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It now seems certain that General Motors will declare bankruptcy on Monday, that the federal government will as part of the reorganization in bankruptcy acquire more than 50 percent of the common stock of the reorganized company, and that the government will invest perhaps $30 billion in the new company, bringing the total cost of the GM bailout to a shade under $50 billion.

These developments raise three questions:

1. Should GM have received any government money?

2. Should the government acquire common stock in GM?

3. Should it invest in GM?

My answer to 1 is a qualified--an importantly qualified--yes. My answer to 2 and 3 is no.

Government bailouts of failing private companies are in general a very bad thing. They weaken the discipline of the market and penalize successful firms by subsidizing their inefficient competitors. But that is in general and there is a case for bailouts in times of national economic emergency, and it is on this ground that I have defended the initial bailout of General Motors and Chrysler, last December. Last December, with the economy in a tailspin that was beginning to remind observers of the Great Depression of the 1930s, the bankruptcy of the two firms would have been experienced as a dangerous shock to the economy. The firms might have had to liquidate (see below), which would at a stroke have increased the unemployment roles by hundreds of thousands, as well as causing ripple effects throughout the chain of distribution of motor vehicles, which includes not only the manufacturers but also the parts suppliers, who supply more than 50 percent of the components of the motor vehicle, and the auto dealers. The effect on employment and therefore on incomes and business and consumer confidence would probably have been profound--and wholly negative. In short, the costs of the initial bailout were outweighed by the costs of doing nothing.

That was the macroeconomic justification for the bailout. There was another, though closely related, justification. As a result of the near collapse of the banking industry, and of financial intermediation generally, last September, lending was severely constrained for some months (it still is severely constrained, though less so). That would have made a reorganization in bankruptcy of the auto manufacturers, as distinct from a liquidation, very difficult to pull off. Bankruptcy is designed to eliminate a crushing debt, but it does not eliminate the bankrupt firm's need for money if it is to continue in business. To acquire the necessary money, the reorganized firm typically obtains what are called "debtor in possession" loans (because in a reorganization the debtor--that is, the bankrupt--remains in possession of the firm's assets), and the lenders are given priority over the old debtholders. GM and Chrysler would have needed tens of billions of dollars of such loans to keep operating, and that money would not have been available, other than from the government, in December; indeed, it seems not yet to be available.

That was a liquidity problem, rather than an allocative-efficiency problem. To understand this, one must distinguish between average and marginal cost. The average cost of producing a car is the total cost incurred by the manufacturer, including interest on its debts, divided by the number of cars it produces. That cost exceeded, and still exceeds, the price at which GM can sell an appreciable number of its vehicles. GM's marginal cost, however, is the addition to its total costs of producing one more vehicle. That cost does not include interest on existing debt, because the interest is a fixed amount rather than varying with how many cars GM builds and sells. (It is the fixity of its debt that made GM insolvent when the demand for its vehicles plummeted last fall.) As long as GM's marginal cost is less than the price it can get for its product, it is efficient that it should remain in business. So if it cannot get the cash that it requires to be able to remain in business, then an efficient production process will be shut down, and that is an inefficient result. It therefore made sense, regardless of macroeconomic consequences, for the government to step in and take the place of the temporarily constrained banks, and become GM's (and Chrysler's) banker. 

But that was then. Five months later, credit is less constrained, and so GM's inability to obtain debtor in possession financing (if indeed it is unable to do so, as I shall assume) may reflect not a liquidity problem but a judgment by the financial industry that GM has no long-run future and therefore could not repay a debtor-in-possession loan large enough to keep the company going. Moreover, these five months have seen a partial, and because gradual an orderly partial, liquidation of GM and Chryster, which has diminished the shock value of their declaring bankruptcy; and they also seen a reduction in panic as the economic situation has stabilized. Not that it has fully stabilized--indeed, it may not really have stabilized; but there is no doubt that business and consumer confidence has increased, and so bankruptcies that would have been real shockers five months ago can now perhaps be taken by the economy in stride. That certainly has been true with respect to the Chrysler bankruptcy, though Chrysler is a much smaller company than GM and the government was able to coerce the agreement of virtually all the creditors, so that the bankruptcy proceeding has proceeded at a lightning pace.

Having already shrunk a good deal, GM might if the government washed its hands of it be able to obtain enough private money to keep going. Or perhaps not; and if not, and liquidity is still a factor (that is, if lending is still inefficiently constrained because the banking industry is still undercapitalized), there is an argument for a further bailout, on the ground that without it GM might liquidate entirely and the effect on employment in both GM and its satellite firms might deal a body blow to what we hope is an incipient recovery from the depression. I am skeptical, but will assume for the sake of argument that there is a convincing case for a further bailout.

It should not, however, take the form of cash for common stock that makes the government the owner of GM. It should be a loan in exchange for preferred stock with cumulative dividends (so that it does not affect GM's current cash flow) and no fixed date of maturity (so that it does not enable the government to step ahead of other creditors). For the government to own an automobile manufacturer doesn't make any sense, for reasons too obvious to dwell on.

The government says that it's not going to interfere in management decisions. I don't believe that. Quite apart from the political pressures that the United Auto Workers, and other entities that have a financial stake in General Motors, can be expected to exert on members of Congress and on the President, the Administration seems determined to preserve General Motors in order to (1) affirm the nation's commitment to remaining a major manufacturer of motor vehicles and (2) advance the Administration's goal of reducing oil consumption and (relatedly) carbon emissions. Achieving these goals will require the Administration to intervene, directly or indirectly, in the design and production and even marketing decisions of GM's management.

Goal (1) is ridiculous. Nowhere is it written that the United States shall produce motor vehicles, any more than that it shall produce television sets, which it no longer does. If other countries, such as Japan, produce better motor vehicles (from the standpoint of price and quality--and of the health of the environment and of reducing our dangerous dependence on oil produced by unstable or hostile foreign countries) than the United States, we should import them, and reallocate the resources that go into the manufacture of motor vehicles to other productive activities.

But what makes goal (1) particularly ridiculous is that even if GM (and Chrysler) liquidated, there would be a thriving U.S. automobile industry. There would be Ford''s production, and there would be the foreign cars that are manufactured in the United States. Toyota and the other foreign producers that have factories in the United States are part of the American automobile industry; their ownership by foreigners has no significance at all.

Goal (2)--operating GM in accordance with the environmental and foreign-policy goals of the Administration (which I happen to agree with)--confuses regulation with ownership. The government can without owning the manufacturers require them to comply with rules designed to make driving less harmful to the environment and to our need to reduce our dependence on foreign oil. All that the government's owning GM will accomplish is to make the company a political plaything.

And then there is the $30 billion that the government apparently is planning to pour into GM so that it won't just limp along but will become a vibrant, revitalized producer. We are becoming accustomed to thinking of anything less than a trillion dollars as small change. But as the government's loans, investments, and guaranties mount into the stratosphere, the danger of the "depression aftershock" that I emphasized in my book and in a number of my blog entries grows, and a further $30 billion expenditure deserves critical scrutiny. We should be concerned lest GM become a kind of economic Vietnam, where the federal government throws good money after bad, year after year, in a vain quest for victory.

One of the reasons, as I explained in my book, for calling our economic crisis a "depression" is that, as was already clear on February 2, when the book was completed, the government was spending trillions of dollars--on top of all the normal expenses of government--to try to arrest the downward spiral and speed recovery. Since then, the expenditures, commitments, and guarantees--all of which represent costs, actual or expected, though many or even most of them will eventually be avoided or recovered--have increased further, and concern has begun to be expressed that the soundness of America's public finance and currency is being undermined by the growing mountain of public debt. The interest rate at which the government borrows to finance the public debt has been rising, and there is even talk, though surely premature, that the government may lose its triple A credit rating!

Remarks by the distinguished macroeconomist Paul Krugman, at a panel discussion of the economic situation published in the current New York Review of Books (June 11), help to bring the problem into focus.

Krugman has been trying for some time, without success, to correct a misunderstanding by the prominent historian (and author of an excellent recent book on the history of banking) Niall Ferguson. Ferguson, who was also on the panel, argued as he has before that the monetary and the fiscal responses to a recession or depression--that is, reducing interest rates by expanding the supply of money, and increasing demand for goods and services by deficit financing of public works--operate at cross purposes. The cost of public works has to be financed by borrowing, and any increase in borrowing raises interest rates and therefore reduces the effectiveness of the monetary response.

