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The 2008 Economic Crisis

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“The Financial Crisis, Its Economic Consequences, and How to Get Out of It” (Asensio and Lang, 2010) is an article by Angel Asensio and Dany Lang. In the article, the author’s present an argument that “mainstream economists” could not have predicted the economic crisis of 2008 (p. 59) and further explains how a strong Keynesian tradition of regulation, fiscal, and monetary policy are required not only to prevent further crises of this nature, but are also required to move the economy at least from recession to growth.

The author’s begin the article by stating, simply, “the economic models framed by the mainstream have well known self-adjusting properties that do not allow any kind of economic crisis” (Asensio and Lang, 2010, p. 59) (interestingly, the authors use the term “mainstream” but do not use the terms “classical,” “neoclassical,” “Chicago school,” or “Austrian school.”). They provide a further one paragraph dismissal of “mainstream economics” and its inability to adapt to external influences to the market which negatively impact its performance (p. 59).

At this point the author’s begin their examination of the 2008 crisis from a Keynesian perspective: “Keynes’s theory … emphasizes how fundamental uncertainty inhibits self-regulating mechanisms” (Asensio and Lang, 2010, p. 59). There are, according to the authors, four major reasons the crisis took place. First, a shift of income from wages to profits over the last 25 years led to a widening gap in income inequality, which led further to wage declines for the middle class (Asensio and Lang, 2010, and Stockhammer, 2005). These wage declines led to many families taking home-equity loans when perhaps they shouldn’t (Asensio and Lang, 2010, and Hannsgen, 2007), leading to a bubble which was bound to burst. Thirdly, these home loan securities were poorly accounted for, leading to many institutions not really knowing how many junk bonds they were in possession of (Asensio and Lang, 2010, p 60). Finally, economic collapses themselves are remembered and are a cause of risk-avoidance (Asensio and Lang, 2010, p 61).

Asensio and Lang offer a number of solutions, all Keynesian based, to help guide the economy out of recession. In summary, they are as follows:

  • Stop wage decline with a combination of management, government, and labor collaboration (p 61);
  • Restore a ‘state of confidence’ in the market (p 62);
  • Use a strong monetary policy to keep interest rates low (p. 63);
  • Central banks purchase of bad debts to remove them from the market (p 63);
  • Strong fiscal policy to induce economic activity (p 64);
  • Re-distribution of income (p 64) perhaps by a tax on unproductive capital (p 65).

Counter Arguments

The first and most scathing disagreement comes from Huerta de Soto, 2009, who states outright “Furthermore, [the market] is the only possible alternative, and it cannot be improved (but only worsened) through government regulations” (Huerta de Soto, 2009, p 44).  Though de Soto agrees with the sentiment that a financial bubble had been formed and burst, he disagrees strongly with the cause of the bubble. Unlike Asensio and Lang, who argue that the bubble was due to unnecessarily easy-to-obtain credit, de Soto argues that financial bubbles are due to fractional reserve systems that encourage banks to lend “un-backed” loans (p 43). The olution, he says, to prevent future such bubbles from happening is to require all banks to maintain 100% reserves, to eliminate central banks, and return to a gold backed currency (p 43). Though he does not outright say so, it can be inferred from his strong stance that he would suggest the government simply remove itself from all fiscal and monetary matters as a sole method of bringing the financial crisis to an end. One wonders, however, if every bank is required to keep 100% of demand deposits on reserve, what would happen if a loan were to immediately be re-deposited in that same bank.

One interesting analysis of the 2008 economic crisis came beforehand, in 2007. Hannsgen (2007) likened the lending craze in the middle of the decade to a Ponzi scheme which, he warned, “The eventual result of this form of finance would be a widespread failure of agents to meet their payment commitments, leading to a crisis, and probably a recession” (Hannsgen, 2007, p 17). Hannsgen seems to have a number of views in common with Asensio and Lang; however, whereas Asensio and Lang discourage it, Hannsgen encourages monetary policy only, in that the FDIC and Federal Reserve must heavily regulate banks and risky mortgages, and that they alone have the authority to prevent “highly risky types of mortgages” (p 17).

Sanchez (2011) agrees very much with the central hypothesis and arguments put forward by Hannsgen, in that a credit bubble was formed by the rapid increase in house prices and, when the bubble burst, led to global turmoil. Sanchez has a further difference from Asensio and Lang  when he states that fiscal and economic policy are a hindrance when he says “In the United States, government-sponsored enterprises promoted massive securitization of subprime loans, something which was crucial in the gestation of the bubbles” (Sanchez, 2011, p 524); similarly, Sanchez echoes Hannsgens arguments for strong monetary policy aimed at price stability and regulations aimed at preventing poor loan decisions (Sanchez, 2011, p 529).

