Credit Crunch

The Great Recession has put enormous strain on the American social contract, exposing not only the many holes in our social safety net but also the weaknesses in its basic design and philosophy.

Mariachi music and the Potomac River don’t often find themselves in the same sentence, but Mexico turned 200 overnight, so an exception had to be made. Mariachi music did indeed waft over the Potomac, emanating from the Grito celebration on the esplanade of the Kennedy Center. Ozomatli played, fireworks ensued, naturally, and thousands of melancholic Mexicans toasted 200 years of independence from the old empire in the capital of the empire many of them feel replaced it.

Mariachi music and the Potomac River don’t often find themselves in the same sentence, but Mexico turned 200 overnight, so an exception had to be made. Mariachi music did indeed waft over the Potomac, emanating from the Grito celebration on the esplanade of the Kennedy Center. Ozomatli played, fireworks ensued, naturally, and thousands of melancholic Mexicans toasted 200 years of independence from the old empire in the capital of the empire many of them feel replaced it.

The first step in treating a severe illness is making the correct diagnosis.  Since passing the stimulus package in early 2009, President Obama and his economics team have groped for a good explanation of why the economy remains stuck in a long-term slump, and in particular, why job growth has remained so slow.  The answers have variously been high health care costs, fiscal profligacy by the Bush administration, recklessness on Wall Street, excess dependence on foreign oil,  and a poor education system.

The single most important reason for the failure of the recovery to take hold thus far is that private credit markets are locked up, especially for small businesses.  Private business borrowing and lending is at a standstill, while private banks are holding an unprecedented $1.1 trillion in cash reserves in their Federal Reserve accounts.  In 2007, before the recession began, the banks held only $20 billion in reserves.  The 2007 figure was itself dangerously low.  But a nearly $1 trillion turnaround in bank reserve holdings is a new form of Wall Street excess.

Mr. President:

With hopes of a V- or U-shaped recovery fading, there is the increasing prospect of an L-shaped future of long stagnation, or even a W-shaped future in which W stands for something worse. The reason for this dismal outlook is economic policy is trapped by failed conventional thinking that can only deliver wage stagnation and prolonged mass unemployment.

Your administration’s current economic recovery program has been marked by four major failings:

At this year’s Jackson Hole conference for central bankers, Fed Chairman Ben Bernanke admitted that the economic recovery so far this year has been “somewhat less vigorous than we expected,” but he expressed hope that the economy would return to a more satisfactory growth rate next year.  Considering that the Fed was already projecting a markedly slower recovery than America experienced after previous deep recessions, the Fed’s economic objectives are far too modest.  Ideally, the US economy should be growing at a 5 percent rate in 2010 and 2011 to recover lost ground and get work

President Obama, his economics team, and the Chairman of the Federal Reserve continue to display a curiously detached view of the economy.  Just the other day, the president indicated that “it took nearly a decade to dig the hole that we’re in” as if that provided an excuse for the lassitude he continues to display in regard to the problem of unemployment.

In July 2008, in a memorandum for the Obama campaign team and later published in Challenge,  I wrote as follows:

If the above analysis is correct, the political capital of the new presidency risks being depleted, quite quickly, in a series of short-term stimulus efforts that will do little more than buoy the economy for a few months each. Since they will not lead to a revival of private credit, every one of those efforts will ultimately be seen as “too little, too late” and therefore as ending in failure.