Actually, as Krugman pointed out, the monetary and fiscal responses are complementary. The monetary response, we have learned, is inadequate, since, as I keep saying, you can lead a bank to money but you can't make it lend. Essentially the monetary response involves the Federal Reserve's increasing the balances in bank accounts, which increases the amount of money that banks are permitted to lend. But because many banks are still undercapitalized as a result of the collapse of the housing and associated mortgage-credit bubble, because loans in a depression are especially risky, and because the demand for loans is way down since production is down and consumers feel overindebted and so want to save rather than borrow, most of the newly created money is piling up in bank accounts and other safe savings havens rather than being spent.

Moreover, the lower interest rates are, the more difficult it is to persuade the hoarders of cash and cash equivalents to invest their money productively. We want interest rates to be low, to induce borrowing and lending, which increase economic activity. But we don't want then to be so low that there is insufficient inducement for the hoarders to part with their cash. Cash that is hoarded is inert; it does not contribute to economic activity; and so hoarding exacerbates a depression.

The role of fiscal policy, in the form of Keynesian deficit spending on public works (though that is only part of the $787 stimulus program enacted by Congress, the rest being tax reductions and benefits enhancements, which unfortunately are less effective means of fighting a depression because their effect on employment is indirect), is to make up the shortfall in private demand for goods and services by increasing the public demand for them. Construction workers laid off because of the fall in the demand for new residential and commercial buildings can be hired to build public buildings. The result is to reduce unemployment, thus increasing incomes, and increase confidence by other workers that they will not be laid off; and increased incomes and increased confidence in one's economic prospects reduce the propensity to hoard. The net cost to the government should be lower than the aggregate outlay, moreover, because an increase in employment increases income tax revenues and reduces unemployment benefits.

But assuming that there is a net cost to the program, Ferguson is right that the government will borrow more, and that this will raise interest rates--but probably only slightly. For as Krugman points out, the fall in private demand has been matched (not dollar for dollar, however) by a rise in savings, included hoarded cash. The personal savings rate has risen in the last year from 1 percent to more than 4 percent. To quote Krugman, "that saving ought to be translated into investment, but the investment demand is not there." Deficit spending on public works is a way of using the pool of savings to increase investment and therefore employment. "Keynesian policy...takes excess desired savings and translates them into some kind of spending. If the private sector won't do it, the government will."

The relation between savings and (productive) investment can be seen most clearly by imagining that the government decided to finance the public works program by selling "Victory [over Depression]" bonds to the general public. Because the bonds would be safe (the risk of the United States' defaulting on its obligations is effectively zero), most of the hoarders would be quick to buy them in lieu of holding cash that carries no interest at all; and so the government would not have to pay a high rate of interest on the bonds to be able to sell them. The government isn't financing the public works program in this way, but the economic substance may be very similar. If a money-market fund in which a person has placed some of his savings buys government securities to be able to pay interest on its money-market accounts, the person is indirectly financing the government.

It is not clear that Ferguson would disagree. For from one of his remarks at the panel discussion it appears that his real concern is not with the impact of the stimulus program on interest rates but with the cumulative effect of all current and planned federal expenditures on the long-term solvency of the U.S. government, including expenditures financed by the creation of money by the Federal Reserve. (When the Federal Reserve buys Treasury securities, this does not reduce federal debt, but merely transfers it from one government agency to another.) That is a legitimate concern, but it does not prove that the stimulus program is unwise. The longer and deeper the depression, the larger will be the federal deficit; so if the stimulus program makes the depression shorter and shallower, it may not increase and in fact may reduce the total public debt.

Krugman is an advocate of universal health care and of other costly social programs, and he argues in the panel discussion that the depression has underscored "the importance of a strong social safety net," such as Europeans have. Their generous safety net has reduced the human costs of the depression to them "because Europeans don't lost their health care when they lose their jobs. They don't find themselves with essentially no support once their trivial unemployment check has fallen off. We have nothing underneath. When Americans lose their jobs, they fall into the abyss." But safety nets are costly, and, Krugman continues,"there are people who say we should not be worrying about things like universal health care in the crisis, we need to solve the crisis. But this is exactly the time when the importance of having a decent social safety net is driven home to everybody, which makes it a very good time to actually move ahead on these other things."

So he is saying that the time is ripe in a political sense for a basic change in the management of the American economy. He may be right. For one effect of a European-style safety-net economy is to reduce the amplitude of the swings that we call the business cycle, and at the moment that amplitude, the human costs of which are increased by the absence of a stroong safety net, is hurting many Americans. Because the European-style safety net raises labor costs, in part by making it difficult to lay off workers, unemployment is higher in Europe than in the United States in boom periods; employers are reluctant to hire if it will be difficult for them to lay off workers when the boom ends. But in the current world depression our unemployment rate is higher than the average European rate (after correction for differences attributable to different definitions of unemployment).

Even if the European approach is thought preferable to ours and compatible with our political and social culture, the costs of moving toward it in the present economic setting must be estimated and given their due weight. The costs are of two kinds. The first is increase that a costly and ambitious program of social reform must create in the uncertainty of the economic environment. As Keynes emphasized, uncertainty tends to dampen the "animal spirits" that drive economic activity, and to increase the incentive to hoard, which retards economic activity, as I have been emphasizing. Second, the costs of ambitious social reform, when added to the costs of the depression-recovery programs and the "normal" budget deficit exacerbated by the decline of tax revenues in a depression, may result in a potentially destabilizing level of public debt.

My own heretical view is that Americans are undertaxed, and so if I thought that the increase in the public debt was going to be financed by higher taxes I would not be upset. But Congress and the public seem adamant against tax increases, even when they take the form of closing ridiculous loopholes, and against spending reductions, even in ridiculous programs such as farm subsidies; and this combination of aversions makes it likely that increases in the public debt will be financed by a combination of continued borrowing, but at higher and higher interest rates, and inflation.

A bit of inflation can be a good thing in a depression, because it operates as a tax on cash balances and thus reduces hoarding and stimulates spending. But I am worrying about the inflation that hits after the depression, when the government decides that it can no longer finance the public debt by borrowing, cannot raise taxes, cannot cut spending, and is left with having to debase the currency. I would like to see greater efforts by the Administration and by the economics profession to determine, so far as may be possible to do, the gravity of this danger.

In the business section of today's New York Times, Greg Mankiw, a prominent economist at Harvard, offers the following defense of his profession's disappointing performance with regard to the current depression: "It is fair to say that this crisis caught most economists flat-footed. In the eyes of some people, this forecasting failure is an indictment of the profession. But that is the wrong interpretation. In one way, the current downturn is typical: Most economic slumps take us by surprise. Fluctuations in economic activity are largely unpredictable. Yet this is no reason for embarrassment. Medical experts cannot forecast the emergence of diseases like swine flu and they can't even be certain what paths the diseases will then take. Some things are just hard to predict."

There is reason for embarrassment; "caught flat-footed" may be unconscious acknowledgment of the point. Mankiw's defense of the economics profession misses the point, which is is not forecasting error but obliviousness to danger. The medical profession knows that it can't predict the emergence of a new pandemic, and knowing this takes appropriate precautions, such as the creation of a global early-warning network, the adoption of protocols for minimizing the spread of a new contagious disease, and the development of new vaccines and treatments. And when a new disease appears, the profession swings into action.

The Federal Reserve is not on a par with the Centers for Disease Control, or macroeconomics comparable as a scientific field to public health, medicine, and biology. An economic disease that was not new--namely, the emergence and expansion to bursting of a housing bubble--appeared in the early 2000s and was ignored by the economics profession as a whole, though a few economists saw what was happening. The bubble burst in 2007 and a recession ensued, the gravity of which was missed by the profession. The near collapse of the banking industry in September of last year came as a shock to economists, both in and out of the government, as did the failure of the economy to respond to the conventional treatment--the reduction of the federal funds rate. The stock of the monetarists, such as Milton Friedman, fell; that of the fiscalists, notably Keynes, who had been in the economics doghouse, rose. Mankiw's dismissal in 1992 of Keynes's great book The General Theory of Employment, Interest and Money (1936) as "outdated" turned out to be itself outdated. Throughout the fall of last year, most leading macroeconomists were strangely silent as the crisis deepened; they seemed to have no idea of what should or could be done to arrest the downward spiral. (As late as last September, the immensely distinguished macroeconomist Robert Lucas was unsure whether the nation was in a recession.) They are continuing to disagree over whether the government has done too much or too little to try to put the economy on the path to recovery.

