Obama makes his first major policy error

Summary:  The Obama Administration is continuing the Bush team’s Wall Street friendly policies, probably because they believe, as do most economists, that the downturn will hit bottom in the 2nd half of this year, and slow growth will resume next year.  That’s bad.  As a result they are missing an opportunity to fix the financial system, clearing their desk for the next wave of problems.  That could be a catastrophic error.  As always when looking ahead in this crisis, these are just guesses.

Contents

1. Stress testing the banks:  real or faux?
2. Why are they doing this?
3. The next phase of the crisis
4. Possible Consequences
5. Afterword
6. For more information

(1)  Stress testing the banks:  real or faux?

Having regulators do stress testing of banks’ balance sheets is a good idea.  Many or most would be shown insolvent under reasonable assumptions involving, for example, a severe downturn lasting into 2010, with peak-trough GDP down 5%.  That would be the worst downturn since WWII for America, but common in our history — and more common in modern world history.  That finding might break the logjam over fixing the financial sector:  rising public anger over the “bailouts” (gifts of public money to banks and brokers) vs. a Washington elite mostly in Wall Street’s pocket.

This might allow rapid nationalization of the affected banks.  Perhaps a domino effect, as nationalized banks might have a substantial competitive advantage over private banks — such as a greater perceived solvency and a lower cost of funds.  This would clear the desks of Obama’s team, allowing them to focus on their political agenda and — more important — deal with the next wave of problems as the financial crisis moves down Main Street.

But it appears that they are not doing this.  Instead we get more kabuki, probably faux stress tests designed to boost confidence.

Note:  imagine if other professions were run like the government.  Instead of fixing your car, removing your appendix, of defending you in court — mechanics, doctors, and attorneys could lie to you in the hope of boosting your confidence!

See page 4 of the FDIC description of the stress test.  The “capital assessment” will cover 2 economic scenarios:  an absurdly optimistic baseline scenario and a slightly more “adverse” scenario.  Here are the adverse scenario assumptions for 2009 and 2010.  These would work as the baseline scenario.

• Read GDP of -3.3% and +0.5%.
• Civilian unemployment rate:  8.9% and 10.3%.
• Home prices:  -22% and -7%.

For more on this see “Wait And See” by Simon Johnson (was Chief Economist of the IMF, now MIT professor), The Baseline Analysis, 25 February 2009 — Excerpt:

So the banks have – by assumption – sufficient capital. The stress test will be relative to this baseline; you can see that the “maximum stress” will be pretty mild and, very important, short-lived.  President Obama therefore can present and emphasize his (admirable) long-term goals, as he did last night.

I just have one question. How exactly do we get growth over 2 percent in 2010 (and after)? The global economy is getting worse, consumer and business confidence is weak everywhere (tell me if you know different). There is no sign of housing turning around, consumers are cutting back, and large organizations are all planning to trim costs for the next financial year. Our policy response so far: moderate fiscal stimulus, underfunded housing policy, and small potatoes for the banking system. Monetary policy sounded bold a month ago; now less so (again, if your central forecast is so rosy, why embark on risky or controversial further monetary expansion?)

The answer is: wait and see. If we get a recovery, then we are fine. If there is no recovery, we’ll deal with it at that time and we can bolder at that time.

Economist Paul Krugman also finds this plan depressing, as we see in these two posts in his blog at the New York Times:

• “Not much stress“, 25 February 2009
• “Feelings of despair“, 26 February 2009.

(2)  Why are they doing this?

My guess is that Team Obama is hoping to “keep their options open”, one of the classic modes of failure for decision-makers facing difficult choices.  Unfortunately time relentlessly closes options.  Every decision taken closes options.  Every opportunity missed closes options.

(3)  The next phase of the crisis

Bad things are coming.  Governments have deployed a wide range of fiscal and monetary police measures, but these can only mitigate the suffering and damage to economic infrastructure.   Also, most are too small.  As people and their leaders understand the potential magnitude and duration of this downturn, additional rounds of fiscal stimulus will be approved.  (See this presentation by Richard Koo, who describes Japan’s experience)

Public policy measures have seldom if ever sparked a recovery.  Economies recover when the imbalances that caused the downturn are burnt off.  In this case, that means the excess private sector debt is defaulted, refinanced, inflated  away, or socialized.  Also helping to spark the recovery will be low asset prices, which eventually stimulate private investment.

