James galbraith’s Introduction speech to the « The Financial Crisis, the US Economy, and International Security in the New Administration » conference



by James K. Galbraith
Language : English - Translation : Discours d’ouverture de James Galbraith

Let me say first a very warm word of welcome to all of you, to this conference organized by Economists for Peace and Security, an organization which I have the honor to chair, the Charles Leopold Mayer Foundation, and the International Initiative for Rethinking the Economy. I would particularly like to acknowledge and warmly thank the support, inspiration and moral contribution of Pierre Calame and Aurore Lalucq and the Levy Economics Institute of Bard College. And I would like, as always, to thank Dimitri Papadimitriou, president of the Levy Institute, for his support and help in these matters.

We are here, I’m very happy to say, at the Schwartz Center for Economic Policy Analysis of The New School in New York, an invaluable institution for contributing to our public debate. And I am particularly pleased and honored to recognize the presence this morning with us of Bernard Schwartz. Thank you very much.

I would like to begin by giving you a brief account of the origins of the meeting that we’re holding today. They lie in a correspondence that began in the early part of this year between myself and mainly Aurore Lalucq but working closely with Pierre Calame. It was our feeling at the time that the problems of the financial sector, which had begun to emerge with great clarity in August and September of 2007, were not yet at that time fully appreciated, nor were their implications for the U.S. economy and the world economy fully understood. And we thought it would be useful at that moment to bring together a group of people who could meet privately over a couple of days and review the situation amongst ourselves so as to develop, to the extent possible, a common viewpoint and to come to a fuller understanding amongst ourselves, principally, of the scope and dimensions of the problems that were likely to develop.

Given the support and the facilities of the Charles Leopold Mayer Foundation and the Initiative for Rethinking the Economy, a venue for meeting in the very pleasant burg of Paris was offered and accepted, and it proved, I have to say, remarkably easy to get a very interesting and distinguished group of people to agree to come and spend a couple of days on this. We duly convened in June 2008 and had, I think, two rather remarkable days of intense conversations.

The question arose of how to summarize those conversations for a larger audience, and I took that responsibility largely on myself, drawing on the records of the meeting. I drew up an extensive memorandum which initially circulated in certain political circles, but also was prepared for publication and is now in print in Challenge Magazine, another vital and far-sighted organ for public discourse in these matters, edited by Jeff Madrick, who is also here this morning. That article, that memorandum, made the case – at a time when the financial crisis was not yet the leading news story nor the leading political issue in the ongoing presidential campaign in the United States – that whatever happened between the summer and the election, this crisis was likely to be the leading item on the agenda of the incoming administration.

The reason we felt that way was that, in our view at the time, the financial system of the United States and of the Western world had come to a pass which we had not seen in our professional lifetimes, that it had developed a series of difficulties which would not be overcome by ordinary processes of market adjustment in a very short period of time, nor by minor regulatory fixes and interventions. And we felt that the macroeconomic implications of this problem would become essentially the dominant economic issue within a reasonably short period of time. I think it’s fair to say that we did not fully anticipate that it would happen as quickly as it did. I certainly felt that my reputation as a prophet would be safe if I published in November and events happened after the election. As it happened, the pace of the crisis was accelerated, relative at least to our expectations, and serious unmanageable problems emerged by the middle of September.

We found ourselves facing a situation in which a sequence of financial events that had been building up for the better part of a decade – I’m thinking here, in particular, of the willful and conscious erosion of regulatory and supervisory standards in the housing finance industry, the emerging and rapidly spreading practice in the middle of this decade of the securitization of sub-prime and all A-mortages and their bundling into mortgage-backed securities and collateralized debt obligations backed and insured by credit default swaps – were creating an environment that John Eatwell has described as “market gridlock”. The financial system had lost the capacity to price the assets that it was trading, lost confidence in the value of the portfolios of counter-party institutions and lost the willingness to play the role of the spark and fuel of economic expansion.

