The Political Nature of the Economic Crisis

September 30, 2008 | 2115 GMT

By George Friedman

Classical economists like Adam Smith and David Ricardo referred to their
discipline as “political economy.” Smith’s great work, “The Wealth of Nations,”
was written by the man who held the chair in moral philosophy at the University
of Glasgow. This did not seem odd at the time and is not odd now. Economics is
not a freestanding discipline, regardless of how it is regarded today. It is a
discipline that can only be understood when linked to politics, since the wealth
of a nation rests on both these foundations, and it can best be understood by
someone who approaches it from a moral standpoint, since economics makes
significant assumptions about both human nature and proper behavior.

The modern penchant to regard economics as a discrete science parallels the
belief that economics is a distinct sphere of existence — at its best when it is
divorced from political and even moral considerations. Our view has always been
that the economy can only be understood and forecast in the context of politics,
and that the desire to separate the two derives from a moral teaching that Smith
would not embrace. Smith understood that the word “economy” without the
adjective “political” did not describe reality. We need to bear Smith in mind
when we try to understand the current crisis.

Societies have two sorts of financial crises. The first sort is so large it
overwhelms a society’s ability to overcome it, and the society sinks deeper into
dysfunction and poverty. In the second sort, the society has the resources to
manage the situation — albeit at a collective price. Societies that can manage
the crisis have two broad strategies. The first strategy is to allow the market
to solve the problem over time. The second strategy is to have the state
organize the resources of society to speed up the resolution. The market
solution is more efficient over time, producing better outcomes and disciplining
financial decision-making in the long run. But the market solution can create
massive collateral damage, such as high unemployment, on the way to the superior
resolution. The state-organized resolution creates inequities by not
sufficiently punishing poor economic decisions, and creates long-term
inefficiencies that are costly. But it has the virtue of being quicker and
mitigating collateral damage.

Three Views of the Financial Crisis

There is a first group that argues the current financial crisis already has outstripped available
social resources, so that there is no market or state solution. This group
asserts that the imbalances created in the financial markets are so vast that
the market solution must consist of an extended period of depression. Any
attempt by the state to appropriate social resources to solve the financial
imbalance not only will be ineffective, it will prolong the crisis even further,
although perhaps buying some minor alleviation up front. The thinking goes that
the financial crisis has been building for years and the economy can no longer
be protected from it, and that therefore an extended period of discipline and
austerity — beginning with severe economic dislocations — is inevitable. This is
not a majority view, but it is widespread; it opposes government action on the
grounds that the government will make a terrible situation worse.

A second group argues that the financial crisis has not outstripped the
ability of society — organized by the state — to manage, but that it has
outstripped the market’s ability to manage it. The financial markets have been
the problem, according to this view, and have created a massive liquidity
crisis. The economy — as distinct from the financial markets — is relatively
sound, but if the liquidity crisis is left unsolved, it will begin to affect the
economy as a whole. Since the financial markets are unable to solve the problem
in a time frame that will not dramatically affect the economy, the state must
mobilize resources to impose a solution on the financial markets, introducing
liquidity as the preface to any further solutions. This group believes, like the
first group, that the financial crisis could have profound economic
ramifications. But the second group also believes it is possible to contain the
consequences. This is the view of the Bush administration, the congressional leadership, the Federal Reserve Board and
most economic leaders.

There is a third group that argues that the state mobilization of resources to save the financial
system is in fact an attempt to save financial institutions, including many
of those whose imprudence and avarice caused the current crisis. This group
divides in two. The first subgroup agrees the current financial crisis could
have profound economic consequences, but believes a solution exists that would
bring liquidity to the financial markets without rescuing the culpable. The
second subgroup argues that the threat to the economic system is overblown, and
that the financial crisis will correct itself without major state intervention
but with some limited implementation of new regulations.

The first group thus views the situation as beyond salvation, and certainly
rejects any political solution as incapable of addressing the issues from the
standpoint of magnitude or competence. This group is out of the political game
by its own rules, since for it the situation is beyond the ability of politics
to make a difference — except perhaps to make the situation worse.

The second group represents the establishment consensus, which is that the
markets cannot solve the problem but the federal government can — provided it
acts quickly and decisively enough.

