What Did We Learn in 2009?

A major recurrent theme in economics is whether to adhere to conventional wisdom or to deviate to cope with new circumstances.

Conventional wisdom paid off in 2009 with:

• Massive monetary and fiscal policy interventions that averted another depression;
• Bailing out “too big to fail” financial institutions despite political unpopularity;
• Some coordination of international economic policies, averting trade wars.

Conventional wisdom failed to:

• Warn of impending economic disaster;
• Avert major job loss;
• Help homeowners avoid foreclosure.

It’s instructive to recall that Treasury Secretary Hank Paulson initially sold Congress in the fall of 2008 on emergency intervention to purchase “toxic assets,” but quickly reversed course in favor of direct capital injections. Those favored financial institutions revived more quickly than most thought possible and most of those injections have already been paid back. However, most of the toxic assets remain on bank balance sheets, impeding new lending.

Last February’s massive $787 b. fiscal stimulus bill probably raised short-run GDP significantly, but economists will debate a long time how effective it was. See the Congressional Budget Office analysis.

I would venture these conclusions and New Year’s Resolutions:

1. Give financial regulators a new tool kit to dismantle “too big to fail” institutions. Paul Volcker wants to outlaw institutions beyond a certain size, say 5% of deposits. The House wants “too big to fail” institutions to pay an annual fee into a resolution fund under the control of a council of regulators. I fear the Senate may fail to pass a bill at all this year, sealing the fate of a future generation to repeat our mistakes.

2. The government should sharply restrict predatory lending, short-term performance based compensation, and sales of complicated derivatives to those who don’t understand the risks.

3. Home ownership is good for those who can afford it, but we proved how devastating it can be for those who can’t, but attempt it anyway. Congress bears a lot of blame here, and the test will be whether Fannie Mae and Freddie Mac remain under federal control.

4. Government can create government jobs, but that doesn’t necessarily raise long-term employment. In the meantime, our unemployment insurance system is badly in need of repair and modernization.

5. Econometric models failed completely to predict this recession because they can’t simulate financial failure either by “too big to fail” institutions or by homeowners. There’s a lot of work to be done here.

6. The economy is too complicated to be run by models. Thank God for Ben Bernanke.

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