entrepreneur—that’s why they so often do well. But after all the talk about “change” and “hope” in 2008, some of the best minds of the current generation are now leery of anything that smacks of rape-and-pillage financial speculation. Policy wonks are actually starting to sound liberal out loud again.

Obama may well move to the center, as many analysts have predicted all along. But mainstream economists like Roland insist it would be a colossal mistake for the new president to shy away from aggressive policy interventions for a clearly ailing economy. Roland also insists that regulators must take the offensive in order to cure blind spots in the financial system—guaranteeing that buyers can know what they’re getting, and requiring sellers to disclose all that they know. A mismatch in knowledge of risks—fueled by false assumptions that one may always be bailed out, say, by skyrocketing asset values—leads to a disease known in economic circles as “informational asymmetries.”

Berkeley’s George A. Akerlof won the Nobel Prize in 2001 for his groundbreaking research on this concept, including a famous study of “lemon” used cars. He has declined, however, to talk publicly about how his findings relate to the lemons of the Wall Street mess (citing complications from being married to Janet Yellen, president and CEO of the Federal Reserve Bank of San Francisco, who in October became one of the first Fed policymakers to openly declare the economy to be in recession).

The bigger question now is whether we are facing another depression. Just the fear itself is a growing concern, because if people start hoarding their savings, it will lead to slumping demand, rising unemployment—and potential “Obamavilles” if the new president has nothing up his sleeve better than the modern equivalent of tent cities. “You need to rebuild confidence,” Roland said. “When you get a crisis on this scale, only government is big enough to intervene.” Most experts agree that the new administration can find the right answers, noting that the new president has an advantage over 1930s policymakers: He can learn from their mistakes. So even if a significant recession in 2009 is all but certain, Great Depression II may be avoided.

James Wilcox, finance professor at the Haas School of Business, said it’s critical to move past the idea that markets can do no wrong when left to their own devices. “One of the lessons here that will be useful going forward is that sometimes financial markets are not only prone to excess, but pretty clearly exhibit excess,” he said. It’s often hard to recognize a bubble when you’re inside it and everybody around you seems to be getting rich. Yet that’s precisely when regulators are needed, to spoil the fun before it gets out of hand. The risk, Wilcox noted, is that innocent bystanders will be the ones hurt most if a crucial market, such as housing, collapses while do-nothing regulators allow the punch bowl to be drained dry at the party.

Sober-minded economists of libertarian bent are still arguing that government ought to just let the markets exact some discipline, painful though it might be. They can find compelling evidence of policy mismanagement going back to the Panic of 1873, an episode of railroad speculation and currency upheaval that helped spawn the brutal 23-year economic downturn known as the Long Depression. Some experts still debate why that panic happened, and what accounts for the aftermath. So if there’s any rational expectation on which everybody might agree, it’s that unanimous judgments won’t arise anytime soon on what happened just a few months ago, or on what should happen next. After all, experts are still untwisting the roots of the Tulipmania that gripped Holland in the 1630s. But there is little doubt that since the election, the voices of laissez-faire capitalism have been muffled.

The global crisis has sent some of Berkeley’s sharpest economists, including Barry Eichengreen, flying all around Europe to consult with central bankers and their advisers. He helped pull together an instant e-book of essays by 19 other international authors, suggesting what the G7 countries ought to do in advance of an International Monetary Fund meeting during the peak of the market meltdown. Eichengreen came as close as anybody to summarizing the consensus among his notoriously argumentative colleagues, in 25 words or less: “There is need for urgent action,” he wrote by way of introduction. “The policy response needs to be decisive. It needs to be global.”

Pretty much all the economists he rounded up could agree on the basic idea that banks have to be recapitalized and deposit guarantees beefed up, so that the credit freeze can be thawed before the “real economy”—the one that provides jobs to you and me—gets frozen along with the bankers’ mysterious lending machinery. Most economists also have signed on to the idea that some kind of coordinated macroeconomic stimulus is needed, too. The economy needs a shot of good old-fashioned stimulus, in other words. And the shot, to be effective, must be delivered with the global nature of the modern economy in mind. That could entail interventions on a scale Keynes never imagined. Central bankers of the world, unite.

Even if all the important policy heads nod the same way, and some kind of economic medicine is doled out in all the leading finance capitals, nobody expects instant results. Not even Obama and his Democratic congressional majority have the power to repeal the Law of Unintended Consequences. Recession, to use one of the many economic clichés, is baked in the cake.

“There are a lot of moving parts here, and it isn’t all in the power of governments to solve this,” said Haas School of Business Professor Robert Edelstein, an expert on real-estate economics who put the chances of the recession turning into a major depression at something like 5 percent—unlikely, sure, but still a real prospect. He points out that while the travails of housing have garnered most of the attention—equity declines of 20 to 50 percent since the 2006 peak are hard to ignore even if you never came near a subprime loan—you can find signs of asset-valuation bubbles popping all over the place, in markets such as wine, art, and jewelry.

Edelstein issued a seven-point strategic plan of “intertwined components” to help guide the new administration. Some elements of his plan got under way even before the election, including some short-term steps to stabilize the financial system. He argues for much more than a rescue of the credit system. He advocates “overarching re-regulation of financial markets”; a ten-year program for energy independence and alternative fuels; and universal public service to build the national morale, ease unemployment, and advance “a well-conceived, socially and economically productive set of systematic programs.” He would also retool Social Security, reform health care, and rebuild the military.

The initial response to the financial crisis focused on mopping up a bewildering mess of financial instruments, shaky lenders, and credit intermediaries. But in order to succeed, Obama has to look beyond the alphabet soup that swamped Wall Street. “The real economy needs to be engaged,” Edelstein said.

One may debate the merits of solar power subsidies or Canadian-style health care, and the few Republicans remaining in Washington are sure to ask plenty of hard questions as Obamanomics takes shape. Maybe it’s true that the best government is the one that governs least. But doing nothing is not an option. Even if we aren’t on the verge of another depression, million-dollar studios may never look cheap again. If nothing else, this promises to be a Golden Age for economists who do well on TV.

From the January February 2009 Effect Change issue of California.
Filed under: Law + Policy
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