From the December 14, 2008 Sunday Times
December 15, 2008
by Irwin Stelzer
Don't project beyond the range of the known observations” is a rule followed by careful economists. In plain English this means, for example, that we know how American consumers behave when petrol prices move between $1 and $4 a gallon, “the range of the known observations”. But we haven’t much of an idea what consumers would do if prices rose to $5 — no experience, no data to inform our forecasts. Which is why we have to be very careful when predicting the effect of the various policies that are being adopted to fight the credit crisis and recession. We simply have no experience of this combination of events.
So we have reason to worry about the galaxy of stars that Barack Obama has assembled to help him right the American economy. They are so bright, so self-confident, so accustomed to being the smartest guy or girl in the room, that doubt is not one of the emotions with which they are familiar, as was true of the bright young “quants” (mathematical economists) who designed the models used to manage the risks taken on by Lehman Brothers and AIG. Something about hubris and nemesis comes to mind.
Consider this. Treasury secretary Hank Paulson persuaded Congress to give him a $700 billion pot of money with which to buy the rotten IOUs on banks’ balance sheets. The theory was straightforward: relieved of this burden, the banks would resume their role of lenders to potential homeowners, businesses and consumers. It sounded like a good idea. But almost immediately it occurred to Paulson that Gordon Brown had a better idea — recapitalise the banks by buying shares so that they could begin lending again. That, too, was confidently touted as a good idea.
But we have moved beyond the range of what we know about credit crunches. All we know is that the results so far have not matched the predictions of the proponents of these policies. Which is one reason why Paulson decided not to use the second half of his $700 billion, and to leave it to the next Congress and the incoming president to decide whether it might not be better to pass the remaining $350 billion direct to homeowners who are falling behind with their mortgage payments. Surely that would reduce foreclosures and repossessions, thereby easing the glut of unsold homes, raising prices and helping to bring the recession to an end. Surely? Better, perhaps.
Then there is the proposed bailout of the Big Three carmakers — GM, Ford and Chrysler — stalled at this writing by the refusal of Senate Republicans to go along with the compromise deal crafted by the White House and congressional Democrats. These senators see no reason to spend taxpayers’ money to underwrite the $70-a-hour labour costs of the unionised companies, when Toyota and other non-union domestic manufac- turers produce great cars in America with workers earning a still-handsome wage of $45 a hour. But even though the Auto Workers Union is refusing to make any significant sacrifices, Bush and Paulson are determined to find a way to pump cash into the industry to put it on life support for 37 days.
Then, the ball will be in Obama’s court. The president-elect has promised to develop a plan to restructure America’s motor industry, something that has eluded the industry’s management during its decade of decline. Experts estimate that Obama will end up spending $125 billion in pursuit of his goal.
Once again, it is difficult to predict the consequences of a government intervention. Advocates of a bailout are predicting that the result will be a lean, mean, green competitive Big Three, and that failure to act will reverberate through the economy. Opponents say that recourse to the bankruptcy courts is more likely to produce a healthy motor industry. Unfortunately, we simply have no experience with a bailout on this scale and in these circumstances. It is beyond the range of known observations.
Then there are Obama’s plans for an economic stimulus costing at least half-a-trillion dollars, more likely a trillion. Roads, bridges, schools and all sorts of other things fitting under the title of “infrastructure” will be built, providing 2.5m jobs. So says Obama’s distinguished team of economists.
But infrastructure projects take a long time to move from the drawing board to a shovel in the ground. So the recession might be over before any worker dirties his or her hands paving a road or putting the first rivets in a bridge. Or the stimulus might actually, well, stimulate. We won’t know until experience performs its historic role as teacher.
Finally, there is the impact of driving up the government’s deficit to something like 10% of GDP, about three times the level once considered the limit beyond which the Federal Reserve Board would be forced to raise interest rates to stave off inflation and save a sinking dollar from complete collapse.
But we have moved beyond the range of the known observations: the Fed is doing things no central bank has ever done. The government borrowing mounts, the printing presses turn out billions of newly minted dollars. But here is the surprise: the Fed is keeping interest rates close to zero, investors are lending the Treasury money without asking for interest (and in some cases paying the Treasury for being allowed to buy its IOUs), and the dollar remains strong as risk-averse investors flee to the American currency.
The point of this exercise is definitely not to persuade you to skip this column every Sunday. Rather, it is to persuade you that the following opinions are best guesses based on the imperfect analytical tools in this economist’s tool kit, and a good deal of real-world experience.
So here goes: the second tranche of $350 billion should be aimed at easing credit markets rather than specifically at the housing market; the GM bailout will fail because the parties won’t give up enough to make the company competitive; the dollar won’t sink because there are few places investors can trust as much as the United States, even a heavily indebted United States. That much I know — well, think I know.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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