The Crisis Is Over: Have We Wasted It?

Rahm Emanuel reportedly has a doctrine: Never let a serious crisis go to waste. His point is a good one: Vested interests usually block change across a wide range of important issues in the United States, and a major financial/economic crisis provides an opportunity to bypass or break through those interests in order to introduce meaningful and substantial change. Emanuel listed five priority areas for change: healthcare (cost control and expansion of coverage), energy (independence and alternatives), taxes (fairness and simplicity), education (fundamental changes to effectively train the workforce), and financial regulation (transparency and accountability).

The crisis in the financial system is abating, although the economic costs continue to mount and new problems may still appear (ask California or Ukraine). At least among the people I talk with on Capitol Hill, there is a very real sense that business is returning to usual; certainly the lobbyists are out in force, they want what they always want, and it's hard to see how many of them have been seriously weakened. How much progress have we made on any of Emanuel's priority areas or, for that matter, along any other public-policy dimension that was previously stuck?

The charitable answer would be: This is still a work in progress and you cannot expect miracles overnight. True, but Rahm's Doctrine (as Larry Summers apparently calls it) says that you should implement irreversible change while you still have the chance. Tell me if I missed something, but has there been any breakthrough of any kind? Was it wrapped up in the fiscal stimulus? Is the credit card bill a bigger blow to vested interests than we have so far recognized? Has there been some secret progress on healthcare (other than a vague and apparently deniable pledge drive)? Were the bank stress tests more subtle than meets the eye?

We discussed this issue on Bill Maher's Overtime segment on Friday. Jon Meacham, the editor of Newsweek, had just interviewed President Obama and came away with no clear sense of where the President is really pushing to make fundamental change, although Jon and Bill nicely summarize where he is compromising.

On financial-sector issues, the lobbies look stronger than ever. "You can't recover without us" appears to be a winning slogan for big banks and their appointees. Tough financial regulation may still appear later this year, but it looks like an uphill struggle, and there is no sense that the administration even wants to break vested interests in this sphere.

Perhaps Rahm's Doctrine was overly optimistic as a broad aspiration, but at least on the financial front some tangible opportunities went to waste.

Meanwhile, over the Memorial Day weekend, I posed the following assignment:

You have been called to the table for top-level policy discussions in a large monetary union. One of the bigger countries in this union has a serious problem. Their exports are down slightly and there are some longer-run structural issues, but the immediate issues are: (1) A housing bubble just burst, resulting in a big fall in tax revenue; (2) the political system seems paralyzed, i.e., it cannot raise other revenues or cut spending in any sensible fashion; and (3) the market for this government's debt appears likely to turn very sour. Sounds like a classic fiscal crisis.

Here are your possible recommendations:

1. Let them go bust. This is tempting, given the failure of the political class in this country to come to terms with its obvious problems. Also, this would presumably shake the rules of the system enough so that these leaders could finally raise revenue or cut spending sensibly. But this would also create dangers for other countries in your currency union, for example by increasing the risk premiums on all debts. And a lot of poor people would get hit hard; you know that always happens in a free fall.
2. Give them a big loan. This, of course, is what the political elite in this country would like; they are asking for money on easy terms, arguing that none of these current difficulties are really their fault. If you feel that at least some of their problems are temporary, a loan makes sense. But you'll also want some conditions, meaning steps they would take to ensure you get paid back. If they don't pay back (or can't pay back for a long while), that creates costs for taxpayers in other (more fiscally responsible) parts of your union and what would be fair or politically sustainable about that? So what conditions do you want to impose or negotiate toward?

• No conditions. You trust them and they are your friends. Hopefully, they will run things better in the future.
• Tell them to raise revenue and/or cut spending. They can decide; it is a sovereign country after all.
• Insist that they raise revenue. If doing so effectively is prevented by their constitution, they need to change the constitution.
• Tell them to cut spending any which way they can. This will hit the poor just like in the "go bust" scenario, but this way the country's elite can blame you.

Underlying all this, of course, you have to take a view on the politics. What vested interests exactly have got them into this mess? Certainly, there was a big shock from circumstances outside their control, but this country's policies were asking for trouble; any time you run a big housing boom, you are vulnerable to a dramatic slowdown (and loss of revenue). If you are going to lend money, don't you want to feel that the loan will allow or even force the political equilibrium to shift? Otherwise, won't this country repeatedly run into the same kind of fiscal difficulties? This kind of fiscal crisis is always about powerful groups, but are we facing oligarchs or something else in this particular instance?

The missing option above, of course, is to give the country a loan at the same time as they restructure their debts; i.e., a form of debtor-in-possession bankruptcy financing. But the creditors to this country are also powerful at the level of the monetary union and perhaps in the more fiscally responsible parts of that union, so count on these groups to oppose any debt write-downs. One argument they'll use is that such restructuring will either trigger a panic or lead to higher borrowing costs for other member countries. So what are you going to do about that?

You can answer these questions either for Spain or California.

Adapted from postings on Simon Johnson’s blog, Baseline Scenario.