The 2008 banking crisis was caused by the private sector borrowing heavily in short-term markets while using swaps, derivatives and complex financial instruments to paper over risks and in some cases outright fraud. Banks collapsed because lending dried up when the market corrected and they couldn't raise money to pay back their creditors. The falling value of their assets combined with their newfound and absolutely insane leverage (sometimes 60-1) to push their liabilities greater than their assets very quickly. The rush to the exits by panicking investors did the rest: the weekend before Lehman collapsed it was trying to raise 50 billion in the (unregulated) repo markets.
What does any of this have to do with Keynes or government spending? Absolutely nothing. The private sector took advantage of financial deregulation in the late 1990s and 2000s to leverage up and start betting in new markets. The trigger was the dismantling of the Glass Steagal act which prohibited bank holding companies from owning speculative investment houses. The economy was certainly weakening in 2008, but it did not need to collapse into Depression-era levels of unemployment and misery.
Obama has made three big policy mistakes in my opinion. The first was not nationalizing the failed banks as Krugman and many others advocated, wiping out the shareholders and recapitalizing the husks into smaller banks which posed no systemic risk to the economy and which could have engaged in lending that would have translated low interest rates into actual business lending. Instead the Obama administration did nothing out of a fear of provoking capital flight from the remaining banks and making nationalization inevitable. This left it to the Federal Reserve to try and keep credit flowing using the only tools at its disposal: low interest rates and creative lending. Bernanke gets a lot of flack but this was good policy which probably prevented financial apocalypse. It is just turning out to be really expensive in the absence of a political willingness to demand anything in return for the bailouts, since the banks are simply using the cheap capital to return to speculative and leveraged investment plays rather than renewing their lending to the private sector. Case in point: the government should not be borrowing from itself and paying the banks interest for the privilege.
The second was agreeing to extend the Bush tax cuts in a tit-for-tat exchange with the Republicans over health care. The administration justified this as a form of economic stimulus, but it was a horrible misuse of the term, since the relatively wealthy who benefit from the cuts tend to save/invest capital instead of spending it right away, which is the point of stimulus. Bush II did the same thing and that is one of the causes of the weak recovery from the last recession and the reason the Fed kept interest rates low after the first dot-com boom.
The third was the failure to pursue real Keynesian stimulus when aggregate demand plummeted. Standard economic projections in 2008 predicted a 2 trillion shortfall, and called for 1.2 trillion in stimulus to keep unemployment under 7 percent. And yet Obama's team never tried for more than 800 billion because they didn't think they could push it through Congress, and because the Republican party was trying to spark a debt crisis by questioning the solvency of the US government and calling for financial austerity!
I am sure there is a conservative blogger out there willing to dump the thing on Keynes and Krugman as "liberals" who promote "government spending". The sad thing is these people have been empirically wrong for ages, and their proposals of what needs to be done are dangerous and ignorant.
Fiscal austerity, as Friedman would agree, is unbelievably stupid at this time. However, because the government is so far in debt to begin with, adding debt through stimulus is guaranteed to be unpopular. The application of Keynesian policy deserves some dumping. When times get crappy it’s spend spend spend and lower interest rates, when times are booming its...maintain current monetary and lower interest rates? It seems they are only following Keynesian theory when times get tough. For political reasons, they are conveniently leaving out the difficult parts of application of Keynesian theory. Overspending and bad policy during times of plenty causes grief during times of trouble. From what I see, misapplication, including uncalled for low interest rates, deserves some blame.
Banks made bad loans (also) because their loans were risk free. They were leveraging because they could. I agree they shoulder the blame, but so do the guarantors of those loans, US Government.
Thanks again for the replies... I copied this and will review it several more times to further my understanding. I was obviously misguided.
I consider myself someone centrist, but I certainly lean towards limited government. Such talk of nationalizing banks to me is dangerous in the long term. I'm not even sure how that would be considered constitutional. But in our situation, hell, they are basically all quasi nationalized anyway. The current structure allows far worse in that only losses are nationalized. So our choice under current policy is to nationalize or recapitalize? We need better options and policy that allows for banks to fail when they make bad loans. But again, can Keynesian theory even be successfully applied in this environment? Don’t we basically have to have smaller banks or national banks in order for it to work?
I agree with the idea that banks should be broken up. The TBTF are alive and well and bigger than ever. That is one of the #OWS grievances I can get behind. Most of the others, to me, are pure nonsense, but that is an entirely different discussion.
Again, thanks for the insightful discussion…time is limited.
Thanks for the thoughtful discussion.... Only one note: subprime loans were by definition those which did not quality for government guarantee. So Fannie/Freddie may be bad policy for other reasons, but they didn't cause the crisis -- they lost market share to private lenders throughout:
What does any of this have to do with Keynes or government spending? Absolutely nothing. The private sector took advantage of financial deregulation in the late 1990s and 2000s to leverage up and start betting in new markets. The trigger was the dismantling of the Glass Steagal act which prohibited bank holding companies from owning speculative investment houses. The economy was certainly weakening in 2008, but it did not need to collapse into Depression-era levels of unemployment and misery.
Obama has made three big policy mistakes in my opinion. The first was not nationalizing the failed banks as Krugman and many others advocated, wiping out the shareholders and recapitalizing the husks into smaller banks which posed no systemic risk to the economy and which could have engaged in lending that would have translated low interest rates into actual business lending. Instead the Obama administration did nothing out of a fear of provoking capital flight from the remaining banks and making nationalization inevitable. This left it to the Federal Reserve to try and keep credit flowing using the only tools at its disposal: low interest rates and creative lending. Bernanke gets a lot of flack but this was good policy which probably prevented financial apocalypse. It is just turning out to be really expensive in the absence of a political willingness to demand anything in return for the bailouts, since the banks are simply using the cheap capital to return to speculative and leveraged investment plays rather than renewing their lending to the private sector. Case in point: the government should not be borrowing from itself and paying the banks interest for the privilege.
The second was agreeing to extend the Bush tax cuts in a tit-for-tat exchange with the Republicans over health care. The administration justified this as a form of economic stimulus, but it was a horrible misuse of the term, since the relatively wealthy who benefit from the cuts tend to save/invest capital instead of spending it right away, which is the point of stimulus. Bush II did the same thing and that is one of the causes of the weak recovery from the last recession and the reason the Fed kept interest rates low after the first dot-com boom.
The third was the failure to pursue real Keynesian stimulus when aggregate demand plummeted. Standard economic projections in 2008 predicted a 2 trillion shortfall, and called for 1.2 trillion in stimulus to keep unemployment under 7 percent. And yet Obama's team never tried for more than 800 billion because they didn't think they could push it through Congress, and because the Republican party was trying to spark a debt crisis by questioning the solvency of the US government and calling for financial austerity!
I am sure there is a conservative blogger out there willing to dump the thing on Keynes and Krugman as "liberals" who promote "government spending". The sad thing is these people have been empirically wrong for ages, and their proposals of what needs to be done are dangerous and ignorant.