The third group spoke Sept. 29, when a coalition of Democrats
and Republicans defeated the establishment proposal. For a myriad of reasons,
some contradictory, this group opposed the bailout. The reasons ranged from
moral outrage at protecting the interests of the perpetrators of this crisis to
distrust of a plan implemented by this presidential administration, from
distrust of the amount of power ceded the Treasury Department of any
administration to a feeling the problem could be managed. It was a diverse group
that focused on one premise — namely, that delay would not lead to economic catastrophe.

From Economic to Political Problem

The problem ceased to be an economic problem months ago. More precisely, the economic problem has transformed into a political problem.
Ever since the collapse of Bear Stearns, the primary actor in the drama
has been the federal government and the Federal Reserve, with its powers
increasing as the nature of potential market outcomes became more and more
unsettling. At a certain point, the size of the problem outstripped the
legislated resources of the Treasury and the Fed, so they went to Congress for
more power and money. This time, they were blocked.

It is useful to reflect on the nature of the crisis. It is a tale that can be
as complicated as you wish to make it, but it is in essence simple and elegant.
As interest rates declined in recent years, investors — particularly
conservative ones — sought to increase their return without giving up safety and
liquidity. They wanted something for nothing, and the market obliged. They were
given instruments ultimately based on mortgages on private homes. They therefore
had a very real asset base — a house — and therefore had collateral. The value
of homes historically had risen, and therefore the value of the assets appeared
secured. Financial instruments of increasing complexity eventually were devised,
which were bought by conservative investors. In due course, these instruments
were bought by less conservative investors, who used them as collateral for
borrowing money. They used this money to buy other instruments in a pyramiding
scheme that rested on one premise: the existence of houses whose value remained
stable or grew.

Unfortunately, housing prices declined. A period of uncertainty about the
value of the paper based on home mortgages followed. People claimed to be
confused as to what the real value of the paper was. In fact, they were not so
much confused as deceptive. They didn’t want to reveal that the value of the
paper had declined dramatically. At a certain point, the facts could no longer
be hidden, and vast amounts of value evaporated — taking with them not only the
vast pyramids of those who first created the instruments and then borrowed
heavily against them, but also the more conservative investors trying to put
their money in a secure space while squeezing out a few extra points of
interest. The decline in housing prices triggered massive losses of money in the
financial markets, as well as reluctance to lend based on uncertainty of values.
The result was a liquidity crisis, which simply meant that a lot of people had
gone broke and that those who still had money weren’t lending it — certainly not
to financial institutions.

The S&L Precedent

Such financial meltdowns based on shifts in real estate prices are not new.
In the 1970s, regulations on savings and loans (S&Ls) had changed.
Previously, S&Ls had been limited to lending in the consumer market,
primarily in mortgages for homes. But the regulations shifted, and they became
allowed to invest more broadly. The assets of these small banks, of which there
were thousands, were attractive in that they were a pool of cash available for
investment. The S&Ls subsequently went into commercial real estate,
sometimes with their old management, sometimes with new management who had
bought them, as their depositors no longer held them.

The infusion of money from the S&Ls drove up the price of commercial real
estate, which the institutions regarded as stable and conservative investments,
not unlike private homes. They did not take into account that their presence in
the market was driving up the price of commercial real estate irrationally,
however, or that commercial real estate prices fluctuate dramatically. As
commercial real estate values started to fall, the assets of the S&Ls
contracted until most failed. An entire sector of the financial system simply
imploded, crushing shareholders and threatening a massive liquidity crisis. By
the late 1980s, the entire sector had melted down, and in 1989 the federal
government intervened.

The federal government intervened in that crisis as it had in several crises
large and small since 1929. Using the resources at its disposal, the federal
government took over failed S&Ls and their real estate investments, creating
the Resolution Trust Corp. (RTC). The amount of assets acquired was about $394
billion dollars in 1989 — or 6.7 percent of gross domestic product (GDP) —
making it larger than the $700 billion dollars — or 5 percent of GDP — being
discussed now. Rather than flooding the markets with foreclosed commercial
property, creating havoc in the market and further destroying assets, the RTC
held the commercial properties off the market, maintaining their price
artificially. They then sold off the foreclosed properties in a multiyear
sequence that recovered much of what had been spent acquiring the properties.
More important, it prevented the decline in commercial real estate from
accelerating and creating liquidity crises throughout the entire economy.

