After Deluge

Azure no. 35, Winter 5769 / 2009
After the Deluge
By Assaf Sagiv



A specter is haunting the financial markets of the world. A crisis of 
enormous proportions, which developed slowly from mid-2007 and achieved 
dizzying momentum after Lehman Brothers collapsed on September 14, 2008, 
is currently becoming a global economic catastrophe the likes of which 
have not been seen since the Great Depression. No one dares to accuse the 
doomsayers of being hysterical and melodramatic now. On the contrary, 
pessimism has become the order of the day.
As anyone who has been following the news over the past few months knows 
all too well, this calamity originated in the false prosperity of the 
American housing market during the years 2001-2006. As a result of low 
interest rates set by the Federal Reserve and other factors, this market 
underwent a dramatic expansion without any real supervision or oversight. 
Lenders approved billions of dollars worth of mortgages to people with 
limited financial resourcesclassified as sub-prime borrowerswho 
understandably jumped at the chance to own their own homes, often for the 
first time in their lives. As housing prices steadily increased, lenders 
were confident that borrowers would be able to make good on their loans. 
This in turn fueled a frenzy of speculation on Wall Street. Large and 
small investment houses began to repackage mortgage-backed securities in a 
decidedly creative way that only the sharpest mathematical minds could 
understand. These securities were then bought and sold around the world by 
financiers who largely ignored the huge risks involved in such 
transactions.
Alas, this financial bacchanalia did not last long. In 2006, housing 
prices began to drop. The beneficiaries of the sub-prime mortgage bubble 
suddenly started taking considerable losses that became more and more 
severe as time passed. From Wall Street to Tokyo, stocks went into a 
nose-dive. Worst of all, the chaos created a worldwide credit crunch. In 
short, the bubble burst, and major financial institutions once thought 
invulnerable burst with it.
In order to limit the scope of the disaster, governments and central banks 
around the world rushed to take emergency measures. Trillions of dollars 
were earmarked to prop up shaky financial institutions, protect bank 
deposits and savings, and reinvigorate paralyzed economies. However, 
countries such as Iceland had already suffered a crippling blow. Indeed, 
even the worlds largest and most powerful economies now appear unable to 
protect themselves from severe recession.
Among informed and uninformed observers alike, the sheer dimensions of 
this crisis have created an atmosphere of apocalyptic panic. Some 
commentators, especially journalists with a sensationalist streak, have 
not been satisfied with broadcasting gloomy forecasts of an approaching 
recession, but have rushed to announcein tones either dismal or elated, 
depending on their ideologythe imminent demise of capitalism itself. 
Indeed, even more restrained analysts have declared that the market 
economy will have to undergo dramatic changes. Everyone seems to agree 
that the Anglo-American version of capitalism, so-called neo-liberalism, 
has suffered a major setback after three decades of economic dominance.
Yet if the reports of capitalisms demise are likely exaggerated, rumors of 
the return of the New Deal are certainly well founded. Major political and 
economic leaders are pushing for extensive government spending in order to 
revive sclerotic economies and provide jobs for the huge numbers of people 
who are or will soon be unemployed. Barack Obama, the new president of the 
United States, announced before his electionand again shortly afterwardhis 
intention to initiate a series of large-scale public-works projects in a 
manner reminiscent of the programs enacted by Franklin Delano Roosevelt in 
order to salvage his country from the horrors of the Great Depression. The 
affinity between the two leadersone of whom became a legend during his 
term in office, and the other even before he entered the White Househas 
already been translated into visual images by the American media. The 
November 13, 2008, cover of Time magazine, for instance, displayed a 
Photoshopped picture of Obama resplendent in Roosevelts iconic fedora, 
pince-nez, cigarette holder, and toothy grin. In the accompanying article, 
entitled The New Liberal Order, journalist Peter Beinart articulated the 
expectations of many voters when he urged the president-elect to do what 
FDR did [take] aggressive action to stimulate the economy, regulate the 
financial industry, and shore up the American welfare state.
There is no doubt that desperate times call for desperate measures. Even 
the Bush administration, which no one would accuse of secretly aspiring to 
bigger government, understood this and has swiftly come to the aid of 
financial institutions nearing collapse. In order to cope with the 
challenges of this crisis, however, policymakers must demonstrate not only 
aggressive action, but also judgment. They must be able and willing to 
distinguish between what is right for times of crisis, and what is right 
in general. This distinction is crucial. If political and economic leaders 
choose to ignore it, they may inadvertently transform a temporary 
emergency into a permanent economic malaise.

