"From Plan A to Plan F" (Brad DeLong, The Guardian, 10/16/2008)
The Bush administration, having entered office as social conservatives, leaves office as conservative socialists, proprietors of the most sudden large expansion of the state's role in the US economy since mobilisation for the second world war. Why did they decide to partially and quasi-nationalise America's banks - to invest $250bn in preferred stock plus warrants and tell the banks that it wanted them to use the capital to expand their loan base rather than contract it via deleveraging? It is certainly not what Henry Paulson signed up as Treasury secretary to do.
I am an economic historian. An occupational disease of being an economic historian is to insist that the answers to all questions lie in the Great Depression that started in 1929. When the financial crisis hit in a sudden squall in August 2007, in the back of the Federal Reserve's mind was that it should not repeat any of the mistakes that led to the Depression. Hence Ben Bernanke and his Fed loaned extraordinarily freely to banks and near-banks and non-banks in order to avoid what Milton Friedman said was the key mistake that made the Depression Great: that the Fed had triggered or allowed a liquidity squeeze that made cash hard to get. Call this Plan A.
In a couple of months it became clear that Plan A was not working. The economy was weakening. And the Fed remembered the theory - put forward by, among others, Lawrence Summers and myself - that what made the Depression Great was that businesses began to expect deflation. The expectation of falling prices made every business postpone its investment spending - better to wait a year and build your plant and equipment then when prices were cheaper - and so private investment collapsed. So Bernanke and his Fed lowered interest rates to what they thought were levels that might trigger inflation, as a way of making sure that no business anywhere would even begin to suspect that a deflationary spiral was in the making. That was Plan B.
But the economy fell toward (if not into) recession, and interest rates had already been pushed down so low that the Fed's monetary policy had lost its virtue and vigour. So it was time for Plan C: mail out a bunch of extra tax-rebate cheques, hoping that they would stimulate consumer spending and that once consumers began spending more the economy would recover with at worst a small recession.
Meanwhile, the investment bank Bear Stearns collapsed. The Federal Reserve and the Treasury concluded that they could not stand by and wait to see if Plan C was working. They had to move to Plan D: case-by-case forced mergers, liquidations and nationalisations of banks and other financial institutions in order to prevent the course of events that the third theory of the Depression said had made it Great.
This theory was Bernanke's: that the downfall of 1929-1933 was largely the result of bank failures that collapsed businesses' ability to borrow to expand or even fund ongoing operations. So we had the forced merger of Bear Stearns into JPMorgan Chase; a lull to see if Plan C would work (it didn't); the renationalisation or deprivatisation of the mortgage lenders Fannie Mae and Freddie Mac; that strange weekend when the Fed bought the insurance company AIG; and the bankruptcy of Lehman Brothers, as Bernanke and Paulson decided that they could not rescue the creditors of every firm on Wall Street.
They were wrong. The failure of Lehman Brothers triggered or uncovered or brought on financial catastrophe - not just in America but in Europe too, where hitherto policymakers had been watching with concern and some alarm. It was time for Plan E: the Paulson plan, a $700bn programme by which the Treasury would buy up troubled mortgages, mortgage-backed securities and derivatives thereof with an eye toward making sure that the banking system recovered so that it could do its job of transferring the savings of Americans to businesses that wanted to hire workers, and so keep the recession a small one and avoid the mistakes that the Bernanke theory said had made the Depression Great.
The hope behind the Paulson plan was supply and demand. Banks and investors want yield, and so are willing to buy risky assets. If the Treasury were to buy $700bn of risky financial assets and put them on the shelf, this would diminish the supply. When supply falls, prices rise. As the prices of financial assets rose, banks would profit immensely - and people would no longer fear that the bank they were dealing with might dry up and blow away in the next week.
The financial markets swallowed the passage of Plan E without a burp and continued on their downward spiral toward universal financial-sector bankruptcy.
It was time for Plan F. If the prospect of buying up mortgage-backed securities did not boost asset prices and bring banks enough investment profits to create confidence that they were not all going bankrupt next month, governments could invest public money in the banks whether they liked it or not, thus making them so well-capitalised that their failure would be inconceivable.
What I find most scary about this is that policymakers (and Brad DeLong, but that's not so important) seem to be thinking so much about the Great Depression. The world economy today is dozens of times bigger, and far more integrated. There have been tremendous technological changes, big changes in the socioeconomic structure of most societies, big changes in policy. Both Wall Street and Washington-- or, more generally (or rather, less metonymously) both finance and government-- have been transformed. Even without any specific story about how 2008 is different from 1929, is it plausible that making the right policy choices now consists of nothing but implementing our best guess about what would have been the right thing to do eighty years ago.
If you look in the rear-view mirror all the time, you crash.