The Committee to Save the World, Ten Years On

The Committee to Save the World, Time Magazine, 15 February 1999

It’s mostly consigned to the past, but it increasingly seems to me that the Asian financial crisis of 1997-98 and the attendant reaction of U.S. economic policy makers was the watershed economic event of the present era. The economic handlers of the time, most outstandingly Alan Greenspan, Robert Rubin and Lawrence Summers came as close to the rank of heros as economic policy makers are allowed (“the committee to save the world” in Time Magazine’s famous formulation). During the period 2 July 1997 through 23 September 1998 — the floating of the Thai baht to the deal to bail out Long Term Capitol Management — the Federal Reserve held rates steady at 5.5 percent, then in September, October and November made a succession of impressively restrained off-committee 25 basis point rate cuts. The firebreak held and the U.S. economy got another 24 months of economic growth, crossing the line to become the longest uninterrupted economic expansion in U.S. history in February of 2000. On such a basis is the formidable reputation of Alan Greenspan built.

But the unenunciated strategy of Greenspan, et. al. during this period was to stave off the spreading crisis by converting the vast and voracious American body of consumers into the buyer of last resort for the world. The countries in crisis would be propped up through IMF aid packages, but also through the newly enhanced competitiveness of their goods on the U.S. market. This was accomplished through the aforementioned interest rate cuts, but also at Treasury through the strong dollar policy.

U.S. trade deficit, 1991-2005

Source: Wikipedia; U.S. Census Bureau, Foreign Trade Division

The broadest mechanism by which interest rates work is through home mortgages. As interest rates decline they set off a wave of home loan refinancing, liberating spending previously sunk into housing costs. That combined with the (psychological) wealth effect of the stock market and a historic credit binge came together in the person of the American consumer to pull the world back from the brink. A glance at the above graph of the trade deficit shows that 1997 was the inflection point.

In so far as the way that the U.S. opted to combat the global spread of the anticipated “Asian contagion” was to transform the U.S. consumer into the buyer of last resort through loose credit, the collapse of the housing market bubble is the continuation of, or the knock-on effects of the Asian financial crisis of 1997-98. It could only be postponed, not avoided; transformed, not stopped. Old wine in new bottles.

It was fairly apparent to most observers during the late 1990s and 2000s that the Federal Reserve was struggling to stave off a crisis and did the best that it could, but was merely kicking the can down the road. There was plenty of commentary at the time that the Fed was merely letting pressure off one bubble by inflating another. And inside the Fed they were fully aware that this was what they were doing, but they had to deal with the crisis at hand and figured that they would cross the bridge of the iatrogenic consequences of their policies when they came to them.

In this sense the ultimate cause of the present economic crisis is a structural imbalance in the world economy that has a tendency to generate crises. One portion of the world, the developing, produces without consuming and as a result experiences a glut of savings. The other, the U.S., consumes by borrowing the surplus savings of that other portion of the world. Witness the current account deficit of the United States with China and the strategic fallout thereof. The problem is political-economic in nature and the ultimate solution lies in the realm of politics, not behind the scenes financial wizardry.

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Moral Hazard and Optimization

Lawrence Summers has an editorial in yesterday’s Financial Times arguing against excess concern with moral hazard (“Beware the Moral Hazard Fundamentalists,” 24 September 2007, p. 11). It is a well deserved and long overdue point. Whenever an economic crisis looms, the usual suspects trot out all the laissez faire tut-tuting. It was probably a day or two after the major news stories about the most recent central bank interventions that The Wall Street Journal editorial page started in with the boiler plate about how a few routine government interventions today spelled cataclysm of serfdom down the road. Mr. Summers’s editorial or others like it should be kept at the ready at more responsible economic editorial boards around the country.

I’m going to refrain from reposting Mr. Summers’s analysis because it is long, but it is worth reading at the link. It is worth noting that Mr. Summers doesn’t split hairs about the significance of his argument though.

Moral hazard fundamentalists misunderstand the insurance analogy, fail to recognise the special features of public actions to maintain confidence in the financial sector and conflate what are in fact quite different policy issues. As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability.

Mr. Summers’s three points of contention all argue that moral hazard, as its soothsayers characterize it, does not in fact obtain. I’m not an economist, but I’m going to go further and suggest that even if it did, under sufficiently dire circumstances, we still shouldn’t concern ourselves too much with it.

The economy isn’t a system that admits a state of perfect tune, but instead of optimization. Many factors trade off and the object is a state of affairs where maximum benefit is derived from a given factor without the deleterious effects of said factor overwhelming the positive. The Philips curve or patent protection are good examples, but others abound. It’s part of the power of economic-like thinking. And the economy is dynamic: the advantageousness or deleteriousness of a certain ratio of factors may change with time, or in relation to a third factor. For instance, central banks may have an easier time controlling inflation and may be able to do so at lower rates of interest when governments balance their budgets.

Given a dynamic balance of harms and advantages, moral hazard is a factor like any other. Moral hazard trades off with other objectives. Like the present, the most common example that people point to where it trades off is with capitol liquidity. Mr. Summers compiles a good list of examples of so objected government programs to preserve liquidity.

Moral hazard is indeed something to be minimized when times are good, it’s affordable, and its harms relatively troubling compared to the mix of harms on the horizon. But it is a goal to be relaxed when its attainment becomes extremely costly in the face of our other goals.

Think of it like this. Not spilling hot coffee in out lap is one of our objectives and under most circumstances it’s a pretty affordable one. On the go, you may have to drink from one of those sippy-cups and lean into a swig as an extra precaution, but still pretty easy. When suddenly an oncoming car swerves mid-coffee-sip into your lane, the equation shifts and the time, attention and dexterity to maneuver the coffee cup into your car’s dashboard cup holder becomes unaffordable. In order to achieve some of your other goals, you may forgo the no-hot-coffee-in-lap objective and just drop the damn cup to get the second hand on the steering wheel in a timely fashion.

When faced with a potential economic crisis, a little moral hazard may be an acceptable sacrifice. So long as the government preserves an element of roulette and just deserts in who survives and who perishes in a crisis and cultivates a reputation of preferred laissez faire — or at least an adequate amount of uncertainty about where and when it will intervene — then economic actors will remain sufficiently terrified about the future as to plan accordingly.