What did we find at that moment? The collapse of the investment banks, either into mergers and acquisition, or, as in the case of Lehman Brothers, into bankruptcy. We found that the organs of government of the Bush administration, after having attempted to deal with this problem on a case-by-case basis, found that they were unable to do so and came to Congress with what they called a systematic approach. That systematic approach took the form of a piece of legislation that was in fact about two-and-a-half pages long and asked for a grant, or an authorization, to repurchase the troubled securities to the tune of $700 billion. And in the initial phases of the legislative process, the request was to do so without supervision or review.

Since that was the situation around the 18th or 19th of September 2008, the members of our group had some advantages of preparation. And we used those advantages in two public forums, one of which was a collaboration between myself and Bill Black in The Nation, which laid out a number of clauses and conditions that we felt ought to be in any legislation that Congress might seriously consider. That is to say, provisions relating to such elementary matters as conflict of interest or unjust enrichment. Given that action was going to become politically inevitable, there was a series of about eight things that we thought should at least be part of a process of effective governance of how that action was conducted. That was the first step and it had, I believe, some influence. At least I heard from those who were engaged directly in the legislative drafting that our intervention and their thinking was running on very similar lines.

Then, in the course of this discussion, I also got an inspired message from John Eatwell, who is here today, who suggested that we really ought to propose an alternative line of attack, that would focus, given the disappearance of the investment banks, on the security and soundness of the banking system and the powers that the federal government already had to deal with this crisis. With the help of a small sub-working group, some of whom had been at the Paris meetings and some of whom had not been, and including some others who are here today – and I’ll mention Marshall Auerbach in particular – I was able to draft and publish an op-ed piece in The Washington Post on the 25th of September which laid out an alternative plan. It was published under the somewhat mischievous headline of “A Bail-Out We Do Not Need,” when in fact the topic of the article was the direction of the action, rather than the necessity for it. But I found myself an inadvertent populist hero as a result of that headline, which I was not going to complain about. I did also find myself being invited up to discuss the particulars of these issues with the members of Congress who were going to have to vote on it on the 28th or 29th of September.

That alternative line of action, which again closely tracked the themes and principles of the conversations in Paris, suggested that what we should do, first and foremost, was deal with the panic that was overtaking the banking system by extending deposit insurance and putting a stop to the purely fear-based run of deposits from smaller banks to larger banks.

Secondly and closely parallel, we argued that something should be done to stabilize and secure the commercial paper market and the money market funds.

Thirdly, that rather than attempting to stabilize the price of the troubled assets – this sea of mortgage-backed securities – in a way that was bound to be both inefficient and futile (by buying them back in an open market), the appropriate way to stabilize and secure the banking system was for the government to buy preferred equity in the banks directly.

It’s very interesting to note, whether one can trace direct influence or not – and I very much doubt that one ever would be able to do that – that within a month reality had pressed the Bush government to largely adopt action along these lines; that is to say, to take the steps that we believed in advance would ultimately be the necessary steps: stabilize the banking system and making a direct capital replenishment of the banks. Major arguments are now ensuing, and should properly ensue, as to whether those steps have been taken in a way which is fully effective, efficient and protects the public interest. Those questions will continue to be pursued; but I think that there is very little doubt that a course of action is underway which is more effective than would have been the case had the initial program of attempted asset repurchases been pursued.

Still, in Paris in June, and in the discussions in Washington in September, those of us who had been involved in this were never in any doubt that stabilizing and securing the financial side of the equation was a necessary but not sufficient condition for an economic program going forward. There is, in discussions of this crisis, a tendency, in certain circles anyway, to treat it as a financial crisis; and an implication of that use of words is that if one deals with the financial issues, the larger economic problems will be resolved. In other words, something has happened to the machinery of the banking sector, a problem of confidence, a problem of liquidity, maybe a problem of solvency, something of that nature – if that something can be resolved and credits start flowing again, then the underlying problem or effects of the crisis on economic growth will be mitigated or dealt with.

