Once an economist, always an economist

Mark Ostow

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Y: The central debate recently has been between economic stimulus on the one hand and fiscal restraint on the other, and it has turned into a very partisan issue. Is there any consensus among economists?

L: The overwhelming majority of professional economists recognize that in a deep recession an active role for government is essential. In normal times, economic theory tells us, private decisions -- decisions made in the self-interest of individuals -- work out for the social good. This is Adam Smith's theory of how markets work. He says that the pursuit of self-interest by the butcher and baker leads to good social outcomes.

But in a credit contraction, the reverse is true, so that what's privately rational is socially injurious. Individuals do not have access to credit, and they have to reduce their spending to compensate. Clearly, it would be better for the economy and for the region if Yale could continue its ambitious program of renovation and new construction. But it's privately rational (and, unfortunately, socially injurious) for us to cut back.

The ultimate economist of recession is [John Maynard] Keynes. This is the time for another look at what Keynes had to say about credit contractions. Modern macroeconomists have forgotten much of the wisdom contained in his General Theory.

Y: So the $1.8 trillion deficit figure for the Obama budget for next year -- that doesn't trouble you?

L: The only way we got out of the Great Depression was a full-scale war. By the second year of the war, the federal deficit was more than 25 percent of GDP, much larger than the proposed deficit next year. It takes pretty substantial overspending by the government to turn a truly depressed economy around.

Y: What do you think about the administration's plan to buy up toxic assets?

L: It's extremely important that credit start to flow. The plan proposed by Secretary [of the Treasury Timothy] Geithner in mid-March might work. It might succeed in providing enough capital to the banks that they can operate. But I'm skeptical about the approach in principle, because, if you believe that the banks are insolvent, then any fair compensation for the toxic assets will still leave them insolvent. The sum of banking assets will be less than total liabilities. Now it is true that the Geithner plan will overpay for the toxic assets, but it may not overpay enough to make the banks solvent, and it's probably not the most effective way to solve the problem.

I have a different approach. The administration has asked Congress for authority to seize bank holding companies, and that's very welcome. This is the standard way that the Fed operates with failed banks. It's like a bankruptcy proceeding, except it's administered by the bank regulators rather than the courts.

I would think about declaring some of our largest banks insolvent and seizing them. Then I would split them along the lines required by the 1933 Glass-Steagall Act, separating the commercial banking function from the riskier investment banking and securities underwriting functions that these institutions have assumed since the Glass-Steagall Act was repealed in 1999. As quickly as possible, I would sell the commercial bank back to the public through an IPO [public stock offering]. Hopefully, within weeks we would have viable commercial banks that could start making loans -- because they would now be adequately capitalized.

Y: They'd be freed from the part dragging them down.

L: Yes, from all the toxic assets, which the government would now own without having to (over)pay for them. We would have a viable commercial banking system in private hands. And the government would be left with a portfolio of investment banking assets -- some of which are viable businesses, and could be spun out quickly. The government could liquidate the remaining assets over time, the way we did when we reorganized the savings and loan banks in the early ’90s.

The approach I'm envisioning has some complexity, because it's not obvious that it's easy to split these banks up. But it seems to me to make a lot of sense, and I've talked to a lot of bankers who agree that this would be a good plan.

Y: On a different bailout front, what do you think about the auto companies?

L: I think the optimum number of U.S. auto companies is one. Maybe two, but certainly not three. The worldwide auto industry is going to shrink, to a Chinese firm, a Japanese firm, an Indian firm, a Korean firm, a European firm -- and an American firm, I hope, but there's a chance there will be zero U.S. auto companies if we don't do this right. There are a lot of assets in America -- technological assets, know-how, skills, and labor. But I think a managed reorganization is the right approach. The companies need to shed their legacy costs. The government can offer protection to current workers and retirees.

Y: Yale is assuming for budgetary purposes that its endowment will remain flat through June 2010. What's your forecast for the economy?

L: I'm not a forecaster, but all my instincts tell me that unemployment will keep rising through this year and persist at high levels through 2010. It's hard to predict when the turnaround will start. We do know that historically, asset markets begin to recover before unemployment starts to decline. People will anticipate that we've hit bottom, and asset values will start to rise. That could come sometime in 2010. With luck.