Today, the term state of emergency is usually linked to the war on terror. 
Since 9/11, several Western countries, led by the United States and 
Britain, have enacted a series of exceptional measures to protect 
themselves from the threat posed by radical Islamic terrorism. In some 
cases, these policies entailed the suspension of basic constitutional 
rights in accordance with urgent security needs. The United States, for 
example, has imprisoned hundreds of suspected terrorists in the Guant?namo 
Bay Detention Camp in Cuba, as well as in secret CIA facilities around the 
world, where they have not been granted due process according to American 
law. This state of affairs has been publicly opposed by liberal-minded 
members of the legal community and by human rights activists. One reason 
for this reaction is the fear that the exception will become the rule. An 
ongoing, indefinite state of emergency, the critics warn, will lead to the 
demise of enlightened legal standards, and thus the destruction of Western 
democracy. (A discussion of various aspects of this issue can be found in 
my essay, The State of Freedom and the State of Emergency, Azure 28, 
Spring 2007; and in Benjamin Kersteins review Batmans War on Terror, Azure 
34, Autumn 2008.)
The current financial crisis has forced many countries to transpose the 
state-of-emergency paradigm onto the economic sphere. There are, of 
course, substantial differences between the two situations: Granting huge 
loans to banks and nationalizing insurance companies are not the same as 
detention without trial or invasion of privacy. Moreover, an economic 
crisis does not stem from the subversive actions of hostile forces, and 
does not require the state to expose and neutralize a known or unknown 
enemy. Most importantly, the emergency economic measures that have been 
implemented thus far do not entail limitations on freedom or basic rights. 
However, there is a common denominator between the interventionist 
policies that the United States and various European governments are now 
promoting and the steps they have taken as part of the war on terror: In 
both cases, the state and the institutions acting on its behalf have 
expanded the reach of their authority beyond its normal limits, and they 
have done so in order to secure public order and prevent social chaos. As 
a result, market forces and institutions that were once relatively 
autonomous have come under government control. The economic sea, in which 
a wide variety of fish once swam, belongs once again to Leviathan.
Opponents of neo-liberalism are making the most of this opportunity to 
sneer at adherents of laissez-faire economics. You see? they are saying. 
The market isnt so nice anymore. Now everyone is rushing into the arms of 
government. For the most part, however, theirs is a straw-man argument. 
Even the most outspoken advocates of the invisible hand have been aware of 
its potential cruelty. One of them was the renowned economist Milton 
Friedman, who led the charge against government intervention in the 
economy during the 1970s and 1980s. Despite his staunch free market 
stance, he was of the opinion that certain policies of the New Deal were 
indeed the right thing to do at the height of the Great Depression. In an 
interview with PBS, the American public broadcasting network, in 2000, he 
explained his position, saying that it was a very exceptional 
circumstance. Wed gotten into an extraordinarily difficult situation, 
unprecedented in the nations history. You had millions of people out of 
work. Something had to be done; it was intolerable. And it was a case in 
which, unlike most cases, the short run deserved to dominate.
There are, of course, those who think otherwise. Some historians deny that 
the New Deal was effective even as a temporary solution to a national 
emergency. In her recent study, The Forgotten Man: A New History of the 
Great Depression, which provoked fierce controversy when it was published 
in 2007, the journalist Amity Shlaes presents a serious indictment of 
Roosevelts economic policy. Shlaes attempts to debunk the widespread myth 
that the New Deal saved America from the quagmire into which it began to 
sink in 1929. In reality, she claims, the opposite is true. From 1929 to 
1940, she writes, from Hoover to Roosevelt, governmental intervention 
helped make the Depression Great. Shlaes maintains that swelling public 
expenses, incessant economic experimentation, a higher tax burden placed 
on the wealthy and the middle class, and a systematic abuse of the private 
sector all contributed to prolonging the Depression until World War II. In 
1938, she writes, the unemployment rate in the United States was still 
frighteningly high: One out of every six Americans was jobless, and many 
others had no job security whatsoever. Ironically, this economic failure 
only increased Roosevelts political power. He had the backing of major 
interest groups as well as broad support from the masses, who believed the 
New Dealers populist rhetoric that blamed big business for the gloomy 
situation.
Shlaess book is convincing enough to give the new-New Deal enthusiasts 
pause. At least it should. Experience demonstrates that, in the long run, 
a massive expansion of the public sector does not help the economy. It 
creates an inflated and ineffective bureaucracy, increases the deficit, 
squeezes taxpayers, and suffocates free enterprise. Given our current 
circumstances, however, it is hard to justify a sweeping objection to 
emergency measures. Abandoning the global economy to the invisible hand is 
simply unacceptable. In a crisis like this, swift and decisive government 
intervention is inevitable. It prevents, or at least restrains, the kind 
of mass panic that could lead to further deterioration, and gives the 
economytrapped in a worsening credit crunchroom to breathe. It is also, 
unfortunately, hugely expensive. But at the moment, such actions are all 
that stand between billions of people and a life of poverty and despair. 
No government can avoid intervening in such a situation with all the power 
at its disposal. We can only hope that it will also know when the time has 
come to withdraw.

