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False Profits

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Dean Baker, codirector of the Center for Economic and Policy Research recounts the strategies used by the country’s top economic policymakers to conceal their failure to recognize the housing bubble or take steps to rein it in before it grew to unprecedented levels, resulting in the loss of millions of jobs, homes, and the life savings of tens of millions of people. He quashes dire warnings of looming rampant inflation and spiraling debt with solid historic evidence to the contrary—evidence that supports more stimulus, not less. With a dose of optimism, Baker outlines a thoughtful progressive program for rebuilding the economy and reshaping the financial system, including new financial transaction taxes that will reduce or eliminate economic waste while providing stimulus and incentives where and when they are most needed.

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1. Economic Collapse: It IsTheir Fault

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Imagine if the economy were managed by people who did not know basic arithmetic, the stuff that we all learned in third grade. Imagine further that as a result of their inability to understand simple arithmetic, huge economic imbalances grew to ever more dangerous levels.

If this happesned, surely the business and economics reporters would be on the job, pointing out the ungodly incompetence of the country's top economic officials and the risks that their ignorance posed for us all. Undoubtedly, thousands of economists, all quite skilled at mathematics, would be pointing out the errors. Members of Congress, especially those sitting on the committees that have major economic responsibilities, would be organizing hearings to call attention to the mismanagement of the economy.

If the media, the economics profession, and Congress somehow failed to move quickly enough, and disaster struck, certainly those most responsible for this calamity would lose their jobs and suffer public humiliation. Lengthy news stories would denounce problems in our system of governance that allowed for extraordinary incompetence at the highest levels.

 

2. Surveying the Damage

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The collapse of the housing bubble has produced a more severe downturn than most economists would have ever imagined possible and more serious than all but the oldest Americans have seen in their lifetime. By the middle of 2009, the unemployment rate had already hit 9.5 percent. As of this writing, the economy was still shedding several hundred thousand jobs a month. And although the rate of decline had slowed from earlier in the year (largely as a result of the impact of the stimulus package), when the economy was shedding close to 700,000 jobs a month, the unemployment rate is still virtually certain to cross 10 percent in 2010 and could very well reach 11 percent before it peaks.

Since the Great Depression, the unemployment rate only approached these levels in the 1981–82 recession, when it peaked at 10.8 percent. As bad as that recession was, the housing crash recession is, in fact, much worse for two reasons.

First, it is likely to last far longer than the 1981–82 recession because the economy lacks any easy way to rebound from the downturn. The 1981–82 recession was a classic post-war recession brought on by the decision of the Fed to raise interest rates to control inflation. The Fed wanted to slow the economy and reduce employment in order to reduce inflationary pressures. Higher interest rates have this effect first and foremost by discouraging new car purchases and house buying, because both kinds of purchases are very sensitive to interest rates. The resulting reduction in demand throws people out of work in the auto and construction industries. A multiplier effect ensues as these industries demand less material and fewer supplies from other industries, and the workers laid off in these sectors start to cut back on their consumption.

 

3. The Terrible Tale of the TARP

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The passage of the Troubled Asset Relief Program, or TARP, in the fall of 2008 was a demonstration of the extraordinary power of the financial industry and what it will do when its fundamental interests are threatened. The industry was quickly able to unite the leadership of both political parties behind a massive $700 billion bailout program that imposed few serious constraints on the industry. The industry was also able to enlist the media in this effort, turning many reporters into TARP cheerleaders until the bill passed Congress. The opponents of the bill, which included many of the country's most prominent economists, were portrayed as knuckle-scraping Neanderthals.

The American public must clearly understand the forces at play in the passage of the TARP, as the industry will undoubtedly muster similar forces in the future to prevent major reforms that threaten its profitability. The passage of the TARP was, in fact, a remarkable political accomplishment deserving of a certain kind of respect. Although Wall Street banks were never very popular institutions, they managed to get themselves a massive bailout when the country was suffering from a serious recession that was a direct result of their greed and incompetence.

 

4. Will They Ever Discover the Housing Bubble?

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The country's top economic policymakers and leading economists somehow managed to ignore the housing bubble as it expanded to more than $8 trillion. Remarkably, even as its collapse has led to the worst downturn since the Great Depression, many people still don't understand the housing bubble and its impact on both the housing market and the economy.

Over the last two years, frequent calls have been made in policy circles suggesting that stabilizing house prices would be both possible and desirable in the current housing market. Rather than recognize the bubble and adjust housing policy accordingly, policymakers still seem intent on ignoring that it exists.