We have discovered that despite the centrality of banking to the macroeconomy, macroeconomists know little about modern banking and that an understanding of the business cycle continues to elude them.  If I may again quote Mankiw, writing in his blog on February 16 of this year, "I don't pretend to be enough of an expert, or to be close enough to the facts, or to have a large enough staff, to know what should be done with the banking system, which is at the center of our current economic turmoil. But I am confident that fixing it should be the main focus of policy efforts." According to Spiegel Online, "When asked the question: 'Can you explain what has happened?' Robert Solow, a winner of the Nobel Prize in Economics, simply shakes his head and says: 'No, I don't think that normal economic thinking can help explain this crisis.'"

Economists can't be blamed for having an imperfect understanding of depressions; these are immensely complex events. But they can be blamed for exaggerating their understanding of them. In 2002, referring to Milton Friedman's theory that mistakes by the Federal Reserve had turned a recession triggered by the stock market crash of October 1929 into the Great Depression, Ben Bernanke stated: "Regarding the Great Depression. You're right [Friedman and his collaborator, Anna Schwartz], we [the Federal Reserve] did it. We're very sorry. But thanks to you, we won't do it again." It has done it again. And the following year, 2003, in his presidential address to the American Economic Association, Robert Lucas announced that the problem of depressions had been solved and macroeconomists should move on to other subjects, such as economic growth.

Economists thus had assured us that they knew how to prevent depressions and that there would never be another one. But now that a depression (or a "recession" of such unprecedented severity as to make the word a euphemism for depression) is upon us they say they never actually knew how to prevent a depression or dig us out of one. One wishes they had told us that earlier.

I have received an email from Alan Greenspan in which he expresses regret at what he describes as my "rather thin analysis of the source of the current financial crisis." He states that his "view is different," and by way of explanation prints excerpts of three pieces written by him. The first is from remarks, entitled "Risk and Uncertainty in Monetary Policy," that he made at a meeting of the American Economics Association in January of 2004, while he was still chairman of the Federal Reserve and the housing bubble was expanding. The second is from an article that he published in the Financial Times on April 6, 2008, called "A Response to My Critics." The third is from an op-ed that he published in the Wall Street Journal on March 11 of this year, entitled "The Fed Didn't Cause the Housing Bubble." Here are the links to the three pieces, and I suggest you read them before reading my reply, which follows the links.

http://www.federalreserve.gov/BoardDocs/Speeches/2004/20040103/default.htm

http://blogs.ft.com/economistsforum/2008/04/alan-greenspan-a-response-to-my-critics/

http://online.wsj.com/article/SB123672965066989281.html

The first piece is a narrative of the Federal Reserve's monetary policy between 1979 and 2004. Greenspan explains that the Fed during this period, under Paul Volcker's chairmanship and then Greenspan's, raised and lowered the federal funds rate (the rate at which banks borrow from each other overnight) in order to achieve so far as possible full employment with minimal inflation. He notes the dot-com stock market bubble of the late 1990s and explains that the Fed did not try to puncture it by raising interest rates, fearing that to do so would cause "a substantial economic contraction and possible financial destabilization." But the article does not explain why he thought those consequences would have ensued. He notes that after the bubble burst and a recession ensued in 2001, the Fed reduced the federal funds rate; by June 2003 it was at 1 percent, "the lowest level in 45 years."

He thought this could be done without risk of inflation (the usual consequence of extremely low interest rates) because "both inflation and inflation expectations were low and stable." In fact, as I have explained in my book and in previous blog entries, the low interest rates had caused asset-price inflation--the housing and stock market bubbles, both well under way when Greenspan wrote the article in 2004.The rest of the article is devoted to generalities about monetary policy. There is no mention of a housing bubble. And rather than "trying to contain a putative bubble by drastic actions with largely unpredictable consequences," he contended that the Fed should "focus on policies 'to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.'" The quotation appears to be from earlier testimony by him before Congress.

Greenspan's second article, published in April of last year, remarks that similar housing bubbles emerged in more than two dozen countries, including the United States, between 2001 and 2006. He attributes these housing bubbles not to monetary policy (namely the low federal funds rate) but a "dramatic fall in real long term interest rates." He therefore refused to acknowledge that the Fed should have started pushing up interest rates before 2004, adding that "regulators confronting real time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act preemptively." He said that tighter regulation would have made no difference. He attributed the entire subprime debacle to "misjudgments of the investment community," thought the situation was stabilizing, and repeated the view expressed in his 2004 article that the Federal Reserve should not try to prick bubbles.

Greenspan's third article, published just this last March, is, as one would expect, more defensive in tone; for by then, as he acknowledges, disaster had struck. He argues in the article that the cause of the housing bubble and the ensuing near collapse of the international banking system was in no measure due to the Federal Reserve's having under his chairmanship pushed the federal funds rate way down and kept it there for years, but instead was the result of the adoption by developing countries such as China of an export-oriented trade policy, as a result of which these countries accumulated huge dollar surpluses which they then lent in the United States, driving down interest rates.

This must be so, he argues, because the housing bubble was caused by long-term interest rates--mortgage interest rates are long term--and the federal funds rate is a short-term rate; and while short-term rates and long-term rates used to move in tandem, this relation was, he argues, shattered, beginning in 2002, by the flood of foreign capital into the United States.

I do not find this analysis persuasive. The federal funds rate, being the rate at which banks borrow reserves (cash) from each other, has a strong influence on long-term interest rates. The lower the cost at which a bank acquires capital to lend, the lower will be the rates at which it lends, whether long term or short term, because competition will compress the spread between the bank's cost (its interest expense) and its revenue (such as interest on the loans it makes). At the beginning of 2000, when the federal funds rate was 5.45 percent, the interest rate for the standard 30-year fixed-monthly-payment mortgage rate was 8.21 percent. By the end of 2003, the federal funds rate was below 1 percent (and was negative in real terms, because there was inflation), and the mortgage interest rate had fallen to 5.88 percent. The Fed then gradually raised the federal funds rate, to 5.26 percent in July 2007, and the mortgage interest rate rose also, to 6.7 percent, a smaller but still significant increase; and the bubble burst. Furthermore, given the popularity of adjustable-rate mortgages--which Greenspan encouraged--short-term interest rates had a direct effect on the cost of mortgages during this period.

Greenspan's analysis implies that the Federal Reserve lost control of long-term interest rates because of foreign capital and therefore could not have lanced the housing bubble even if it had wanted to, which is hard to square with the fact that the bubble did burst when the mortgage interest rate rose. (Though there was a lag, as I explained in a blog entry of May 19, because of the self-sustaining tendency of a bubble.) And it is plain from the earlier statements to which Greenspan has directed us that he neither was aware that there was a housing bubble nor would have lanced it had he realized it, since it was and appears to still be his position that bubbles should be allowed to expand and burst, and then the Federal Reserve will wake up, step in, and clean up the debris ("mitigate the fallout when it occurs")--which we have discovered it cannot do. 

There is enormous speculation in the media, fed by statements by government officials, with regard to the question whether the current economic downturn has reached, or will soon reach, its bottom and start upward. I believe this speculation, and the data and opinions on which it is based, are of little value, probably too little to guide individual or business decisions. People got tired of reading about economic gloom and doom, so the media were happy to play up indications that the worst was over.

The problem, which is related to the discussion of uncertainty in my last blog entry in this series, is the inherent instability of a capitalist economy. (This is a fact, not a criticism.) The average growth of the U.S. economy has long been about 3 percent a year, but the actual growth from year to year oscillates around that trend line in an irregular, unpredictable fashion. This oscillation is the "business cycle," but the word "cycle" is misleading in this context because it suggests a smooth, wave-like motion, like a pendulum; and the real motion is anything but.

