The Crisis and the Response

Originally posted on Half an Hour, November 24, 2008.

The economic crisis is now familiar news to all of us.

Most of us are familiar with, and agree with, the main story line of the current downturn.

First, it was caused by the collapse of the housing bubble in the U.S. Too much credit was extended to too many people who were unable to support it when housing prices turned downward.

And second, it was caused by the ripple effect of this bad credit as it spread through the economy. Bad debts were bundled together and repackaged to look like good debts, and these debts were sold to investors looking for safe and secure income.

And though the cause was the bad debt, most people are in agreement with the observation that the situation should never have been allowed to come to this point.

They agree that, first of all, banks and other financial institutions should operate in a much more transparent manner, so that the sneaky things they do - such as bundling bad credit to make it look good - are exposed to the light of day.

And they agree that, second, these institutions ought to be regulated, that an environment of self-regulation is simply ineffective. An unregulated marketplace simply creates an open playing field for people who skirt the bounds of honesty and decency.

All of this reflects common wisdom, and I am in agreement with this analysis to this point.

As a consequence, I am in agreement with the initial response to the crisis. As was the case with the great depression, we are suffering from an immediate crisis of liquidity. Businesses are unable to obtain the financing they need to conduct normal operations because lenders are uncertain they will sustain the revenues to pay back those loans.

So I am encouraged to read that our Prime Minister, along with other leaders of the industrialized economies, is thinking not in terms of cutting government spending and trying to balance the books, but rather, of generating enough financial activity to get the economy moving again.

It is interesting - and ironic - to note that this is exactly the measure undertaken by former Prime Minister Jean Chretien, as on his election he launched a national 'infrastructure program' that effectively ended Brian Mulroney's 'Made in Canada' recession.

All of that said, this is merely the first step in what will need to be a much more well-considered set of measures. Because though the crisis looks and felt like a bubble, it was not merely a bubble.

First and perhaps foremost, just as the collapse of the Berlin Wall almost twenty years ago represented the bankruptcy of central state economic management, this year's crash represents the analogous vacuity of the alternative paradigm, the of the free market system.

The ideas that an unregulated economy produces anything other than shadey and dishonest practices has been effectively refuted. The idea that the free market can address the problems described in the 'tragedy of the commons' should be clear. An ethic based on looking out for oneself first leaves us with an economy in which the majority are not well served.

But the response to the failure of marketplace economics cannot be to return to the era of centrally managed economics. While during the short term we will see drastic policies undertaken, such as the effective nationalization of the financial system, we cannot imagine that such measures will serve in the long term.

We will need to find an alternative to the free marketplace which is not something like central management. This requires a rethinking of the incentives that govern the marketplace. When Michael Douglas, in Wall Street, intones, "Greed is good," he is describing the very ethos that led us to this point. We need to find our way to a paradigm in which greed is not good.

This, I think, is going to be a two-part process. On the one hand, we will need to restructure the basis of individual actions such that these actions are conducted in an above-board, honest and socially responsible manner. And on the other hand, we will need to build in limits to effective power and control in the system, such that growth mechanisms like greed no longer produce a return.

Let me address the latter of these points first. Over the last forty years, the limits to the growth of individual enterprise have been effectively removed. Corporate tax, which was once an impediment to unrestrained growth, was virtually eliminated. Anti-trust measures and other controls were scaled back in the name of the free market. The financial network became, effectively, scale free.

This not only produced enormous imbalances in wealth, it also concentrated power and control into the hands of a small group of individuals. These individuals governed effectively out of their own self-interest, to the detriment of society as a whole. Even were we to suppose that their intentions were honorable (and the parade to the prisoners' dock suggests that they were not) it remains the case that such agents were simply incapable of managing a complex economy. Centralized management works no better in the hands of capitalists than it does in the hands of socialists.

There must be limits to the growth of individual industries and to the power that can accrue to the hands of a few. These limits must be hard limits, such that there is no effective route around them (such as proxies or syndicates). The intent of these limits must be clear: that we regard the unrestrained growth of any segment of our economy to be dangerous and destabilizing, likely to harm the whole, and therefore something that must be stopped.

And we need to be clear that these are limit mechanisms, not governing mechanisms. We don't want to slow growth generally, because that would also impair the economy as a whole. Rather, we want to slow growth only once it reaches a certain point. Essentially, we want companies to be able to reach their maximum size quickly, but to sharply cut their growth once they reach that point.

Such a mechanism not only prevents dangerous and unrestrained growth, it also redirects such enterprises to objectives other than making money. We will want to consider how we approach this. We want to reward people for dedicating themselves to something other than the pursuit of ever-increasing power and wealth.

As to the former, the conduct of actions in an above-board, honest and socially responsible manner, while it is hoped that the mechanisms limiting growth would impel actions in that direction, it would be unwise to depend on such motivations. This is generally the purpose of management activities, to ensure that individual actions are not taken in an unwise and unproductive manner. However, the number of separate individual actions in any given economy far outweighs the possibility of any attempt to manage these actions.