In summary, one author, de Soto, suggests strong de-regulation of as much of the financing industry as possible, up to and including the removal of central banks; the other two authors, Sanchez and Hannsgen, suggest both firm regulations and strong monetary policy to keep prices in check. All three disagree with Asensio and Lang in the areas of fiscal policy: none of these three authors believe fiscal policy is particularly beneficial to prevent or cure the economy of a major financial crisis.

Supporting Arguments

Stockhammer (2005) presents empirical historical evidence of a decreasing profit to investment ratio, from 80% in 1970 to about 60% in 2000 (Stockhammer, 2005, p 197). Though the author argues that one of the main causes of this change is an increase in shareholder power in how the company manages its finances, he makes a point to say that “A decrease in firms’ investment expenditure will have an effect on aggregate demand…” (Stockhammer, 2005, p 204). If we take the classic definition of GDP being a total sum of all “final goods and services produced” (Heyne, Boettke, and Prychitko, 2010, p 284) we know that GDP must equal total aggregate demand. If aggregate demand shrinks, by necessity, GDP must also shrink. Further, if firms participate in this shrinkage by decreasing investment, Stockhammer argues that an increase in government fiscal spending just might revitalize growth (Stockhammer, 2005, p 213).

Davanzati (2011) agrees with Stockhammer that decreased business investments damage economic growth, but also puts forth the argument,, as Hannsgen (2007) and Sanchez (2011) did prior, that real wage declines are a large factor of economic declines. Though he does not relate the housing equity bubble to a Ponzi scheme, he does write that decreasing real wages lead to increased consumer debt to keep abreast of a way of life. With this increase in debt, business sees profits moving to the economic centers, away from manufacturing, which leads to a decrease in investment (as Stockhammer (2005) also argued) which also leads to a decrease in employment. A vicious circle of events ensues – or perhaps a more appropriate term in a spiral of events. Davanzati’s central thesis that wage declines and decreasing investment played a key role in the economic downturn agrees with Asensio and Lang’s viewpoint as well.

Interestingly, Etzkowitz and Ranga (2009) further this line of view by stating the economy in the US has moved away from an industrial economy to a “knowledge based” economy (Etzkowitz and Rang, 2009). A knowledge based, or information based, economy, as opposed to an industrial/manufacturing economy, no longer requires as heavy an investment as capital as previous; this could also account for the decrease in investment seen by previous authors. To help alleviate this problem, Etzkowitz and Ranga take the idea of fiscal policy one step further and argue that the government and academia both must partner with business to develop new technologies and knowledge based systems: “The necessity to foster innovation, entrepreneurship, and investment in R&D goes hand in hand with the need for education and labor policies to upgrade workers’ skills, provide adequate numbers in the workforce and ensure stable employment” (Etzkowitz and Ranga, 2009, p 802). For these two authors, fiscal policy and fiscal spending alone is not enough; instead, government policy must be to partner with academia and business – the Triple Helix (Etzkowitz and Ranga, 2009, p 802) – and choose the right technologies to foster. This would, arguably, not only bring about the end of the economic downturn, but would also foster new research in emerging technologies.

Conclusion

A common theme through all literature is that the 2008 economic downturn was brought about in large part by poor lending practices which created a financial bubble that ultimately burst. There is disagreement as to the original cause of the poor choices, ranging for corporate greediness to poor oversight to monetary policy itself, and there is also disagreement as to the causes to get out of the crisis.

Amongst Keynesian economists a common theme is strong monetary and fiscal policy, as well as firm regulation of the financial industry. Monetary policy suggestions typically involve a focus on stable prices with a secondary focus on the interest rate, and fiscal policy revolves around higher government expenditures to kick start the economy and, in one instance, the suggestion that government should work with business to identify growth areas and focus on them.

Non-Keynesian disagreements, or alternatives, focus on monetary policy solely, either as a price-stabilizer, or monetary policy as removed from the equation. In either case, the idea that the government cannot revitalize an economy by spending alone is prevalent amongst non-Keynesians and should not be attempted.

The idea of a Triple Helix – of a government sponsored innovation focus financed by industry with brain power from academia – is a particularly interesting idea. The combination of new investment, tax relief, and academic research could provide benefits to all parties involved.

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