Comment on Professor Joseph Stiglitz's article "How to Fail to Recover" on Project Syndicate
(Date Written: March 16, 2009)

Professor Joseph Stiglitz discusses two issues in the above-mentioned article -- (i) the stimulus package, and (ii) the crisis in the financial markets. I have some points of my own to make on these two issues:

(i) Misconception: if the stimulus bill is not large enough, it would not deliver a recovery.

By the end of Summer 2008, political support for a new stimulus bill began to gather in earnest. At that time, it was not known for certain whether the American economy was in a recession. Now, in recent decades, a large number of research papers have been written combining insights from Keynesian theory with business cycle theory towards the aim of smoothening the fluctuations in the business cycle. In fact, the boom in East Asian economies that extended to more than 25 years before 1997, and the 63-year long recession-less growth in the world economy since the end of the second world war, lent credence to the view among academic economists that a recession could be made short and shallow, if not altogether bypassed. As a result, throughout Fall 2008, many economists repeatedly stated that if the stimulus bill is not large enough, it would not lead to a recovery.

Sometime during the winter of 2008, NBER announced that the American economy had actually been in recession since December 2007. It was after this announcement that there was a realization that the current economic recession is a really serious one, and cannot be wished away by a massive one-time stimulus bill. Till then, economists had been pre-occupied with preventing the crisis in the financial system from spreading to the real economy. However, the realization of a serious economic crisis came too late. The political momentum for a massive one-time stimulus bill had already been set in motion. Moreover, since it was now getting very difficult to justify a huge one-time stimulus bill on a theoretical basis, some political compromises had to be made to get bi-partisan support. As a result, a large part of the $800-billion stimulus bill was marked for tax cuts.

However, there were some sensible last-minute adjustments. With the economy already mired in a serious recession, a massive stimulus spending would be like flogging a dead-tired horse. So, the sensible approach was to change the focus of the bill towards structural re-adjustment rather than a stimulus, and back-load much of the spending to 2010. Keynesian theory requires continuous monitoring of the markets to enable the central bank or the government to step in and take corrective measures whenever it is obvious that the resource allocations made by the markets would not be optimal in the long run. There is no provision in Keynesian theory to spend several trillion dollars at one time, so that a recession can be postponed by a decade, say. Hence, it would have been better to enact a series of small spending bills to come into effect every three months or so. With the flexibility of tuning the spending according to how the economy reacts to the current recession during each three month interval, it would have provided a much better support for the economy to fight its way out of the recession.


(ii) Financial markets.

Recently, Professor Nouriel Roubini has argued that the US financial system is effectively insolvent (Ref: his March 5, 2009 article on Forbes.com). By his calculations, the total losses in the financial system is about $3.6 trillion, of which about half ($1.8 trillion) would have to be absorbed by US financial institutions and the other half by foreign institutions. But the total capital in the US financial institutions is only about $1.4 trillion. Hence the financial system is insolvent, and it needs to be nationalized quickly, in his opinion. Here, I would like to point out that it has always been the case that the estimates for losses in any crisis keep changing dynamically. For example, during the 1989 - 91 S & L crisis, initial estimates for the bank losses ran up as high as 500 billion dollars during 1988 - 90. However when the American economy grew robustly after 1992, the Resolution Trust Council (RTC) was able to sell off the foreclosed assets at reasonably good prices, and reduce the total losses to as low as 100 billion dollars.

Secondly, Professor Roubini's solution to the insolvency of the financial system is that the banks should be nationalized quickly. This solution is fraught with grave danger. Nationalizing banks would lead to the problem of 'socializing losses and privatizing gains', which Professor Joseph Stiglitz points out above. Just today (March 16, 2009), a Wall Street Journal article disclosed that more than two-thirds of the $173 billion of Federal aid given to bailout AIG so far has gone to counter-parties to cover their damages in their CDS and insurance contracts with AIG. These counterparties include (i) municipalities within the US, (ii) foreign institutions, and (iii) well-known US financial institutions like Citigroup, Merill Lynch, Bank of America, Goldman Sachs, Morgan Stanley, etc. The fundamental truth is that the financial system benefits some people more than others. No matter how quickly Professor Roubini is able to get the government to nationalize insolvent banks, he would find that well-connected financiers have already returned the institutions under their charge to profitability, mostly by using public money, all done through perfectly legal means.

An alternative solution proposed by Professor Kenneth Rogoff is for the Federal Reserve to print a lot of money and invest it with the financial institutions. This would re-capitalize the financial institutions and save them from bankruptcy. Moreover, in a few months, there would be widespread inflation. This would help the home-owners because inflation would reduce the relative severity of their mortgage debts. Since a large percentage of the households in America are also immersed in credit card debt, inflation would help them there as well. In addition, the government could spend massively by way of fiscal deficits to ensure that deflationary forces are surely defeated. This solution has the additional feature of fitting in nicely with the Rogoff doctrine, which recommends that Western economies go through a period of sub-optimal growth in order to avoid a global price war for commodities. (The Rogoff doctrine was published in the Financial Times on July 29, 2008).

China was quick to wake up to Professor Rogoff's solution for the financial crisis. Inflation would benefit everybody inside the United States in their current predicament of debt obligations that are disproportionate to their incomes. However, it would severely affect those countries, like China and Japan, which are holding trillions of dollars as foreign currency reserves. To preserve the relative value of its dollar reserves, China has announced its own two-year fiscal spending program of 4 trillion yuan to ensure that its annual GDP grows at a rate of 8%+. The biggest losers in this inflation game would be the poor countries who could not possibly finance their deficits. Even if they did, many of the poor countries do not have a democratic framework in order to hold their rulers to account for the deficit spending.

In October 2008, I proposed a simple low-cost solution for the financial crisis (Ref: Question 5 in my "FAQ on the Financial Crisis"). I would like to make one point here that I have not made elsewhere: my solution has the unique feature that it is sustainable. To make this point clear, consider the phenomenon of consumer spending. The global supply chain connects to factories where goods are produced. These factories, in turn, connect to the distribution channels that apply just-in-time technology to stock their retail outlets. The consumer then goes through the shopping experience at the shopping malls or online stores. Consumer shopping trends are cyclical, with each annual cycle having several seasonal cycles as well. In case, there is an over-production of goods during one particular shopping season or a dullness in consumer demand, the stores immediately announce discounts and price cuts.

These price reductions benefit the consumer directly, and they work all the way back through the distribution channels and the supply chain. In this way, a sustainable feedback loop helps to implement an 'informal contract' between the consumer at one end, and all the other participants of the supply network at the other end. And this unwritten contract, in effect, extends over many years. In fact, this mechanism for price adjustments has become an integral part of the consumer culture of the 20th century. My solution for the mortgage crisis aims to provide an analogous feedback loop that connects the security-owners on Wall Street with the home-owners on Main Street.