What will be necessary, therefore, is to enact and enforce sets of principles that can be understood, in general, to lead to positive outcomes. This is indeed the method of many of our governing bodies today. The principles of general accounting, for example, are well known and widely practiced. Or the principles of project management (a course in which I finished last week). The idea here is that, by following appropriate methods, we will be led to appropriate results.

This in turn raises a couple of key points. On the one hand, we want our principles to be such that they will lead to effective outcomes. A simple statement of principles, announced as if by fiat from some authority, will have no more likelihood of effectiveness than blind luck. We need to ensure that our principles are derived from experience and sound practice, which requires a methodology and mechanism for veting and articulation.

And on the other hand, we need mechanisms to ensure that these principles are in fact followed. It seems clear that we cannot depend on observation and voluntary reporting, in part because the observers are no more trustworthy than the actors, and in part because the sheer volume of actions precludes the possibility of an observation-based system. Nor either, however, can we depend on secondary mechanisms, because these mechanisms can be gamed.

What will be necessary will be to both create mechanisms that support appropriate actions, as well as to create mechanisms that detect inappropriate actions. The development of tools for performing actions will tend to guide the conduct of those actions. And those tools can also participate in the detection of inappropriate actions. For example, think of the process of filing one's taxes. If this is done through a standard tool, which connects automatically to sources of revenue and expenses, then there is little scope for cheating on those items.

The measures outlined here represent a substantial change to the manner in which we conduct economic activity. They represent a change not only from the idea that the marketplace can run in an unrestrained fashion, but they also represent a change from traditional concepts of 'managing' an economy to the idea that we are creating mechanisms that assign methods to actions and limit excesses. A 'methods and limits' model of economics may be radical, however, the alternative is to allow cancerous and destructive growths to run rampant through society.

Reforming our paradigm of management is only the first of the issues we must address. Second, and perhaps equally important, we need to reform the patterns of production and consumption in our society.

One of the underlying principles of the housing bubble was, after all, the idea that "they aren't making any more land." The idea that housing and real estate were good investments was brought on by the growing recognition of scarcity in the economy.

The principles of economics have always been understood as mechanisms for allocating resources under conditions of scarcity. The idea that 'price' is based on 'willingness to pay' captures the condition of relative need in society. One would continue to be willing to pay provided one was not sated. But once staed, this willingness would pass on to the next person. Thus, the market would ensure the most effocient distribution of scarce resources.

The same logic, however, does not apply in conditions of desperately scarce resources. In such conditions, demand not only exceeds supply, it exceeds all possible supply. The result is that there is no upper limit on the potential willingness to buy (and hence price). Moreover, because no such limits exist, there is no natural barrier to speculation; the scarcity of the resource is therefore compounded by hoarding and speculative resale.

This is what happened in housing. Our major cities have grown at enormous rates. What was farmland two generations ago and the edge of the city a generation ago is now inner city. Every major city in North America is surrounded with a ring of suburban development and tract housing. In Europe, the crush is forced into the already crowded central city apartment complexes. In other regions, such as Kuala Lumpur, the number of high density apartment complexes is in the hundreds. And even so, there is not enough room. Commutes times become longer.

The surprise, to many, is not that there was a housing bubble. The surprise is that it collapsed.

A similar pattern is shaping around other resources. Coincident with the market crash in September and October was an unprecedented spike in the price of oil. This shock, which it stimulated investment and strengethened the currencies of producing nations (including Canada's) was based on the idea that conditions of scarcity would prevail in the future.

The bottom fell out of the price of oil when it became apparent that the economic conditions (and hence, consumption of oil) would slow, and also, when consumers, for the first time, demonstrated that they would, at a certain price (which appears to be $US 4 per gallon), reduce their consumption. Again, what is surprising is not that the price of oil fell, but rather, that the bubble in the price burst so suddenly and so deeply.

In the case of oil, we can mitigate the cost by reducing consumption. In the case of housing, we can limit demand by reducing speculation. However, in the case of many other commodities, we will not be so resiliant. With oceans fished almost to extinction, with grains being used for fuel as well as food, with the forsts of the Earth largely depleted, and with climate change creating deserts and wreaking havoc, we will face shortages we cannot sustain.

The continuing environmental crisis is only one part of the problem. The other is that as this crisis unfolds we will be increasingly unable to cope with this.

For, not only is our current consumption depleting the world of its resources, this current consumption has been purchased on credit, and is credit is based on the assumption that current consumption will continue to be sustained. In other words, our economy is backed by future resources that do not exist.

This will be a problem that government investment into the marketplace cannot fix. The reason government investment can work today is that, for now at least, we can return to former levels of economic activity. However, in the near future, this will not be the case. We will run out of the ability to feed ourselves, to clothe ourselves, to house ourselves.

Understanding how we, as a global society, are going to be able to pay back this environmental credit requires understanding how the problem was created in the first place.

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