Global strategies to fight this recession have standardized on two policies: bailouts of troubled banks and stimulus through deficit spending—the latter advocated in recent days by Larry Summers, director of US president Barack Obama’s national economic council and a Clinton-era treasury secretary.
Different tack: The Lehman Brothers headquarters. The liquidationist would have let others go the way of the failed financial services firm. Jeremy Bales / Bloomberg
There is an alternative approach, propounded by another former treasury boss, Andrew Mellon, in December 1929: “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate... It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”
In the 1929-33 downturn, Mellon was overruled by president Herbert Hoover, who followed policies of stimulus and bailout, along with protectionism and tax increases. Franklin Roosevelt continued Hoover’s policies—minus the protectionism—with more vigour, adding redistribution and union-fostering to the mix. Since the New Deal’s apparent success, his has been the generally accepted answer to deep recessions. The liquidationist approach to the current problems is, however, worth examining.
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To do so, suppose a Mellonist had arrived to head the US treasury in, say, June, after the current recession was baked in but before it had actually unfolded. The new secretary’s first task would have been to confront the prospect of financial institutions failing in September-October—with only his predecessor’s experience of the Bear Stearns Companies Inc. rescue by JPMorgan Chase and Co. in March that year to go on. A Mellonist would have encouraged the bankruptcy of Fannie Mae and Freddie Mac, which have no place in a free housing market. Those bankruptcies would have removed various kinds of support from primary mortgage lenders, causing a crisis of lending confidence but few immediate credit losses, since the underlying mortgages would have remained in place.
The liquidationist would have allowed Lehman Brothers Holdings Inc. to go, as happened in reality. He would also have allowed American International Group Inc. (AIG) to fail, causing a crisis in the credit default swap markets, with losses of up to $180 billion (Rs9.32 trillion) at current count among the other major dealers and the hedge fund community. That would have hastened the collapse of Merrill Lynch and Co. Inc. and Citigroup Inc., and would also have damaged Morgan Stanley and Goldman Sachs—most likely wiping out the major investment banks. Among commercial banks, Washington Mutual Inc. (WaMu) would probably not have been rescued by JPMorgan because of the risk involved and, most likely, its additional losses on the bankruptcies of Fannie, Freddie and AIG, and Merrill Lynch might not have been rescued by Bank of America Corp. for the same reason.
On the other hand, the Wachovia Corp./Wells Fargo and Co. and PNC Financial Services/National City Corp. transactions would probably still have occurred, since the cataclysm in investment banking would not have affected them as severely. The scale of any resulting flight of deposits—as seen in 1930 after the bankruptcy of the Bank of United States— would now be lower thanks to the existence of deposit insurance.
Assuming a Mellonist mood had also prevailed at the the Federal Reserve, monetary policy would have been expansionist since September last year, but less so than actually occurred. Our fictitious treasury secretary would have supported the treasury bill and inter-bank markets through heavy open market purchases. He would probably not have supported the commercial paper market directly and would certainly not have supported the mortgage-backed securities market. The principal interest rate effects of Mellonist policy compared with actual policy would thus have been a sharp increase in home mortgage costs, perhaps to somewhere near the current jumbo mortgage cost of around 7%, and a higher level of commercial paper interest rates.
At the end of 2008, the US financial system would have lost AIG, Fannie, Freddie and all the investment banks, plus Citigroup and WaMu. Wells Fargo and PNC would be in severe danger. On the other hand—unless it had large exposure to AIG—Bank of America would be relatively solid, since it would not have bought Merrill Lynch. There might also have been a failure or two among regional banks with a large exposure to Citigroup or one of the investment banks, but the majority would have remained sound.
If the Mellonist had managed to survive the change in administrations, his subsequent impact would have been on Obama’s budget. Without a stimulus package, and minus the bailouts of Fannie, Freddie, AIG and the bank recipients of Troubled Asset Relief Programme funds, the 2009 budget deficit would have been only around $700 billion, against the current estimate of $1.75 trillion. Even without additional fiscal austerity, the 2010 deficit would have been only in the $500 billion range—about 3.6% of gross domestic product (GDP), a relatively modest size in the circumstances.
The damage done along the way, especially to financial institutions, sounds horrific. But the principle behind Mellonist policies is that liquidation produces a short, sharp recession, which does less damage than a drawn-out one. Their main danger is that the wreckage of liquidation may cause enough collateral economic damage to make the recession deeper than necessary. Conversely, such tough policies avoid the damaging and potentially long-term effects of extensive bailouts, involving huge budget deficits and over-expansive monetary policy.
In this case, the argument is finely balanced. Under the Mellonist, the death throes of big financial institutions would have made the fourth quarter of 2008 even more unpleasant than it was in real life. However, provided there was no major cascade effect, the decline in GDP might have been only moderately worse than the 6.2% annualized rate actually seen in the last quarter of last year.
The economic effect of bankruptcies would have carried into 2009, again perhaps hurting the economy more than has actually occurred. On the brighter side for the financial sector, though, interest rates would currently be higher, particularly on home mortgages and commercial paper. For the regional banks and the survivors among the national banks, lending would be exceptionally profitable—so they might be doing more of it.
After a further decline in GDP in the second quarter, the Mellonist would expect a rapid return to growth, with monetary policy being only mildly inflationary and the federal deficit easily finance-able. The US financial system would reorient itself around the remaining banks, with investment banking business being carried out by boutiques and risky trading being concentrated among the remaining hedge funds. The long-term growth rate of the US economy would have been unaffected by the recession, as would the government’s share of GDP, while the role of the financial sector would be reduced. So far, the bailout and stimulus policy has almost certainly been less painful than the Mellonist approach. But going forward, the costs of avoiding liquidation are likely to be high. The banking system will remain sick, with zombie-like institutions depressing profitability for their competitors and housing finance being subsidized by the state, crowding out business borrowing.
With gigantic budget deficits to be financed, the excessive money creation of the last six months will be difficult to reverse—and will probably create inflation. And the deficits and increased government spending are likely to crowd out private sector activity, hurting productivity and economic growth for some time.
On balance, the Mellonist approach would probably have resulted in less long-run trouble in exchange for a short burst of slightly greater pain. The unknown quantity, however, is the extent to which allowing more bank failures last autumn could have cascaded through the US banking system, dramatically worsening the recession. Like Mellon himself, we’ll never know if that risk would have been worth taking.