In the long run, John Maynard Keynes once said, we are all dead. This may 
be true, but that is no excuse for shortsighted thinking. Indeed, it is 
precisely because todays politicians and economists are being forced to 
consider extreme measures that they must also contemplate what will happen 
after the crisis is over. They must remember that a policy suitable for 
times of crisis may notand perhaps should notbe suitable in times of 
normalcy. After all, a drug that cures a critically ill patient may be 
poisonous to a healthy person.
So what will the global economy look like when the storm has passed? It is 
clear that the American financial sector, and probably those in other 
countries as well, will be placed under stricter public supervision. 
Investment banks, insurance companies, and credit-rating agencies, all of 
which bear the lions share of the blame for this catastrophe, will be much 
more heavily regulated by the government. In all likelihood, the most 
important lesson these regulators will take from the experience of the 
past two years is the need to change incentive structures. In an article 
published in Harpers in November, Nobel Prize for Economics laureate 
Joseph Stiglitz warned that:

     Too many bankers and other lenders have been focused on trying to beat 
the system by getting around accounting and banking regulations (through 
what is called accounting and regulatory arbitrage). Indeed, with bonuses 
based on short-term profits, they had every incentive to gamble and 
connive. And now that theres a bust, no one is being asked to pay back the 
hefty bonuses earned during the boom. On the contrary, even as they are 
dismissed, those who helped send their firms and the American economy into 
a tailspin are rewarded with generous severance packages. They are 
enriched regardless of what happens to investors, homeowners, and others 
who lost so much. Unless we reform incentives, the financial sector will 
only try to circumvent whatever new regulations are put in place. We 
simply have a short respite before the next crisis.

It seems, therefore, that there is no way of avoiding a certain degree of 
regulation in the short run, and perhaps even in the long run as well. Yet 
it is best to minimize this regulation and not set our hopes too high. 
After all, bad regulation is no less responsible for the current downturn 
than lack of regulation. Indeed, decisions made by senior government 
bureaucrats turned out to be just as ruinous as the shenanigans of 
financial moguls. The United States Securities and Exchange Commissions 
2004 decision to allow investment houses to use their reserves as 
investment capital proved disastrous. Likewise, the fact that Freddie Mac 
and Fannie Mae are sponsored by the American government did not prevent 
them from acting in an extremely reckless manner, accumulating such 
enormous losses that they had to be nationalized in September 2008.
In the final analysis, this crisis, however severe and unprecedented, does 
not change one basic truth: The state is not the most qualified or 
rational actor in the economy. Its conduct tends to be inefficient and 
often simply unintelligent. In most cases, it is best to permit the 
mechanisms of the free market to operate without hindrance. Their ability 
to repair themselves is vastly more efficient than bureaucratic attempts 
at central planning. Accordingly, governments that currently control 
larger and larger segments of the financial market would be wise to 
transfer some of this power back to private hands as soon as possible. The 
most troubling question that remains, however, is when that soon as 
possible will be, and what we must do until then in order to weather the 
storm.

Assaf Sagiv
December, 2008


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