One reason, perhaps a main reason, for the oscillation (rather than steady growth) is feedback effects. There is an analogy to climate, another unstable system. Carbon dioxide in the atmosphere raises surface temperatures by trapping heat radiated from the earth; the higher temperatures, among their other effects, melt the Alaskan and Siberian permafrost, releasing methane, another "greenhouse gas," which leads to a further increase in surface temperatures. Also, the warmer the atmosphere, the more water vapor it holds, hence the more cloud cover there is, and clouds by blocking sunlight can reduce surface temperatures. Similarly, we know how an asset-price bubble can expand and then burst, and in bursting can trigger a recession, which can feed on itself: demand falls, so output falls, so unemployment rises, so incomes fall, so there is hoarding and a further reduction in demand, so output declines further and unemployment rises further. Eventually, as inventories shrink and durables wear out and hoarding produces a savings glut, the downward spiral stops and then reverses. In either direction, feedback effects amplify the effect of what initially may be a small change in economic behavior.

Because of the inherent instability of the economy, as of the climate, it is not possible to spot with any confidence a bottom or turning point in a recession or depression until recovery is well under way and one can look back and see the bottom through the rear-view mirror as it were. As long as unemployment is increasing, as it seems still to be doing, there is a danger that the downward spiral will continue--that a further increase in unemployment will cause a further reduction in spending and investment by reducing incomes and increasing the propensity to save rather than spend by those whose incomes have fallen or who fear becoming unemployed or, if they are unemployed already, fear that it will take a long time for them to find another job.

The government's enormous expenditures on containing the downward movement of the economy have undoubtedly had some effect; the analysis of fear in my last blog entry suggests that a returning sense of business and consumer confidence can have an independent positive effect on recovery from a depression; and sheer passage of time is beneficial--inventories shrink, durables wear out, and eventually safe (and therefore unproductive) savings stop increasing (the savings glut). But whether these developments have merely slowed the economic decline, rather than bringing it to the verge, at least, of a full stop, remains to be seen. The recent rise in stock prices has encouraged many to think that the depression is actually over, which is surely premature. The Dow Jones Industrial Average was 7,900 at the beginning of February, when the nation was in a state verging on panic about the economy, and it has risen only modestly since, to 8,400 today, and thus remains far below its peak of 14,000 in October of 2007. The housing market remains in very bad shape, and large losses in commercial real estate loans, other business loans, and credit card debt loom. Defaults and bankruptcies, business and personal, are at a high level. General Motors may declare bankruptcy soon, with unpredictable consequences. Other shoes may drop.

Even assuming that the worst is over, one cannot know how fast, or along what path, the economy will recover, reaching the trend line so rudely interrupted by the economic downturn that began at the end of 2007 and accelerated dramatically beginning last fall. The sharp drop in the market value of people's savings, concentrated as those savings are in houses and common stock, the continuing economic distress in major trading partners of the United States, and the ballooning budget deficits and money supply, may prevent a full recovery for a number--an unknown number--of years.

I make no predictions. The burden of my argument is that the instability of the economy makes predictions about the recovery from a depression perilous.

In an article in Monday's Washington Post, David Cho reports that the Treasury Department is having a good deal of trouble implementing its ambitious program of recovery from the depression. Cho and the people he has interviewed attribute the problem to delays in appointments of high-level officials (the number two man in the department has yet to be confirmed), but also to an excess of cooks spoiling the broth, the excess consisting of White House officials, such as members of the staff of the National Economic Council, which is headed by Lawrence Summers, prowling the corridors of the Treasury building and distracting the denizens with demands and commands.

I have been concerned since the beginning of the Obama Administration with what seems a determined effort at overcentralization. The tendency in American government in recent times has been to centralize power more and more in White House staff. The effect is to insert a layer of managerial control above the Cabinet officers, who themselves constitute a layer of control above a number of other political appointees in their departments (laterals), who in turn are layered over the career civil servants. A recent and very pertinent literature in economics--"organization economics"--emphasizes the costs of hierarchical management in slowing and distorting the flow of information up the chain of command and the flow of orders down it. The problem is compounded when as in the federal government the top layers are political appointees who may have little experience with the operation of the agency they find themselves managing.

Obama is extremely able and self-confident and has appointed on the whole very able people to his staff and to the departments; some of them are brilliant. But the capacity of brilliant people, appointed to high positions in the federal government from outside, to screw up is legendary. The danger is amplified when the government tries to do too much. The economist Frank Knight used to quip that although production beyond capacity is a contradiction in terms, it is observed every day in academia--to which we can add, in the U.S. government as well. There is danger that the government is trying to do too much and that the economic consequences will be negative and serious.

We begin with the fact that the federal government has spent, lent, committed to spend or lend, or guaranteed a total of almost $13 trillion to fight the depression. Something more than half of this Brobdingnagian sum consists of expenditures or commitments by the Federal Reserve, and about two-thirds of the remainder consists of expenditures or commitments by the Treasury Department; the rest consists mainly of guarantees by the Federal Deposit Insurance Corporation. The total number will probably grow. Only about a third had (as of March 31 of this year, the latest date for which the data are available) been spent, and perhaps not all of the committed funds will actually be disbursed. Even if the total amount allotted to spending (mainly buying stock in failing financial institutions, such as AIG) and lending is actually disbursed, much of it will be returned or "unwound" (I'll explain the difference in a moment), and the guarantees will not cause a loss to the government if there are no defaults in the guaranteed obligations (such as the guaranty of bank deposits if a bank fails).

Thirteen trillion dollars is more than the national debt and almost as great as a year's Gross Domestic Product. Although it is as yet largely a contingent liability, some trillions of dollars will doubtless be lost, adding to the national debt, and it is small comfort that the loss of the nation's wealth would probably be even greater if no costly depression-recovery efforts were undertaken. The Federal Reserve's share of the liability is especially worrisome, because it creates a serious risk of future inflation. As I've mentioned previously in this series of blog postings, the banks are, thanks to the Federal Reserve's "easy money" rescue efforts, awash in excess reserves (i.e., lendable cash). When recovery is well under way, and demand for loans soars, and the banks start lending those $800 plus billion in excess reserves, the amount of money in the economy will jump. And it will jump further because the Federal Reserve is continuing to pump cash into the economy by buying private and long-term private and public debt. As economic activity quickens, and confidence returns, consumers as well as businesses will spend hoarded cash, increasing the ratio of cash to goods and services.

In principle, and perhaps as a technical matter in practice, the Federal Reserve can sop up all the excess cash in the economy by selling the debt that it bought in order to put cash into the economy, thus bringing the cash back into the Fed, where it can be retired. (The cash that the Fed creates it can also uncreate.) But the effect of a sudden withdrawal of huge amounts of cash from the private economy is likely to be, as in the 1979-1982 induced recession (and before that in the 1937-1937 recession that set back recovery from the Great Depression by several years), a sudden rise in interest rates and resulting contraction in economic activity.

If at the same time that the Federal Reserve is trying to unwind its stimulus efforts the Treasury is trying to pay for its heavy expenditures on recovery from the depression, the risk of inflation (and an ensuing corrective recession) will increase. As government debt mounts up, the interest rate the government must pay to service the debt is likely to rise, and so the deficit will rise farther. If tax increases to pay down the debt prove politically infeasible, the government may resort to inflation--paying its debts in cheaper dollars--to alleviate the debt burden.

But this is just the beginning. For the current depression has greatly reduced the government's tax revenues, as a result of which the budget deficit would be growing by leaps and bounds even if there were no extraordinary expenditures on recovery from the depression. The budget deficit for the current fiscal year (which ends on September 30, 2009) is estimated to be $1.8 trillion, and this may well be an underestimate. Further compounding the budget problem, the Administration wishes to spend trillions of dollars on ambitious social programs without having any good prospects of being able to finance the expenditures either by higher taxes or by reducing other spending.

And if that isn't enough to frighten one, the immense financial problems crowding in on the government, and the variety and complexity of the short- and long-range spending programs, make it extremely difficult for a poorly structured, top-heavy government to execute competently any of the multidinous problems that clamor for solution now, so that the government's efforts to speed recovery from the depression can succeed.

To understand the role of the Federal Reserve in the causation of the current depression, we must understand its influence on interest rates, and how interest rates influence economic activity.