Many of those involved in S&Ls were ruined. Others managed to use the RTC
system to recover real estate and to profit. Still others came in from the
outside and used the RTC system to build fortunes. The RTC is not something to
use as moral lesson for your children. But the RTC managed to prevent the
transformation of a financial crisis into an economic meltdown. It disrupted
market operations by introducing large amounts of federal money to bring
liquidity to the system, then used the ability of the federal government — not
shared by individuals — to hold on to properties. The disruption of the market’s
normal operations was designed to avoid a market outcome. By holding on to the
assets, the federal government was able to create an artificial market in real
estate, one in which supply was constrained by the government to manage the
value of commercial real estate. It did not work perfectly — far from it. But it
managed to avoid the most feared outcome, which was a depression.

There have been many other federal interventions in the markets, such as the
bailout of Chrysler in the 1970s or the intervention into failed Third World
bonds in the 1980s. Political interventions in the American (or global)
marketplace are hardly novel. They are used to control the consequences of
bad decisions in the marketplace. Though they introduce inefficiencies and
frequently reward foolish decisions, they achieve a single end: limiting the
economic consequences of these decisions on the economy as a whole. Good idea or
not, these interventions are institutionalized in American economic life and
culture. The ability of Americans to be shocked at the thought of bailouts is
interesting, since they are not all that rare, as judged historically.

The RTC showed the ability of federal resources — using taxpayer dollars — to control financial processes. In the end, the S&L story
was simply one of bad decisions resulting in a shortage of dollars. On top of a
vast economy, the U.S. government can mobilize large amounts of dollars as
needed. It therefore can redefine the market for money. It did so in 1989 during
the S&L crisis, and there was a general acceptance it would do so again
Sept. 29.

The RTC Model and the Road Ahead

As discussed above, the first group argues the current crisis is so large
that it is beyond the federal government’s ability to redefine. More precisely,
it would argue that the attempt at intervention would unleash other consequences
— such as weakening dollars and inflation — meaning the cure would be
worse than the disease. That may be the case this time, but it is difficult to
see why the consequences of this bailout would be profoundly different from the
RTC bailout — namely, a normal recession that would probably happen anyway.

The debate between the political leadership and those opposing its plan is
more interesting. The fundamental difference between the RTC and the current
bailout was institutional. Congress created a semi-independent agency operating
under guidelines to administer the S&L bailout. The proposal that was
defeated Sept. 29 would have given the secretary of the Treasury extraordinary
personal powers to dispense the money. Some also argued that the return on the
federal investment was unclear, whereas in the RTC case it was fairly clear. In
the end, all of this turned on the question of urgency. The establishment group
argued that time was running out and the financial crisis was about to morph
into an economic crisis. Those voting against the proposal argued there was
enough time to have a more defined solution.

There was obviously a more direct political dimension to all this. Elections
are just more than a month a way, and the seat of every U.S. representative is
in contest. The public is deeply distrustful of the establishment, and
particularly of the idea that the people who caused the crisis might benefit
from the bailout. The congressional opponents of the plan needed to demonstrate
sensitivity to public opinion. Having done so, if they force a redefinition of
the bailout plan, an additional 13 votes can likely be found to pass the
measure.

But the key issue is this: Are the resources of the United States sufficient
to redefine financial markets in such a way as to manage the outcome of this
crisis, or has the crisis become so large that even the resources of a $14
trillion economy mobilized by the state can’t do the job? If the latter is true,
then all other discussions are irrelevant. Events will take their course, and
nothing can be done. But if that is not true, that means that politics defines
the crisis, as it has other crisis. In that case, the federal government can
marshal the resources needed to redefine the markets and the key decision-makers
are not on Wall Street, but in Washington. Thus, when the chips are down, the
state trumps the markets.

All of this may not be desirable, efficient or wise, but as an empirical
fact, it is the way American society works and has worked for a long time. We
are seeing a case study in it — including the possibility the state will refuse
to act, creating an interesting and profound situation. This would allow the
market alone to define the outcome of the crisis. This has not been allowed in
extreme crises in 75 years, and we suspect this tradition of intervention will
not be broken now. The federal government will act in due course, and an
institutional resolution taking power from the Treasury and placing it in the equivalent of the RTC will emerge. The question is how
much time remains before massive damage is done to the economy.

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