We do not think this to be the case. In our view – and it’s a very simple view really – there needs to be a borrower as well as a lender for a credit transaction to take place. And the borrower has to have a reason to want to borrow – that is to say, an expectation of profit – and an asset against which to borrow. And that asset in the American economy for many years has been housing equity, which, of course, is now gravely impaired.

financial stabilization and economic recovery

So we have a situation that is going to require, as a first condition, financial stabilization, but as a second condition, a broad-based program for economic recovery. Already the outlines of that program were being discussed at the Paris meeting. They are basically common sense. They are put together out of the pieces of the problem that we actually face. A major piece of that problem is housing, the fact that there are millions of houses out there which are in foreclosure or threatened by foreclosure, and many more whose value in the open market is driven down to well below the debt that is owed on them; and therefore are both no longer a font of collateral for consumer household borrowing, and also pose the temptation for homeowners to walk on those houses rather than have to pay the bank if they choose to leave.

So, this is a crisis that can only be resolved at the level of the housing industry, the housing sector, and by a mechanism that was already proposed in January 2007, I believe, by Paul Davidson, who is here. And the mechanism is to reestablish something along the lines of the Homeowners Loan Corporation (HOLC) of the 1930s, able to renegotiate and reset mortgages in ways that would make them largely sustainable for the population. This is not a small endeavor. The HOLC at its peak employed 20,000 people, and we are now in a much larger economy with perhaps an even larger housing problem. But it is something which is increasingly recognized as necessary. And I can also report that the principle of such an operation was accepted in a colloquy between Congressman David Scott of Georgia and Chairman Barney Frank of the Financial Services Committee on the floor of the House in the debate just before the final adoption of the TARP [Troubled Asset Relief Program] bill on the second vote. A couple of the principles were actually in the legislation, and there was an agreement between those two leading members of Congress that the other principles should be put into place when the opportunity arises. This is the first major initiative whose necessity is increasingly accepted across the board.

Secondly, we live in a federal system where state and local governments fund themselves to a very large extent from taxes on local activity and particularly on the value of property. As property values decline, state and local revenues decline. We have every indication that there will be massive cuts in the budgets for public services, for schools, for police, for fire, for libraries, for parks, which can only make the problem worse in two ways: one, by diminishing the value of the property assets that everybody holds; and secondly, by layoffs of public personnel who will then have increasing difficulty in servicing their mortgages. So it becomes a fundamental part of the solution that the revenue base of the states and localities be back-stopped, be supported, by direct federal assistance. We need to dip into the tool bag of that great liberal innovator, President Richard Nixon, and reenact general revenue sharing so as to stabilize the state and local public sector.

I would say thirdly that, just as states and localities are forced by revenue cuts to cut their budgets, they are forced by the closing of the credit markets to cut their capital budgets; and this just at a moment when capital expenditure by state and local governments and by the federal government is absolutely essential in order to absorb the resources that are being released in the housing sector and elsewhere in the economy. In other words, this is a moment when, from every practical point of view, we ought to be doing all of the things that we neglected to do in the flush times of the private sector, through the technology boom and bubble of the late 1990s and through the housing boom and crash of the last decade. We have an enormous backlog of public work that should be done and an enormous prospect of things that will need to be done in order to give the private economy a focus and a direction that will help meet some of our major long-term problems, in particular the problems of energy, security, and climate change. It is clear that this is the moment, if we are ever going to do this, to put such a program into place, to get it started. One institutional feature of this would be a national infrastructure fund, and another would be a mechanism at the federal level to lay the groundwork for a sustainable energy future.

Fourth: we need to worry about the effects of the collapse of asset values on the income positions of the elderly population and the population which includes, I think, a fair number of those in this room: people who would like eventually to be elderly. This is a situation where it is the private part of the retirement system which has fallen into crisis, a system which has built up over the last generation into defined contribution pension plans, many of which were invested in very volatile assets and whose value has now declined dramatically.