The Treasury Department borrows money to finance government activities by issuing bonds, which are bought by banks and other investors, and also by the Federal Reserve. When the Fed wants to stimulate economic activity, it buys Treasury bonds from banks and other investors, paying cash, which increases the balances in bank accounts and by doing so provides more money for lending and spending. (The process is actually somewhat different and more complicated, but I am presenting an intuitive version that will be easier for readers who are not experts to understand.) As the supply of money for loans rises, interest rates fall (the larger the supply of a good, including loans, the lower the price, which in the case of a loan is the interest rate). As interest rates fall, borrowing becomes cheaper, and people borrow more and go deeper into debt, rather than saving. With more borrowing, banks need more money to lend, so they borrow too; as it is cheaper to borrow capital than to raise it by issuing more stock (because interest is deductible from income tax and the compensation that providers of equity capital to firms receive from those firms is not) banks become more indebted too, and hence more risky. And because houses are a product bought mainly with debt (for example, an 80 percent or 90 percent or even 100 percent mortgage), the demand for houses rise. So more houses are built, but in addition, because the overall stock of housing is so durable and is therefore not replaced frequently, the increase in demand pushes up prices. If nothing else besides low interest rates is pushing up housing prices, we have a bubble, in the sense that, as soon as the crutch of low interest rates is withdrawn, prices are likely to fall, as houses become more expensive to buy, the higher interest rates are. It was the collapse of the housing bubble when interest rates rose (mainly in 2005 and 2006) that started the economic collapse, and because banks were so heavily invested in housing through their role in issuing mortgages, they came near to collapse as well, triggering the depression.

The Federal Reserve pushed interest rates way down at the end of 2000 and kept them there until 2005 and during this period of low interest rates (in part of the period, the short-term interest was negative in real terms, because it was lower than the inflation rate). This was the decisive error that put too much risk into the economy, against a background of deregulation that allowed the banking industry to take whatever level of risk was profit maximizing given interest rates. The Fed was fooled by the fact that the usual indices of inflation, such as the Consumer Price Index, did not indicate a high rate of inflation. But the reason was that low-cost imports from China and other East Asian countries kept prices of most goods and services down. Inflationary pressures caused by an overheated economy flooded with lending were deflected into assets such as houses and common stocks.

The Federal Reserve missed all this. As late as October 2005, as the housing bubble was beginning to leak air, Ben Bernanke, the chairman of the President's Council of Economic Advisers--and about to be appointed the chairman of the Federal Reserve--stated publicly that the rapidly rising housing prices were not the product of a bubble. And so the finance industry, reassured, continued making risky mortgage loans and selling risky securities backed by those loans.

There were plenting of warnings of a housing bubble, going back to 2002 and found even in local newspapers. But most economists missed the bubble, and so it was easy to dismiss the few who warned as Cassandras and sourpusses. I do not fault the Federal Reserve for following the conventional wisdom. I do fault it for having failed either to take the warnings seriously enough to evaluate them in depth (the Fed has 250 Ph.D. economists), or to prepare contingency plans in the event that the ascent of housing prices proved to indeed be a bubble and the bubble collapses and brought the banking industry (so heavily invested in housing) down with it. As a result of the Fed's unpreparedness, when the banks began collapsing in September of last year the government was caught by surprise, improvised spasmodically, failed critically to prevent the bankruptcy of Lehman Brothers, and by its pratfalls deepened the downturn.

I read recently the statement by one business economist that if there is any hero in this mess we find ourselves in, it is Ben Bernanke. As far as I can judge, he has since last October managed the response to the crisis competently--perhaps more competently than his predecessor Greenspan would have done, or other possible replacements for Bernanke. But he is like a general who having been defeated in battle because of his errors manages the retreat of his army competently. He does not thereby escape blame for the defeat, and should not be permitted to shift blame to the soldiers under his command who gave way under attack.

My book contains a short list of suggested readings, which I hereby supplement with (1) a list of additional books and articles that are both accessible to nonexperts and helpful to an understanding of the current economic mess, and (2) a very short list of blogs or other online sources that I find helpful in keeping up with events and ideas relating to the mess.

Books and Articles:

Acharya, Viral V., Irvind Gujral, and Hyun Song Shin, "Dividends and Bank Capital in the Financial Crisis of 2007-2008" (Stern School of Business, New York University, March 2009).

Axilrod, Stephen H., Inside the Fed: Monetary Policy and Its Management, Martin through Greenspan to Bernanke (2009).

Bewley, Truman E., Why Wages Don't Fall during a Recession (1999).

Brunnermeier, Markus K., "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, Winter 2009, p. 77.

Dillar, Dudley, The Economics of John Maynard Keynes: The Theory of a Monetary Economy (1948).

Feldstein, Martin, "The Risk of Economic Crisis: Introduction," in The Risk of Economic Crisis 1 (Martin Feldstein ed. 1991).

International Monetary Fund, Global Financial Stability Report: Responding to the Financial Crisis and Measuring Systemic Risks (World Economic and Financial Surveys, Apr. 2009).

Keynes, J. M., "The General Theory of Employment," 51 Quarterly Journal of Economics 158 (1937).

Minsky, Hyman P., John Maynard Keynes (1975)

Restoring Financial Stability: How to Repair a Failed System (Viral V. Acharya and Matthew Richardson eds. 2009).

Stern, Gary H., and Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts (2004).

Swagel, Phillip, "The Financial Crisis: An Inside View" (Brookings March 2009).

Symposium: "The Mortgage Meltdown, the Economy, and Public Policy," The B.E. Journal of Economic Analysis & Policy, vol. 9, issue 3 (2009), www.bepress.com/bejeap/vol9/iss3 (visited Mar. 28, 2009).

Taylor, John B., Getting off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (2009).

Walsh, Carl E., Monetary Theory and Policy (2d ed. 2003).

Blogs and Other Online Sources (and I would be grateful for further suggestions):

Baseline Scenario, The, http://baselinescenario.com/.

Bloomberg Press, http://www.calculatedriskblog.com/.

Calculated Risk, http://www.calculatedriskblog.com/.

Econbrowser, http://www.econbrowser.com/.

Economics and Politics, http://krugman.blogs.nytimes.com/.

My book A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, published just days ago by the Harvard University Press, was finished on February 2 of this year. Much has happened in the more than three months since, and so I decided that as soon as the book was published I would begin to blog on the economic situation in an effort to keep the book up to date, as well as to enable me to rethink my views about the situation on the basis of criticisms of the book and of comments on the blog. I have written a number of blog entries in accordance with my plan, and they can be found at "A Failure of Capitalism," http://correspondents.theatlantic.com/richard_posner/. This week, as a visitor to Andrew Sullivan's blog, I will be highlighting a handful of issues arising from the book and the blog entries and whatever exciting developments occur during the week.

The title of the book has aroused concerns in some quarters, and this first entry in the new blog series is addressed to those concerns. First, the preferred word for our current economic situation is "recession"; readers wonder why I insist on using the more ominous "depression." Second, they wonder whether I want to replace capitalism with some different economic system.

Most economists would reserve the word "depression" for a situation in which either output or employment has fallen by at least 10 percent. But that is round-number thinking. There is no basis for drawing the line between "recession" and "depression" at a particular percentage rate of decline. One month of 10 percent unemployment cannot be thought more serious than ten years of 9 percent unemployment. What marks our current economic situation as a depression in a meaningful sense, though not one likely to match in severity the Great Depression of the 1930s, is the intensity of the anxiety that it has aroused, the enormous costs that the government has incurred to try to stop the downward spiral of the economy, the possiblity that those costs will bite us as the economy begins to recover and by doing so will knock the recovery off its path, and the further possibility that the recovery will be extremely protracted because of long-term changes in consumer preference. To illustrate the last point, the sale of automobiles has fallen by almost a half in the last year. Millions of people evidently decided to keep their "old" car a year longer than they were planning. They may discover that modern cars are extremely durable, that one can be quite content with another year or two years or three years driving their "old" car, and so in the future that they will buy a new car less frequently. Then hundreds of thousands of jobs that have disappeared from the auto industry in the last year, because of the economic downturn, will not return. The occupants of those jobs will not be rehired. They will have to find jobs for which they may have no skill or training. That may take a long time, and if so (and if the pattern is repeated in other industries) unemployment may remain high for a long time.

