Things can get better if leaders make the right policy choices

The Guardian ran an interesting column on the leadership vacuum that has accompanied the credit crisis.

When the credit crisis began in 2007, governments adopted the policy of protecting the banking system at all costs.  They interpreted this policy as meaning that they must protect the status quo.  Hence, the moral hazard of too big to fail.

Unfortunately, this policy carried with it an unintended consequence.  The act of protecting the status quo meant not coming to grips with the "toxic" assets on the banks balance sheets, but instead adopting Japanese policies that have resulted in lost decades.

The role of markets is to establish a clearing price.  But how are markets, like the residential or commercial real estate market, suppose to establish a true clearing price when they know that supply is being artificially reduced (banks are not forced to recognize the losses) and demand is being artificially boosted (due to government policies like low interest rates)?

The answer is that markets do not function under these conditions.

Market participants know that following the policies that Japan has implemented since its real estate bubble burst is a prescription for lost decades.  In their desire to protect the status quo, western governments have managed to reproduce the results of Japan's policies - we are looking at lost decades.

There is however a way out of the policies that contribute to lost decades.  It is to implement the same advice that the US freely gave to Japan at the start of its credit crisis.  That advice was to recognize losses.

Obviously, it was easier for the US to give the advice than act on it when faced with the same problem.

It is not too late for the US and western governments to take their own advice.  Doing so would lead to the brighter future that everyone wants.

The cry goes up: this crisis is a moment for leadership. And of course that is true .... But if leadership is needed then to where, and with whose consent? 

In the face of financial apocalypse ... They rub against the progressive expectation of democracy: that tomorrow can be better than today. Perhaps that isn't always true. 

Despite their differences, capitalists, socialists, liberals and conservatives are united by a common idea. It is the assumption of linear progress for human civilisation: the belief, seldom stated because rarely challenged, that things can only get better or – if they seem not to be – can get better if we choose the right policies. 

To this way of thinking, a turn for the worse is seen as a setback: a reason to condemn one set of politicians for choosing the wrong policies, and elect another instead who offer different ones. Normal service will be resumed shortly. We'll sort the problem out, maybe try a new tack – and continue on an upward path. 

For several centuries the west has been right – most of the time – to assume this rule applies.  

It may still be right to assume it now.... But behind the sloth of a European elite on holiday as so much goes wrong lies a miserable possibility. Perhaps no G7 summit, no telephone call, no brilliant speech by Barack Obama, no amount of breezy calm from Cameron, no hammering by Ed Balls, can break paralysis. 

The terror of the financial crisis is not that it requires a series of complex policy responses which, if followed, will set the world economy back on a path to growth. It is that no amount of fiddling may do anything other than delay the judgment: and the sentence is decline. 

What, once summoned back to their offices, do we expect ministers to do? Fix the financial meltdown, of course. But how? Through a tax rise, or a tax cut? More austerity, or a spending boom? By permitting a United States of Europe with one government and one debt, or by busting up Europe into many currencies? By appeasing the markets or defying them? 

No one can agree, of course, but it's worse than that: no proposed strategy carries complete conviction even with those who propose it. There is a thundering absence of bright ideas, of the "hey, here's how" variety. Hence the frightening silence. 

Actually, this blog has been discussing the very bright idea that the government leaders should be looking for.

The result of implementing the FDR Framework is not decline, but a very bright and stable future. 

Yesterday eurozone leaders talked; today they may buy some Italian bonds and perhaps tame the markets temporarily; but few think this will do anything other than carry us on to the next disaster. 

That is because it is a policy that addresses a symptom and not the underlying solvency problem.  Until solvency is comprehensively addressed, it will weigh on the global economy.

We want government and we need government, but perhaps we are wrong to hope that government will always be able to protect us.

Under the FDR Framework, government is not suppose to "protect us".  It is suppose to make sure that all the useful, relevant information is made available in an appropriate, timely manner so that we can protect ourselves.  For good measure, it allows governments to make use of the analytical capabilities of the market to step in when imbalances start to develop.

... Yet it runs against the grain of the politician's job to promise voters a poorer tomorrow. 

Democracy depends on there being competing sets of positive possibilities. 

Cameron appealed most in opposition when he attempted to associate his party with optimistic plans for the future. But he has found himself leading a government which has come closer than any other in recent times to believing itself to be powerless. 

The implicit message from the coalition is that the best Britain can do in this storm is avoid drowning, while others, worse off, sink.  It may be good policy but it is a peculiarly lowering way to behave. 

The prime minister has found himself on the pessimistic side of politics, as he never intended to be. He must explain to a nation which wants decent state provision of services, that this (in his view) is no longer possible, and to people looking for a plan for growth why all he has to offer is the removal of obstacles to business. Maybe, if the world grows, that will help us. But it is not much use now. 

In prior posts, this blog has discussed that austerity related policies carry with them their own economic headwind.  Their biggest flaw is that they do not address what is the problem with the economy.  The problem is the failure to address the "toxic" assets (broadly defined) that are clogging up the financial system and making it impossible for markets to operate without massive government intervention (as oppose to regulations).

When historians look back on this period what will stand out most is the absence of political heroes. No one – not even Obama, who is the closest thing the world has to a leader – seems able to turn present disaster into a sense of future possibility. We are left with politicians who have persuaded themselves that there is nothing significant they can do to rescue their citizens from crisis. 

"The markets caused the trouble. Now the markets must put things right," Angela Merkel's office said on Friday evening: and that from the one person in Europe with the cash to respond.

It was not the markets that caused the trouble.  It was the failure of regulators that caused the trouble.  Rather than ensure disclosure, regulators decided that markets should police themselves.

The lesson of the Great Depression is that Wall Street will sell opaque products that investors cannot properly analyze if regulators allow it.  Regulators allowed it and the result has been massive damage to the financial system.

... But the routes away from this disaster involve things that will be unpopular: higher taxes, lower spending, the controlled impoverishment of people conditioned to believe their lives would get better. It's no surprise politicians shy away. 

This is a list of the routes that Wall Street wants away from the crisis.  Notice how none of these ideas actually addresses the problem of solvency.

Disclosure does not require higher taxes, lower spending or the controlled impoverishment of people conditioned to believe their lives would get better.

Disclosure addresses the solvency problem and allows markets to operate without Wall Street extracting an opacity premium because of a non-market making informational advantage.

Wall Street naturally does not want anyone to address solvency because it will also show a bright light on how Wall Street behaved prior to and since the crisis.