The Economy: "No Return to Normal" - Galbraith

But, Galbraith argues, we are in a collapse of the financial system, and the only comparable event, the Great Depression of 1929-1939, simply is not built into economists’ models. For example, there is the assumption of a "natural rate of unemployment" of 4.8 percent; Galbraith notes that the CBO’s economic "model moves the economy back toward that value no matter what."

Galbraith highlights other crucial assumptions of Team Obama that are dangerously in error.

Third, the initial package was affected by the new team’s desire to get past this crisis and to return to the familiar problems of their past lives. For these protégés of Robert Rubin, veterans in several cases of Rubin’s Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities."

Galbraith argues that this economic downturn is so severe, that the thing to do now is to increase social security benefits and lower the mandatory retirement age, because we need to

offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.

Finally, there is the assumption about the primacy of finance in the economy.

To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."

But the plain fact is that the big banks are insolvent, and actual examinations of the loan files which were securitized reveal "a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud" that make it extremely unlikely that derivatives based on these loans will ever again reach a market price that will make the banks solvent.  And, there has to be a sea-change in the way bank managers see and work with the world:

Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.

Galbraith then turns to a discussion of the liquidity trap, which is entirely outside the experience of all economists living today.

The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?