Another thing that marks our economic crisis as a "depression" is its potential for profound political consequences. There is a rage to reregulate the banking industry, and more broadly to increase the scope of government intervention in the economy, perhaps dramatically. It has increased dramatically--with the bank bailouts and the auto bailouts and the conditions attached to the bailouts and the $787 billion stimulus package--and while these are emergency measures, which can and should be ended when recovery from the depression is well under way, there is fear that they have given the federal government an appetite for permanently redrawing the line that separates government in a capitalistic economy from the production and distribution and consumption of goods and services, which are tasks of the private sector.

There is a sense, in short (turning to the second concern that I flagged), that capitalism has failed us, and we need something different, and that the title of my book signals support for that view. But that is not my intention. "Capitalism" is not a synonym for free markets. Capitalism is a complex economic system with many moving parts, and buying and selling and investing and borrowing and other activities carried on in private markets are only some of those moving parts. Others include a system of laws for protecting property and facilitating transactions, institutions for enforcing those laws, and regulations of markets designed to align private incentives with the goal of achieving widespread prosperity. One of the key regulatory institutions is a central bank, which in the United States is the Federal Reserve.

The part of capitalism that consists of a private banking system is unstable and can fail and can bring down much of the rest of the economy with it, and that is one reason a capitalist system cannot consist just of free markets. A central bank has a key role to play in preventing the banking system from failing; so do the other government agencies involved in the regulation of banking. These "moving parts" failed crucially in their responsibility for preventing the banking system from failing. And for reasons that I will explain in subsequent entries in this series, the blame for the depression should be allotted primarily on the Federal Reserve, on other parts of government (including the Treasury Department and Congress), and on the economics profession, rather than on the banks.

I want first to consider the following argument, made by a number of conservative economists, against the $787 billion stimulus enacted by Congress in February. The argument is that since savings equals investment, if the government borrows money to finance public investment (say in the form of a public-works program, such as highway construction or repair) this reduces by the identical amount the money available for private investment; and therefore only if the public investment is more valuable than a private investment of the same size is the public investment, and hence the stimulus, a worthwhile anti-depression measure. I disagree.

To begin with, not all savings are forms of investment in an illuminating sense. One form of savings, which is quite attractive in a depression especially if there is deflation (and, as I explained in a previous entry, we are experiencing a mild deflation at present), consists of putting cash in a safe or safe-deposit box, or even under the mattress. Such money is not invested, unless investment is defined as deferred consumption so that if I put money under my mattress I am in effect deciding to spend it sometime in the future, and knowing this firms will invest to create the productive capacity to meet my increased future consumption. But that is not a good definition of "investment." I may be refraining from spending not because I have any definite intention of spending the sum saved in the future but because I want cash on hand to meet a possible urgent need for it--a common concern during a depression and one that helps explain the surge in the personal savings rate since last fall. In fact the amount of currency in the economy has increased substantially since then and the sale of safes has increased as well.

Critics of Keynesian deficit spending as a depression remedy may reply that, setting the mattress example to one side, if I have decided to lend my savings in some form it will be borrowed by either a private investor or the government, and there is no reason to think the government will use the borrowed money more efficiently. That is, if I have $100 in a demand deposit account, meaning that I have lent the bank this amount (depositors do not own the money in their deposit accounts; they are merely creditors of the bank), the bank can lend it either to some business or to the government. The government will be interested in borrowing the money because, to finance a Keynesian public-works project, the government must borrow the cost of the project (unless it raises taxes--and at present it is reducing rather than raising them, in order to help fight the depression). One way it can do this is by selling a Treasury bond to the Federal Reserve.

But this picture is overdrawn. If the government does not borrow the money in the depositor's account from the bank, it does not follow that the bank will lend it; the bank may instead decide to add the money to its "excess reserves"--that is, to its cash hoard. Or the government may borrow the money to pay for the public-works program not from an American bank but instead from foreigners--foreigners finance a great deal of our public debt. And if the government follows that route it will not be withdrawing any cash from the American economy. In both cases, the expenditure of the $100 in my bank account on public works will be a net addition to investment and thus contribute to increasing output and employment.

Furthermore, the fact that there is money available to be invested doesn't mean that it will be invested even if banks are eager to lend money to entrepreneurs. If entrepreneurs are afraid to invest in a depression, as many are, because they are uncertain about what the business environment will be when any investment they make is completed, then even if the money is deposited not in a demand deposit but in a money market account it may not increase the amount of investment. The money be largely inert from the standpoint of stimulating economic activity.

What is true is that if any of the money that the government is borrowing to finance public works would have been invested privately, the withdrawal of that money from the private sector will raise interest rates, and in turn dampen private investment. But the negative effect on investment may be much less than if the money remained in the form of precautionary savings. It is also true, however, that heavy government borrowing to finance a Keynesian anti-depression program exacerbates the "depression aftershock" problem, of which more presently.

There is a further difference between private and public investment during a depression, a difference in timing as distinct from size. A well-designed Keynesian program (unfortunately the current program is not as well designed as it could be, because of political pressures) is geared toward channeling as much money as possible into investment and production as soon as possible, moreover in the industries hardest hit by unemployment. Private investment of the same money might proceed at a more leisurely pace, because it might be oriented not toward filling potholes (say) but instead toward building factories that might take years to be completed and employ few unemployed workers.

There is a further and decisive reason for a Keynesian anti-depression program, and that is to restore confidence. Fear of the economic environment in a depression causes both business and consumers to freeze and hoard, rather than invest and consume, and that freezing and hoarding cause output to fall and unemployment therefore to rise. Confidence (hope, optimism) could not be restored by monetary policy and bank bailouts alone during the present economic downturn because these measures were having only a limited effect in pulling the economy out of its hole. They no doubt made the depression somewhat less severe, but they were not arresting the downward spiral but merely slowing it down. The government had to show the public and business its resolve to beat the depression, and the enactment of an ambitious program of deficit spending was the key to showing that. The slight improvement in the economy in the last month may be due in part to a general feeling that the government is tackling the nation's economic situation vigorously, makiing it safe for business and consumers to loosen the purse strings slightly.

But what about the long-term effects of the anti-depression programs--the "aftershock" that I mentioned? The government has created a great deal of money, and borrowed a great deal of money, to finance the bailouts and the stimulus package and increase the amount of money in circulation (to help push down interest rates). If when demand rises the banks lend their $800-plus billion in excess reserves, the ratio of money in circulation to the output of goods and services is likely to rise--and this will mean inflation. The ratio will rise further if the government decides to finance some of the huge additional debt that it is incurring as a result of its anti-depression expenditures by increasing the money supply, that is, by inflation, which is a form of taxation--taxation of cash balances. A low rate of inflation is manageable and does little economic harm, but a high rate is very harmful, and can be broken usually only at the cost of a sharp recession (consequent upon a sharp rise in interest rates in order to reduce the amount of lending and hence the amount of money in circulation). And the recession might (as in 1937) disrupt a recovery from the depression. These costs have to balanced against the benefits of the anti-depression programs; unfortunately only guesses are possible.

Another long-run effect of a depression goes by the name of "moral hazard," a term best illustrated by the tendency to be less careful than otherwise if you are well insured against the consequences of your carelessness. If the government is expected to make vigorous efforts to dampen the consequences of a bust, investors and consumers will be less cautious in a boom. In particular, if the secured creditors of large financial institutions are confident that they will be insulated against default, they will not only lend more to such institutions but also make fewer efforts (which are costly) to police the conduct of their debtors. (Hence the shellacking that the secured creditors of Chrysler are taking is the silver lining of the cloud that that shellacking has placed over secured credit.)

Another possible long-term consequence (which may also be a short-term consequence) of the current depression is worth considering. There is recent speculation in the media that Americans will not return to their "free-spending," debt-financed ways. The personal savings rate bounces around a lot. It was 10 percent in 1980, declined pretty steadily after that, reaching negative territory in 2005, but since last fall it has risen from about 1 percent to more than 4 percent. The question is whether it will remain there or instead return to the 1980 level. I am skeptical that we are entering an era of thrift. Memories are short, and I argue in my book that the low savings rate is due in part to the impressive ability of the modern marketing profession to separate people from their money.