What should be done then? I have a very simple proposal, which is that we should consider, for the first time in a generation, an across-the-board increase in Social Security benefits. You cannot, of course, make everybody whole for the value of their own investment at any particular time. People made different choices, took different kinds of risks, and are going to have to bear the consequences of that. But, as a public policy matter, it is essential that the elderly population as a whole and individuals in it not be allowed to fall into poverty, and that the purchasing power of this segment of the population be maintained in order. As it is, we have a system in place that would permit us to do this in a relatively easy way. We don’t have to reinvent the Social Security system; it exists.

Looking ahead

We may be required, as time goes forward, to take even larger measures. We do not know the full extent and the implications of the problems that are emerging in the automobile industry – and no doubt throughout much of the industrial sector. We’re only learning now, in the last few days, that General Motors could easily be out of business by the end of the year if action is not taken to provide it a lifeline. It’s a complicated, difficult problem, there are many arguments on both sides; but the reality is the full extent of the industrial and economic decline that we may be facing. So we may need to be prepared to go beyond the stabilizing measures I’ve just described and take additional steps. I’m thinking about the equivalent of a holiday on the payroll tax, or the reinvention of the Reconstruction Finance Corporation, or the reenactment of the Comprehensive Employment and Training Act, the jobs program, something that would bring us back toward the major employment enterprises of the New Deal which had an enormously impressive effect, when you actually count the people who worked for those agencies as employed, in reducing the actual unemployment rate in the 1930s from 25 percent to down to 7 percent by the middle of the decade.

I think that there is really no need at this stage to present measures like those I’ve just been outlining as part of a unified ideological or philosophical framework. It’s really up to people who will come later to decide whether it deserves that level of definition and identification. It’s up to us, however, to advance the ideas that we think will work in a practical way, in a spirit of pragmatism, in a discussion which I hope to carry out and listen to over the course of today, a discussion that is open-minded, that is flexible, and that will at the end of the day advance the cause of an early, as opposed to a delayed, solution to the specific problems that we face.

The underlying premise is clear: that doing nothing is not an option. Doing little is not an acceptable option. Assuming that a problem which is rooted in a major meltdown of financial confidence and governance, and in a major crisis in the housing sector, will go away in a short period of time, that it would respond to regulatory measures alone, or to a stimulus package of a short-term character alone, seems to me something that we can safely set off the table as being beyond the realm of plausibility. Therefore, we are faced with the task of designing a sequence of economic policy measures that will be effective over the length of a presidential term or longer, and thinking through how to sequence those measures so that you can have some short-run successes that will lead toward a more stable and sustainable outcome over time. It’s a complicated problem but it is a problem at which we cannot afford to ignore.

In thinking about it we have two enormous advantages. Compared to the 1930s, or even the 1960s, we have the institutions that were created in those days, institutions which have been deeply deprecated in our political discourse for many decades, but which are in fact the foundation of the success and resilience of our economy, from deposit insurance, to Social Security, to Medicare, to the whole structure of the New Deal and the Great Society, which left us with a tradition of orderly governance. Even if that tradition has been under attack for a long time, it’s still there.

The second advantage that we have, of course, is this extraordinary event that occurred on the 4th of November 2008, an event that changed the terms of dialogue in the politics of this country, and perhaps in the politics of the world, moving it away from the rigid ideology opposed to public interest and the public purpose, away from the use of government institutions as masks for private and predatory purposes, and closer to – what? Nothing more than the practical, open-minded, open-handed, and responsible approach to the enormous challenges and problems we actually face. I don’t think the population of the country was asking for more than that, and they certainly shouldn’t get any less.

External links

The Economists for Peace and Security’s website

Levy Institute’s Website

1.AAA is the highest ranking accorded by rating agencies to any bond or security.

2.Collateralized debt obligations are a type of asset-backed securities that are considered to greatly increase risk in the financial markets, since loan issuing institutions retain no risk for the loans they make. As shown by the credit crunch 2007/8, this leads to uncontrolled degradation of underwriting standards.

3.A credit product where the buyer receives credit protection, whereas the seller guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

4.Established in 1933 by the Homeowners Refinancing Act, in order to refinance homes to prevent foreclosure

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