Getting there will be painful.

A fair number of our major banks are technically insolvent, even after many rounds of government bailout programs.  Public anger is rising as they see vast sums of our money funneled to Wall Street.  Slowly the realization spreads that recapitalizing the banks will take several trillion dollars, a sum impossible for even the cleverest apparatchik to gift to banks.

Note:  Legend has it that Hank Paulson was once asked if it was in the people’s interest to have so many ex-Goldman Sachs partners working in the Treasury Departments of Western nations.  “There is no such thing as an ‘ex’ partner of Goldman Sachs” he replied.

Another note:  Paulson did not say that.  Putin did say that about the KGB.   But the earliest instance I find of this is by Aleksandr Nikitin, the ex-Soviet Navy officer arrested on charges of treason in 1996 for exposing the Russian Navy’s harmful nuclear dumping practices.  He said “There is no such thing as an ex-KGB employee, just as there is no such thing as an ex-German shepherd.”   (Source:  “The Two Worlds of Vladimir Putin”, Amy Knight, The Wilson Quarterly, Spring 2000 — subscription only)

To use another bad analogy, the crisis has been traveling  during the past two years through the virtual space of “Wall Street” – the financial markets.  That has caused severe damage.  During the 4th quarter it made landfall at Main Street.  Now it travels through the real economy, leaving behind a trail of unemployed people and wrecked businesses.  During the next two years our government will be busy coping with the resulting bankruptcies, poverty, and structural damage.  Plus any geopolitical turmoil caused by this global depression.

Our leaders must clear their desks NOW to prepare.

(4)  Possible Consequences

The Obama Administration has many bold policy objectives.  Reforms in health care and education.  To re-unionize US companies.  More critically, they must manage the domestic and international dimensions of the depression while winding down the war in Iraq and heating up the one in Afghanistan.

It’s a heavy schedule.  Fail to deal expeditiously with problems, they risk getting overwhelmed by events.  Their observation-orientation-decision-action loops (OODA loops) can fall behind the situation, so that they cannot effectively absorb new information and forecast events — the basis for planning and executing policy.  As the late John Boyd (Colonel, USAF) said in page 44 of  The Strategic Game of ? and ?:

{the decision-maker} will experience various combinations of uncertainty, doubt, confusion, self-deception, indecision, fear, panic discouragement, despair, etc.,
which will further disorient or twist his mental images and impressions 0f what’s happening;
thereby
disrupt his mental maneuvers for dealing with such a menace;
thereby
overload his mental capacity to adapt or endure;
thereby
collapse his ability to carry on.

OODA loops are especially vulnerable to this form of collapse when operating without a plan.  Plans provide a context for new information and a baseline of policy from which policies can be modified.  This is a common cause of battlefield defeat, and I suspect contributed to the failure of the Hoover Administration in 1930-32.

(5)  Afterword

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(6)  For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

• About Financial crisis – what’s happening? how will this end?
• About the Obama, his administration and Ameican policies today
• Good news about America, a collection of articles!

Forecasts about the crisis:

1. Geopolitical implications of the current economic downturn, 24 January 2008 – How will this recession end?  With re-balancing of the global economy — and a decline of the US dollar so that the US goods and services are again competitive.  No more trade deficit, and we can pay our debts.
2. What will America look like after this recession?, 18 March 2008  — The recession will change many things, from the distribution of wealth within the US to the ranking of global powers.
3. Consequences of a long, deep recession – part I, 18 June 2008
4. Consequences of a serious US recession – part II, 19 June 2008
5. Consequences of a long, deep recession – part III, 20 June 2008
6. A look at one page of what lies ahead in America’s history, 7 August 2008 — Death of an American industry.
7. Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
8. Forecasting the results of this financial crisis – part II, a new economy for America, 14 October 2008
9. A look at the next phase of the crisis, as it hits the real economy, 31 October 2008
10. A look at out future, 2009 – 2010 … and beyond, 9 November 2008
11. A look at 2009 economy – some guesses, 28 December 2008