Comprehensive monetary reform needed - Lessons from Keynes in war and financial turmoil

Published: Friday October 3, 2008

Treasury Secretary Henry Paulson in his three-page rescue plan proposed that his office be authorised to purchase, to make and fund commitments to purchase, on such terms and conditions as determined by the secretary, mortgage-related assets from any financial institution having its headquarters in the United States, and that secretary's authority to purchase such assets be limited to US$700 billion outstanding at any one time, and that his decisions may not be reviewed by any court of law or any administrative agency.

The rescue proposal for Wall Street was effectively a blank cheque.

A bit more than a week later, September 28, opposition to the proposal and spirited debate on its lack of equity or fairness, possibility for success, and market responses forced its transformation into 100-plus pages of documentation attempting to craft a bailout plan acceptable to the public and various factions of United States lawmakers.

US representatives facing re-election by constituents who reportedly disagree with the proposal by as much as 3-to-1 along with others who themselves oppose it on ideological grounds voted it down on Monday.

The Dow recorded its single largest drop in any one day - 778 points - for more than two decades.

Lukewarm efforts

The White House is being blamed for lukewarm efforts to sell the proposal to the people. 'Sell' may be unfortunate for it is precisely its effective 'selling' of weapons of mass destruction and the Iraq war that has had so much to do with the loss of credibility underlying mistrust of a decidedly unpopular bail out.

As I write it is not clear what the outcome of deliberations of the authorities will eventually pass into law. Undoubtedly, some form of accommodation must be agreed. It is beyond contemplation for this not to happen given the disruption of credit for everyday business operations that will otherwise ensue.

But regardless of the immediate attempt at solution, there are troubling aspects of governance and management of the world's monetary system.

In 1940, John Maynard Keynes, the celebrated British economist who gave us the core of today's macroeconomics and counter cyclical expenditure to avoid or mitigate economic downturns, published an influential piece entitled 'How to pay for the War - A radical plan for the Chancellor of the Exchequer'.

For Chancellor of the Exchequer read Secretary of the Treasury or Minister of Finance.

Keynes had published three articles in The Times of London in November and December 1939. He refers to these articles as a "discussion of how best to reconcile the demands of war and the claims of private consumption". There was much controversy over his ideas in part because he advocated "compulsory savings". He said there is a time when the "necessities of a war economy are realised; and there is much evidence for the belief that the public are not so far behind."

Keynes felt wartime Britain could not both pursue the war and expand domestic consumption. In a time of peace he said, "the size of the cake depends on the amount of work done.

But in wartime the size of the cake is fixed. If we work harder, we can fight better. But we must not consume more. This is the elementary fact which in a democracy the man in the street must learn to understand if the nation is to act wisely - that the size of the civilian's cake is fixed."

That this was true of Britain is not contested but is it true for the US today? Clearly US economic policy does not reflect such a view for the idea was that Americans ought not to worry.

Underlying assumption

There was no need to tighten the belt but rather continue going to the mall. Furthermore, significant tax cuts, it was suggested, could be afforded since such a policy would produce jobs and fuel demand to keep the economy humming. The underlying assumption of this policy though not spelled out, is clear.

Both consumption and war effort would be funded by borrowing. And until a few months ago this was not only the prevailing wisdom, but the reality. Holders of US government and Wall Street debt instruments were quite happy to keep their claims denominated in US dollars in these securities. They were the savers who allowed, as Keynes may have said it: 'the size of the civilians' cake to be unfixed'.

Rising asset values

Wall Street's participation in this operation took advantage of the housing bubble which created rising asset values and the basis for credit expansion. The now infamous credit default swaps ballooned simultaneously as mortgage - backed securities were sold across the globe. Holders were sovereign wealth funds, various funds across Europe, Asia and the Americas. If insurers of these risks are unable to cover them because of holes in their balance sheets the whole edifice of creative debt instruments collapses.

Deregulation with repeal of the Glass-Steagall Act at the end of the 20th century was greeted with enthusiasm. Financial services were to be allowed an almost free-for-all expansiveness. Previously, responding to the 1929 great crash, investment and commercial banking, insurance and other services were firewalled from each other. Evidently, whereas for the last decade this procedure was thought to minimise risk, today's results show otherwise. Goldman Sachs has transformed itself into a bank holding company, hence now subject to regulation.

Whatever is concluded for the short term to free up credit markets and avoid generalised economic collapse, the regulatory regime for our increasingly global financial arrangements will have to be redesigned.


Source: Jamaica Gleaner
http://www.jamaica-gleaner.com/gleaner/20081003/business/business10.html