What seems more likely is that the composition of people's personal consumption expenditures will change. This depression has been marked not only by a shift from consumption to savings but also by a change in consumption. A wealthy friend of mine who owns three cars that he used to turn over every two years has decided, in reaction to the modest losses in his investment portfolio that he has experienced recently, to wait another year before buying a new car. Because modern cars are of high quality and durability, and design changes from year to year are modest, he may discover that changing cars every two years isn't worth the expense and bother. People who have reacted to their losses by moving a notch down the luxury-goods hierarchy from Nieman Marcus may discover to their surprise that they are quite happy with the switch. And the terrible decline of the newspapers may turn out to be permanent as people switching to free news on the Internet to avoid the cost of subscribing to a newspaper decide they prefer obtaining their news electronically.

Contrast the current depression with a recession or depression in which sales of every category of consumer product falls by the same percentage. Then when demand returns to its pre-recession level the sellers will rehire laid-off workers, and increase their purchases of supplies and materials, until they are back to their pre-recessions levels. But suppose that demand for the output of a major industry, such as automaking, does not return to its previous level. Then some of the laid-off workers in that industry will have to find jobs in other industries--jobs for which they are not trained--and those jobs may be in other parts of the country. And suppliers to the industry may have to retool. The need for such adjustments in labor and materials supply will delay recovery. This is one reason why the recovery from the current depression may be slow.

With the economy appearing to begin to stabilize, more attention is being given to possible measures for preventing a recurrence of an economic crash as calamitous as this one has been and continues to be. Advocacy of specific measures seems to me premature, however. This is not only because proposals for overhauling the regulation of banking adds additional uncertainty to the economic environment. It is also because the reform of banking regulation is an immensely complex undertaking that should be attempted only after careful deliberation. There is no urgency about strengthening bank regulation at present or in the immediate future. Memories are short, but there isn't going to be another housing or credit bubble in the immediate future even if no regulatory changes are made.

Congress seems about to pass a law that would create an investigatory commission, modeled on the 9/11 commission, to explore the causes of the current depressioin. The 9/11 commission issued, in the summer of 2004, an exhaustive narrative and analysis of the events leading up to the terrorist attacks of September 11, 2001, and of the failure of our intelligence agencies to discover the terrorists' plot in advance of its execution. Almost as an afterthought the commission made a number of ill-conceived recommendations for reform of the intelligence system, many of which were adopted with, I have argued in several books, meager results. One hopes the commission to investigate the causes of the current depression will devote more attention to formulating intelligent, constructive recommendations for reform than the 9/11 commission did. (It would be nice if we could occasionally learn from our mistakes.) But the completion of the commission's report will doubtless take a long time, so one can hope that the rush to reform banking regulation will be halted until the report is published and its recommendations digested.

Many reforms are being discussed, and in this entry I will offer my reactions to just a few of them. The first is to have two tiers of banking regulation, one for the vast majority of banks, the other for the handful (about 20) banks that among them account for about two-thirds of the revenues of the U.S. banking industry. The latter group, often described as banks "too big to fail" (more precisely, too big to be allowed to fail, that is, to go broke), would, in the suggested reform that I am discussing, be carefully regulated by a "systemic regulator" charged with responsibility for preventing the banks from taking risks that, if the risks materialized, could precipitate a general economic crash and require massive federal bailouts, as in the current crisis. A radical alternative that is unlikely to receive serious consideration is to break up the banks or shear away the parts of their business that do not fit the traditional understanding of commercial banking.

The concern with the big banks is understandable, but the idea of subjecting them to a "systemic regulator" doesn't make a lot of sense. To begin with, size per se is not a good indication of the macroeconomic significance of a financial institution. Lehman Brothers, which the government allowed to collapse last September, was not very large. But it occupied a strategic position in several important financial markets, such as commercial paper, letters of credit, and credit default swaps, with the result that its collapse, against the background of the severe weakening of the banking industry as a whole by the collapse of the housing and mortgage markets, caused a substantial disruption of the global finance industry.

 Furthermore, regulations triggered by the regulated firms' size or (what is more difficult to ascertain and evaluate) strategic significance will induce many institutions to avoid becoming large enough or strategic enough to be subject to the regulations, and the result may a less efficient banking industry, if scale and position in financial markets confer substantial benefits.

Then too, the idea of the systemic regulator doesn't match up with the concern that underlies the expression "firms too big to be allowed to fail." The concern is valid: a firm that has reason to think that it will be bailed out by the government if it gets into deep financial trouble will be able to borrow at lower interest rates than other firms, and this will give it a competitive advantage unrelated to superior efficiency. The managers and shareholders of the banks that have had to be bailed out by the government have taken a shellacking, but not the bondholders; and that is the basis for the fear that banks too big to be allowed to fail can borrow at lower rates--their bondholders don't have to worry that the banks will go broke and default on the bonds.

But even if the 20 biggest banks were split five ways, so that 100 banks instead of 20 banks accounted for the bulk of bank lending, the "too big to fail" problem would not be solved. It is not any individual bank that is too big to be allowed to fail, but the banking industry as a whole. Any single bank, even the largest, could have been allowed to fail without catastrophic consequences. The problem was that the bursting of the housing bubble impaired the solvency of a very large fraction of the banking industry (weighted by size of bank). Had that very large fraction consisted of 100 banks rather than 20 banks, the need for bailouts would have been no less urgent and the resulting windfalls for the creditors of those banks no smaller.

We also need to worry about the identity and incentives of a systemic regulator. The regulation of the American banking industry, broadly defined as it must be to include all financial intermediaries (that is, lenders of borrowed capital) rather than just commercial banks, because of the substitutability of the financial products sold by the different types of financial intermediary, is divided among a large number of federal and state agencies. Is the systemic regulator to be layered over them? Presumably so, and that would be a recipe for bureaucratic turf wars, delay, and loss of information and control.

Moreover, any agency that has a single mission is likely to perform it out without sufficient attention to the costs. An agency charged with preventing the collapse of the banking industry is likely to place an exaggerated emphasis on safety, for it will be blamed if there is a collapse, but it will not be praised for the economic benefits of a less safe, but more dynamic and profitable, banking industry. There is an analogy to the security officers who conduct background checks on applicants for jobs in the CIA and other intelligence agencies. They are too conservative in their recommendations because from a career standpoint it is better to err on the side of advising against hiring an applicant who might turn out to be a security risk; if he does, they will be blamed, but if instead he turns out to do a terrific job, his supervisors will get the credit.

A further objection to the idea of a systemic regulator is that because banking is thoroughly international, tighter regulation of U.S. banking, by reducing the profitability of U.S. banks, will tend to divert banking business to foreign banks. I would not give too much weight to that objection, however, because it is quite possible that the U.S. banking industry grew too large during recent years--to the point where its private value exceeded its social value. An efficient financial system creates wealth, but some unknown but sizable fraction of the profits that it generates are merely transfer payments from losers to winners in trades. Such transfers may merely rearrange rather than augment the wealth of society, for example by sucking talented people into the finance industry who might have a larger social product in some other field; the example I give in the book is Harvard Ph.Ds in physics who go to work for financial firms, which highly value physicists' mathematical skills.

An alternative to creating a systemic regulator is simply to reimpose some of the old rules that made banking, which as I have stressed is inherently risky, less risky than an unregulated banking industry would be. They include such regulations as forbidding payment of interest on demand deposits (which gave banks a very cheap source of capital, enabling them to make money by lending that capital at the low interest rates that safe borrowers pay) and limiting branch banking--that is, limiting competition among banks and thus making it easier for them to make money without taking many risks (risk and return being positively correlated).

There are two objections, apart from the reduction in the availability of credit that more conservative lending practices would bring about. The first is the difficulty of deciding which financial intermediaries should be subject to such regulations. Should hedge funds be forbidden to pay interest to their investors? To open branch offices? Those would be ridiculous regulations. Hedge funds would attract no lenders at zero interest, and they have no branch offices. But if left unregulated, which is essentially their condition today, they would be in a position to eat the lunch of the commercial banks if the latter were subjected to tight regulation and they were not. Yet any regulation of hedge funds would have to be tailor made to the unique character of such enterprises, rather than being a carbon copy of the regulation of commercial banks; and the same goes for the regulation of any other nonbank financial intermediary. Designing a mosaic of regulations that would create a "level playing field" for all financial intermediaries would probably be impossible.

