The Economists’ Hour (part 3)

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Binyamin Appelbaum calls the period from 1969 to 2008 the “Economists’ Hour” because of the unprecedented influence professional economists had over public policy during those years. At the same time, within the economics profession and in public policy discussions, the government activism of Keynesian economics was giving way to the free-market conservatism advocated by Milton Friedman and the Chicago school.

The “Great Moderation”

The latter part of this era, beginning around 1985, goes by another name in economics, the “Great Moderation.” That was a time when both inflation and unemployment were at lower rates than during the stagflation of the 1970s. Unemployment did rise during the recessions of 1990-1991 and 2001, but not as severely as during the recession of 1981-1982, when the Federal Reserve was putting the brakes on the economy to tame inflation.

Not surprisingly, free-market economists attributed the Great Moderation to the success of their recommended policies—lower taxes, less market regulation, and both fiscal and monetary restraint on the part of government. Appelbaum is skeptical, suggesting that other forces were at work. “The ‘peace dividend’ from the end of the Cold War made it easier to reduce federal spending; globalization weighed on wages and prices [that is, global competition made wage and price hikes harder]; new technologies drove a surge in productivity and prosperity.” He also points out what wasn’t so great about those years—relatively slow economic growth, increasing inequality of wealth and income, and reduced public investment in future growth.

The financial crisis

In his assessment, Appelbaum has the benefit of hindsight, since he knows that this period of economic history ended in disaster, the greatest financial collapse since 1929 and the deepest recession since the depression of the 1930s. “The Economists’ Hour did not survive the Great Recession…. In the depths of the Great Recession, only the most foolhardy purists continued to insist that markets should be left to their own devices.”

Appelbaum’s account of what went wrong focuses on developments in the expanding financial services industry. The bank failures of the 1930s had led government to impose stricter regulations, including limits on the interest rates banks could pay depositors or charge borrowers. When other interest rates spiked after the Federal Reserve started tightening the money supply in 1979, pressure from both consumer groups and bankers led Congress to deregulate bank rates. In the previous year, the Supreme Court ruled that credit card companies could charge whatever interest rate was allowed in the state in which they were headquartered, even if they did business nationwide. Financial institutions rushed to locate in states with the most permissive rules, and states competed for their business on that basis.

In addition to relaxing old regulations, governments failed to develop new regulations to keep up with financial innovation. The prevailing view that financial markets were efficient and self-regulating encouraged policymakers to leave them alone. The riskiest innovations were new forms of derivatives—securities whose value depended in some complex way on the fluctuating value of an underlying asset. Instead of buying and selling real estate, investors could buy and sell packages of mortgage loans. They could even invest in a derivative that represented a bet that such packaged loans would either gain or lose value. The gains and losses from derivative investments could be many times the gains and losses from trading in the assets on which they were based.

When Brooksley Born was appointed head of the Commodity Futures Trading Commission by President Clinton, she began to advocate for the regulation of derivatives. She was opposed, however, by Fed Chair Alan Greenspan, Treasury Secretary Robert Rubin, and SEC chair Arthur Levitt. In 2000, Senator Phil Gramm quietly inserted a provision to prohibit such regulation into a broader bill, which passed without much notice.

Signs of the financial trouble ahead appeared early in this period of financial deregulation—or non-regulation. Many Savings & Loans failed between 1986 and 1995 after being bought by financial speculators and swindlers. (The failures cost the taxpayers over $100 billion, since the deposits were federally insured.) Risky investments in derivatives led to bankruptcies like Orange County, California in 1994 and Long-Term Capital Management in 1998. But it was the housing boom of 2003-2006 that encouraged the most dangerous behavior. In their zeal to profit from the boom, financial institutions engaged in subprime lending on a massive scale, lending to borrowers who didn’t qualify for traditional fixed-rate mortgages but could be sold more complicated loans with the potential for spiking monthly payments. Lenders could disguise the shakiness of the individual loans by selling them off in packages that were assumed to minimize risk, just like a diversified stock portfolio. The packages were then overrated and even insured by companies willing to bet on their continuing value. When the bubble of inflated asset prices finally burst and the 2007-2009 recession began, borrowers who owed more than their houses were now worth defaulted in large numbers, causing massive losses to investors and financial institutions.

The financial crisis and deepening recession forced the federal government to act, both to keep huge financial institutions from failing and to stimulate aggregate economic demand with federal spending. Suddenly, Keynesian ideas were dusted off and given a new look.

Larry Summers, who was installed as head of the National Economic Council [in 2009, in the Obama administration] had said in 2001 that government stimulus spending during an economic downturn was “passé” because its merits had been “disproven.” In 2009 he changed his mind. When a reporter asked Summers to describe the government’s plans, he responded with one word: “Keynes.”

The federal stimulus plan passed by Congress in 2009 was controversial, supported by Democrats but opposed by almost every Republican. Obama himself wavered in his support for stimulus, calling for more “belt-tightening” the following year. Support for government austerity remained strong for several more years, but many economists began to believe that budget restraint was prolonging the recession. Paul Krugman and Robin Wells say in their macroeconomics text, “By 2014, the intellectual debate seemed to have gone mostly against the advocates of austerity.”

The Federal Reserve also became more activist, broadening its focus on fighting inflation to include the goal of creating jobs. Not only did the Fed bring short-term interest rates down to near zero, but it tried to reduce long-term rates as well by buying up Treasury and mortgage bonds. (That has the effect of raising prices on bonds and lowering their rates, since bond prices and rates move in opposite directions.)

Appelbaum wrote this book before the 2020 pandemic and associated recession. That new crisis led both the Trump and Biden administrations to propose additional stimulus spending, further undermining the free-market position. The leading advocate of free-market economics, Milton Friedman, did not live to see either the 2008 financial crisis or the pandemic. He died in 2006.

Economies, people, and imagined futures

I will finish by citing two of the grander themes of The Economists’ Hour. In his conclusion, Appelbaum says, “If you have taken anything from this book, I hope it is the knowledge markets are constructed by people, for purposes chosen by people—and they can be changed and rebuilt by people.” We invented the market economy as an awesome wealth-producing machine, but it remains our invention. When we start to think of it as an autonomous machine requiring no creative human intervention, I think we reduce ourselves to cogs within the machine.

A related idea is that we must always keep one eye on whatever future we desire. Appelbaum complains that “the emphasis on growth, now, has come at the expense of the future: tax cuts delivered small bursts of sugar-high prosperity at the expense of spending on education and infrastructure.”

Jonathan Levy adopts a similar perspective in his new economic history, Ages of American Capitalism, which I am currently reading. “Because a capitalist financial system is a perpetual leap of faith, over and over again, confidence becomes the emotional and psychological mainspring of economic activity.” Where do we place our confidence? In the stock market, or a bank, or a technology company, or in world trade? In a country with both a capitalist economy and democratic government, are we wise to put all our confidence in markets and none in our government? Or vice versa? If the economic machine keeps breaking down, or serves the few better than the many, or seems to be pushing us towards environmental disaster, must a democratic people be precluded from trying to actualize a better future through honest political debate and collective decision-making? If a loss of faith in government gave us the “Economists’ Hour,” maybe some recovery of that faith can give us a wiser and more balanced approach to public policy.

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