The Primacy of Politics

By: Barry Eichengreen

Now that we have reached the second anniversary of the credit crisis, the chattering classes are in lesson-drawing mode.   They are laying out lists of regulatory reforms designed to prevent another crisis.   They are drawing lessons for the conduct of monetary policy.   They are describing what we have learned about the effectiveness of fiscal stimulus.

            But in doing so they are missing the real lessons of crisis, which have to do more with politics than economics.    Thankfully, the response to the crisis has staved off another Great Depression.   As a result of measures taken, the world economy is likely to have commenced at least a tepid recovery by the end of the year.   But we could have done better.   And at each stage it is political constraints, not disagreements among economists, that have stood in the way.

            Consider the US case.   The stimulus package proposed by the Obama Administration and passed by the Congress has helped to stabilize the demand.   But it was undersized from the start, and it was overly skewed toward tax cuts, which are unlikely to be spent, as opposed to grants to the states and infrastructure projects.  

But it is not as if Obama’s economists were unaware that a $787 billion stimulus could not replace the $3 trillion of private spending that had been vaporized by the crisis.   Rather, they made a judgment that the public, instinctually opposed to big government, would not buy a larger package.   It made a judgment that the skeptics of public spending had to be bought off with tax cuts.    Obama’s people were painfully aware that a larger stimulus more heavily tilted toward public spending would have been better.   But they concluded that more was politically impossible and that an imperfect stimulus was better than none.

The same kind of populist backlash similarly prevented adequate recapitalization of the banks.   After the experience of the TARP, the public rebelled against more public assistance for financial institutions.   Their reaction was understandable – the TARP was hardly transparent, and the Paulson Treasury had asked to be freed of all accountability for its actions.   But the resulting rhetoric – “not one more thin dime for those fat cats on Wall Street” – made adequate recapitalization impossible.  

As a result, the Geithner Treasury moved the goal posts.   Rather than the $275 billion of new bank capital deemed necessary by the IMF, the Treasury’s infamous stress tests concluded that all that was needed was the $75 billion that could be raised from private sources.   More would have been better.   We would not be looking forward to a credit-less recovery.   But injecting public money was impossible for political reasons.   Rather than alarming the markets and further damaging confidence in the banks, Treasury simply announced that less was needed.   This was all that was possible under the political circumstances.

A second form of political constraint, in addition to the populist backlash, has been the pushback from vested interests.   The banks have pushed back against significantly tighter regulation.   There clearly will be no new Glass-Steagall Act over their opposition.   There will be no attempt to break up institutions that are both too big to fail and too big to save.   There will be no meaningful reform of executive compensation.  

The housing industry similarly pushed back against giving bankruptcy judges new powers to modify mortgages.   This key provision of the Obama Administration’s housing package has not made its way through the Senate.   The regulators themselves have pushed back against the creation of a unified supervisor.    As a result the Administration’s much vaunted proposals for regulatory reform have been reduced to rearranging the deckchairs on the Titanic.  

In each case it is not as if economists failed to understand what was needed.   But in each case, politics stood in the way.   And our leaders understandably concluded, given insurmountable political obstacles, that the perfect should not be allowed to be the enemy of the good.

   For years US and European economists were critical of Japan for its failure to take aggressive measures to end its lost decade.   Japan needed concerted fiscal stimulus.   It needed to properly recapitalize its zombie banks.   If obtuse Japanese policy makers only understood these points, the Lost Decade could have been averted.   Now we Westerners understand that it was not economic obtuseness but political constraints that prevented more effective action.   Too bad that there was not a better way of learning sympathy for Japan than by emulating its example.    

Barry Eichengreen is Professor of Economics at the University of California, Berkeley.

        

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