Second, trying to limit risk taking by financial intermediaries is like trying to compress a balloon by squeezing it without bursting it. Suppose a bank were forbidden to pay interest on demand deposits. The amount of those deposits would plummet as depositors sought alternative investments. If banks were forbidden to have branches, competing financial intermediaries would gain a leg up because banks would no longer be as convenient for customers as they had once been. Moreover, if risk taking is profit maximizing, banks will find ways of imparting risk to their operations. Suppose banks are somehow constrained not to make risky loans. They can make loans risky nevertheless just by increasing the ratio of debt to equity in their capital structures.

To illustrate this important point, let us suppose that a bank has a debt-equity ratio of 30 to 1, and that it makes a $100 loan, so that the bank's equity stake is only $3 and the rest is borrowed, and the interest rate on the loan is 5 percent. The loan will yield the bank $5 in annual interest (if there is no default), and that will generate a large percentage return on equity even after subtracting the interest rate on the borrowed capital used to make the loan. Suppose the bank borrows at 3 percent. Then its spread is 2 percent (5 percent, the interest rate on the loan it makes, minus 3 percent), which yields a net gain of $2 ($5 minus $3) on its $100 loan--2/3 of its equity stake ($2 net gain divided by $3 equity stake). That is a very high rate of return. Of course, there is a lot of downside risk (think of the loss to the bank's shareholders if the value of the loan declines by 10 percent). The regulators could put a ceiling on the bank's debt-equity ratio to limit the downside risk. But how would they determine the ratio? And would they impose a ceiling on the debt-equity ratio of all potential lenders?

There is much more to be said about the difficulties of re-regulating banks. But to keep this entry to a manageable length, I shall discuss just one more proposal, and that is to eliminate the various subsidies to home ownership, such as the deductibility of mortgage and home-equity interest from income tax. That is not going to happen, but what is more within the limits of the politically feasible (if only barely) is to eliminate Fanny Mae and Freddie Mac, the huge mortgage companies that financed much of the housing bubble, and to repeal laws such as the Community Reinvestment Act of 1987 (along with measures by the Clinton and Bush administrations) that encouraged risky mortgage lending, for example to members of minority groups who might not be able afford to make a normal down payment on a house.

Fannie Mae and Freddie Mac are what are called "Government-Sponsored Enterprises," but until they collapsed last summer and were placed under federal control they were private corporations. Their pertinacious and well-informed critic, Peter Wallison of the American Enterprise Institute, contends that these GSEs, along with the laws that encouraged them (and indeed encouraged the fully private mortgage sector as well) to make risky mortgage loans, were single-handedly responsible for the housing bubble.

I have no truck with the GSEs and see no great social interest in promoting a nation of homeowners rather than a nation of renters (one advantage of a nation of renters is that relocation to a different city or state to pursue new job opportunities is easier when one rents rather than owns one's home, and job mobility is one of the great strengths of the American economy). But I think Wallison exaggerates the effect of the GSEs and the "ownership society" propaganda on the risky mortgage lending that has gotten the banking industry in so much trouble.

He contends that the GSEs and the government's encouragement of risky mortgage lending caused loose lending practices to spread to the prime loan market, vastly increasing the availability of credit for mortgages and thereby leading to speculation in houses and ultimately to the housing bubble.There are three objections to this diagnosis.

The first is that to the extent that the GSEs provided a market for risky mortgages, the loss when the default rate on those mortgages skyrocketed fell on the GSEs rather than on the banking industry as a whole. The second objection is that much of the risky lending occurred completely outside the chain of distribution that included the GSEs. Banks that originated mortgage-backed securities that were sold to other banks, hedge funds, foreign investors, and other investors had no connection to the GSEs; they made their own decisions about making, buying, and packaging mortgages. Third, I can't think of any economic process by which the GSEs' providing a market for substandard mortgage loans would have induced other financial intermediaries to do likewise. If they had thought that the mortgage loans were excessively risky, they would have ceded this part of the market entirely to the GSEs.

I turn to the remaining components of the current depression-recovery package.

(4) I argued in my book that the government was right to lend money to General Motors and Chrysler in December to avert their being forced to declare bankruptcy. The shock effect of such bankruptcies, and their potential effect on employment because more than a million workers are employed by these companies or their dependencies (dealers and parts suppliers), provided compelling reasons not only for keeping the companies from having to liquidate but also for keeping them from having to reorganize in bankruptcy, until the economy stabilized. For even if declarations of bankruptcy would not have resulted in the immediate liquidation of the businesses and thus the sale of their assets at distressed prices and the laying off of almost all their employees, the effect on consumer morale and willingness to buy cars from bankrupt companies might well have been profound. It was not worth taking that risk. The government bailout moneys thus purchased a kind of insurance policy against macroeconomic calamity.

The bailout worked. At a relatively modest, though by ordinary standards very large ($17 billion), cost to the government, the auto companies were kept out of bankruptcy until the acute psychological phase of the economic crisis had passed. Last December, and indeed until sometime in March, government officials, the media, and the public were understandably fearful that the economy was in free fall and might land somewhere near where the economy had landed in March 1933 (25 percent unemployment, output 34 percent below the GDP trend line, 18 percent deflation). Such a fear can constitute a self-fulfilling prophecy, because by causing consumers and producers to hoard cash rather than to spend, it can push the economy into a very deep downward spiral. That fear has now abated. Moreover, General Motors and Chrysler (and Ford as well) have in fact partially liquidated since December, closing many plants and laying off (for good, probably) many hourly and salaried employees, and terminating many dealerships. As a result of these drastic measures (but spread out over months, which reduced their psychological impact), the incremental shock effect of the auto companies' declaring bankruptcy has diminished greatly. And government promises to back any bankrupt automaker's warranties have begun to sink in and reassure consumers. Chrysler has just declared bankruptcy and GM may follow suit in a matter of weeks, yet the perturbation caused by the bankruptcy of the one company and the prospect of the bankruptcy of the other has been slight.

Concern has been expressed that, subject to possible modifications by the bankruptcy judge, Chrysler will be controlled by the United Auto Workers and therefore managed inefficiently, as worker-managed firms typically are. But it is not true that the UAW will manage Chrysler. Not the union, but the Chrysler retirement plan, will be a shareholder in the reorganized company (in fact the principal shareholder), and it will have a fiduciary duty to maximize shareholder value rather than to increase the earnings and benefits of the current workers. More important, whether Chrysler is managed efficiently or inefficiently has little macroeconomic significance. It is an unimportant company in a highly competitive global industry. If it is inefficiently managed it will disappear and its place will be taken by better-managed rivals in the United States and abroad. GM is bigger but its gradual disappearance would have no greater consequence for the economy as a whole.

(5) As of February 2, the House of Representatives had passed an $829 billion stimulus bill, which I analyze in my book. A couple of weeks later a slightly smaller bill ($787 billion) was passed by both houses of Congress and signed into law by the President. The differences between it and the original House bill are not great, but a disappointment is the reduction in the amount of money allotted to transportation infrastructure (mainly road and bridge construction and repair, and other construction and improvements, such as painting school buildings). As explained in the book, this is the class of stimulus expenditures that comes closest to satisfying the conditions for an effective Keynesian deficit-spending depression-recovery plan. It targets an industry in which the unemployment rate is high; most of the projects financed by it can be started quickly, in part because the states can use money they receive from the stimulus program to begin or resume delayed or interrupted construction projects; and there is an economic need, unrelated to the depression, for improvements in the nation's dilapidated transportation infrastructure. Hence the projects are likely to have value independent of their contribution to digging us out of present economic hole.

(6) Finally, there are the "stress tests" on the banks conducted by the government; the results of which are to be announced tomorrow. These tests are examinations of bank balance sheets to determine whether any banks need additional capital in order to survive a further decline in the economy, since a further decline, which is expected (especially in employment), will increase defaults on bank loans and thus reduce the value of banks' capital, of which loans are a major part. The tests themselves hardly constitute a program of depression recovery; they are a minimum precaution that the Federal Reserve and other bank regulators could have been expected to conduct in the ordinary course of their regulatory responsibilities, without publicity. The reason for the publicity is to reassure the public about the essential soundness of the banking industry and hence (perhaps) of the economy as a whole. Thus, it is a confidence-building measure, and restoration of confidence is a key goal of depression recovery.

Besides the categories of depression relief that I have discussed, there are plans for ambitious regulatory reform, intended to prevent a similar crisis in the future. I will discuss these plans in a future entry.