Keynes on Steroids

By Steven Pearlstein
Wednesday, November 26, 2008

We are all Keynesians now.

That was Richard Nixon's famous line from 1971 after announcing that he had taken the United States off the gold standard, a day that will live in infamy for monetarists still among us.

Nixon's Keynesian conversion, however, looks positively quaint compared with the fiscal and monetary stimulus that is about to be brought to bear on the U.S. and global economy. I doubt even Keynes himself could have imagined the scale and scope of what's ahead.

Yesterday, President-elect Barack Obama and the members of his new economics team made clear that they would be moving toward a budget plan that could push the federal deficit toward $1.5 trillion this year and next, as borrowed money would be channeled into infrastructure investment, tax breaks, loans for ailing industries, and badly needed funds for cash-strapped state and local governments.

The Bush administration, meanwhile, is completing a $250 billion investment in the banking system on easy terms, while extending government guarantees to all bank debt and providing the loss insurance to the most troubled institutions such as Citigroup, AIG and the remnants of Bear Stearns.

And the Federal Reserve announced yesterday that it would pump an additional $800 billion into the financial system, buying $100 billion of bonds issued by Fannie Mae and Freddie Mac and $500 billion in mortgage-backed securities and lending $200 billion against packages of newly issued auto, student and small-business loans. All that is in addition to the $1.4 trillion it has added to its balance sheet, and injected into the financial system, since the spring.

This isn't exactly what Fed Chairman Ben Bernanke once promised when he said that, as a last resort, the central bank could print money and drop it from helicopters, but it's pretty close. Think of it as the functional equivalent of lowering the federal funds rate below zero.

The scale and scope of this intervention is breathtaking, is totally without precedent and certainly puts the lie to those who complain that there has been a lack of urgency in Washington in response to the crisis. Just about every tool that anyone has thought of is being tried, to one degree or another, and those that haven't been tried have not been ruled out.

That's not to say that there have not been disagreements over which approaches to take and disappointment that some initiatives have not had their intended effect. But to suggest, as some have, that the entire effort has been a failure ignores the harsh reality that, without the efforts so far, things would actually have been worse -- a lot worse.

As Treasury Secretary Hank Paulson acknowledged yesterday, that's a "hard sale" for voters who want to believe that, with one initiative or another, the government can reverse the slide in stock and house prices, rescue any industry that needs rescuing, and prevent a further rise in unemployment. In truth, given the size of the credit bubble and all the mistakes that contributed to it, there was no way to avoid a financial and economic crisis. The only question is whether we are sufficiently nimble and clever and bold to prevent it from turning into a decade-long depression.

As Obama rightly pointed out yesterday, there is a difference between being bold and being reckless. While additional government spending will be necessary, his emphasis will be on investments that do double duty -- stimulating employment and output in the short run while also offering high economic and social returns in the long run. Congress should certainly have a say in identifying those investments and allocating funds among the various categories. But to make good on his promise that the money be spent wisely, the stimulus bill should stipulate that the allocation of funds among specific projects be done by independent experts who are insulated from politics.

There also ought to be a recognition that there are a number of stimulus ideas that sound good but won't have much impact in an environment where businesses and households are hunkered down. It is unlikely that businesses facing the prospect of declining sales are going to hire a new worker just because Washington offers a tax break. And if middle-class households are as worried as Obama says they are about losing homes and jobs and paying down their enormous credit card bills, then giving them a tax break probably won't get them to buy a new car or splurge on the next vacation. Economists liken such efforts to pushing on a string. Better for government to use the money to directly hire the unemployed or buy goods and services from the private sector.

Obama also struck the right balance yesterday by saying that aggressive increases in spending over the short term had to be accompanied by equally aggressive cuts in spending over the longer term. The conventional wisdom is that powerful special interests will rise up to protect every last program and tax break. With the financial crisis as his lever, Obama now has the opportunity to challenge that wisdom by identifying a package of $25 billion in cuts, demand that they be voted on as a package and marshal his impressive grass-roots organization to overwhelm the special interests. My guess is that he'd win handily.

What wasn't particularly helpful this week was the published leak from the Obama camp that former Treasury Secretary Larry Summers would be named the next chairman of the Federal Reserve when the term of Bernanke, the current chairman, expires at the end of January 2010.

A Category 4 financial crisis is hardly the time to undermine confidence in -- or confidence of -- the Fed chairman. Nor is it the time to create unneeded tension between the Fed and the White House, where Summers will be the president's closest and most powerful economic adviser. Whatever his original intentions, Obama would do well to announce publicly that there will be no change at the Fed until the crisis has passed -- and maybe not even then.

Steven Pearlstein can be reached at

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