To better understand the impact of a housing bubble, one needs to know a bit about the housing market. At the most basic level, one should recognize the implication of house prices that are hugely out of line with the fundamentals of the market. Suppose that the houses in a bubble-inflated market are selling for twice the price warranted by the fundamentals of the market. For instance, a house that would sell for $200,000 based on the fundamentals is instead selling for $400,000 due to the bubble.

 

5. Stimulus: It IsJust Spending

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When the economy began to deteriorate more rapidly following the financial panic in September 2008, the economy's desperate need for another dose of stimulus became increasingly clear. And although the economy had been shedding jobs since December 2007, the rate of job loss quickened following the collapse of AIG and Lehman. The economy lost 380,000 jobs in October and another 1.3 million in November and December. The unemployment rate hit 7.2 percent in December 2008, a full percentage point above its September level.

While the economy was deteriorating, Washington was largely paralyzed because of the election. President Obama won a decisive victory on November 4, but it was still two and a half months before he would take office. In principle, Congress could have pushed through a stimulus package providing for tax cuts or spending in areas where it could reach agreement with the Bush administration.

Aid to state and local governments would have seemed an obvious choice. At that point, collapsing house prices were already leading to a big hit on property tax collections, in addition to the falloff in sales and income tax revenue due to the downturn. And governments at all levels were finding borrowing much more costly due to the chaos in financial markets. In response, local governments across the country were cutting services and jobs, and raising taxes, all steps that would worsen the recession. Funding commitments from Washington could have relieved some pressure from these governments.

 

6. Real Stimulus: Progressive Programs to Boost the Economy

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The country having to endure long periods of high unemployment is wholly unnecessary for the simple reason that we know how to prevent it. Ever since Keynes, we understood that high unemployment, as occurred in the Great Depression or what we are experiencing in the housing crash recession, is caused by a lack of demand in the economy. The way to address high unemployment is to create demand. In other words, the answer was and still is to throw money at the problem.

That solution is not meant facetiously. Typically, we think that the economy's ability to meet the needs of the nation or the world is limited by the supply of resources: the number of workers; the output capacity of our factories and carrying capacity of our transportation system; the amount of retail, office, and residential space; and availability of natural resources, such as land, water, and oil. Though this thinking may be true in normal times (even then, the limits are not as hard and fast as is often portrayed), it clearly is not true during a period when the unemployment rate is in the double digits. The main economic problem in that situation is to generate demand for the huge amounts of excess capacity in almost every area.

 

7. Reforming the Financial System

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The U.S. financial system is badly in need of reform. This country is paying an incredibly high price for abuses and mismanagement within the financial sector. However, reform will not be an easy task. In spite of all the damage the banks have wreaked, in spite of the fact that they were forced to run to the government begging for bailouts, they are still prepared to fight tooth and nail against any reform that will limit their power and profitability. And given their enormous political power, this is a battle they still have a chance to win.

This chapter lays out a reform agenda that focuses on the two most important reforms that need to be enacted as soon as possible: restructuring the Federal Reserve Board and instituting a financial transactions tax (FTT). Although many other important reforms are necessary to have a financial system that genuinely serves the rest of the economy, these two stand out as fundamental.

Reform of the Fed is crucial because of its control of monetary policy and its central role in financial regulation. An FTT is an important tool to limit the size of the financial sector. Both reforms will reduce the waste associated with a bloated financial sector and, by reducing the size and profit-ability of the financial sector, restrict its political influence. Such a restriction is essential because no set of regulations will be effective without the political will to enforce them.

 

8. Remember the Housing Bubble!

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If a liberal government ever pursued policies that produced the sort of disaster caused by the collapse of the housing bubble, liberal ideas would be banished from public debate for decades. Conservatives still make reference to policies of the 1960s, now more than 40 years old, when they want to rev up their faithful. But even the most wrongheaded program developed by the Johnson administration didn't cause a fraction of the damage wreaked by the housing bubble and its collapse. Yet, most of the bubble perpetrators continue in their careers, almost completely untainted by this incredibly destructive mistake, and their ideology largely passes unchallenged.

These perpetrators are able to get away with not paying any consequences because the people responsible for letting the bubble grow unchecked are still the people who dominate debates over economic policy. They have therefore airbrushed the real story away and filled the media with accounts of how complicated it all was.

Thus far they have been largely successful. The public doesn't realize that the vast majority of people currently in policymaking positions were either unable to see an $8 trillion housing bubble or too intimidated by the consensus in the economics profession to express their opinions. And the same holds true for the experts who prognosticate on the economy on the evening news shows or write opinion pieces in the newspapers.

 

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