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A Year Later: Which Reforms Have Made a Difference?

broken Wall Street sign; file photo

Editor’s note: All this week on the Business Desk, we’ll be featuring contributions from economists, financial journalists, and other experts on the origins and impact of the financial crisis.

We asked several experts to weigh in on the single most important action that has been taken to combat the crisis in the past year.

Robert Shiller:

With hindsight, we can surmise that the most important action that the U.S. government has done is the almost complete bailout of our large failing financial institutions. They bailed out all systemically important financial institutions with only one exception: Lehman Brothers. These bailouts are much more fundamental than the fiscal stimulus package, or the expansion of the money supply, for they represent a suspension of market discipline that has been the foundation of our economy.

We needed to do this, lest confidence collapse massively, as it did after the U.S. government allowed massive bank failures in the 1930s.

Leaving Lehman behind was a gambit that might have gone much worse than it did. The gambit has seemed to work well, as of now, for confidence appears to be back and the economy improving. There was a general perception that our financial system was collapsing. That perception is gone, and still we have semblance of market discipline: Not everyone was bailed out.

But leaving one institution behind is not enough to restore any real sense of market discipline. The next steps need to be some fundamental changes in our economic institutions to reduce the systemic risk that brought us this mess, so that we can let market forces play out without a bailout the next time. This story will have a happy ending only if there is a major overhaul of our financial institutions and regulatory framework.

Robert Shiller, professor of economics at Yale University, co-developed the Case-Shiller Index, the widely watched index of housing prices, and is co-author of this year’s Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

David Smick:

Generally speaking, when it comes to reviving an economy, fiscal stimulus is like a small pistol while monetary stimulus is like a howitzer. Hands down, therefore, the Federal Reserve’s quick decisions to slash short-term interest rates, set up generous liquidity facilities, and allow large non-bank U.S. financial institutions access to easy credit (through the Fed’s Discount Window) were the most important policy actions.

With the Fed’s actions, a depression scenario was taken off the table. Banks would continue to experience enormous problems, but a 1930’s-style scenario of widespread bank insolvencies, with long lines of frantic depositors, was no longer a possibility.

The future, however, looks problematic. These same financial institutions are buying (and trading) securities, not lending. The good news is that they are beginning to repair their damaged balance sheets. The bad news is that small businesses and start-ups, the source of most job creation, are finding it difficult to borrow.

Complicating matters further: Consumer credit demand is swiftly contracting. American households are deleveraging at a rate much faster than anticipated, which means consumer demand (70 percent of GDP growth) will remain sluggish. During the crisis, American households took a hit to their collective balance sheets of at least $10 trillion (U.S. GDP is only $14 trillion). Meanwhile, household debt remains close to its historic high of 130 percent of disposable income.

And speaking of debt, the Congressional Budget office is predicting a public debt explosion. Here’s the stunner: Within a decade, our net interest expense on the national debt will exceed the amount we’ll need to borrow. And that doesn’t include the expected sharp rise in Social Security and Medicare costs.

The bottom line is that the Fed saved us from financial Armageddon, but we still face the fight of our lives.

David Smick is founder and editor of The International Economy magazine and author of The World Is Curved: Hidden Dangers to the Global Economy.

James Galbraith:

The most important steps combating the crisis weren’t taken last year. They were taken under FDR and Lyndon Johnson.

Social Security, Medicare, the other programs of the New Deal and the Great Society, and the progressive income tax together saved us from a repeat of the Great Depression. In two ways: A bigger government, as a share of the economy, means that the private collapse takes down a smaller share. And the fact that in a slump public spending goes up, while tax revenues collapse, means that total spending, public and private, falls less than total incomes and employment do. The result is a built-in rebound, which we are now beginning to see.

These effects are called “automatic stabilizers.”

In the past year, two important actions also helped. The first was the decision to expand deposit insurance and to nationalize the commercial paper market — decisions taken in the heat of the crisis at the end of September, 2008. These steps quelled a panic that might otherwise have crippled the payments system.

Second, the ARRA (also known as the stimulus bill) is helping. It could have been bigger, and it could have been better. But it did slow the implosion of state and local budgets, it will employ construction-sector resources that would otherwise be on the street, and it has begun to put important funds into green jobs — the seed money for the next expansion.

On the other hand: Job loss and unemployment are unacceptable, and will remain so unless we act directly on that issue.

And the failure to resolve the bad banks, the failure to set a strategic path toward a smaller and less monopolized financial sector, the failure fully to stabilize state and local budgets, the failure to deal forcefully with the foreclosure crisis, the lack so far of an effective energy strategy — all of these will haunt the economy going forward.

James Galbraith is professor of government/business relations at the LBJ School of Public Affairs at the University of Texas at Austin and author of The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too.