Thursday, October 16, 2008

John Kenneth Galbraith and Our Great Crash

John Kenneth Galbraith died in April 2006. Had he lived, he would have been 100 on October 15th.

Galbraith taught economics at Harvard, and advised several Democratic Presidential candidates and Presidents.

President Kennedy appointed Galbraith Ambassador to India. From there he made several trips to Vietnam and wrote to the President that the US should get out of Southeast Asia. We now know that Galbraith was successful in his efforts, and Kennedy planned to withdraw from Vietnam following the 1964 election. Alas, Galbraith could not persuade President Johnson.

But economic policy rather than foreign policy was where Galbraith made his mark. He was fascinated by the recurring financial follies in history, and became well-known for his work on the 1929 stock market crash.

The Great Crash 1929 documents the factors leading to the market bubble, its crash, and its major consequence, the Great Depression.

According to Galbraith, four problems in the 1920s led to the crash and then turned it into a depression-- an unequal distribution of income, corporate fraud, a financial system lacking regulation and oversight, and poor economic policy. These exact problems plague us now.

Galbraith was clear that great inequality breeds financial speculation. When the wealthy have more money than they know what to do with, they willingly gamble with it. Those not so well off, and who aspired to great wealth, follow the leaders and see speculation as the way to climb the economic ladder.

Inequality also means that middle-class households, which spend most of their income, receive too little income. This greatly reduces the spending necessary for robust growth.

Inequality today is nearly as great as during the 1920s. However, things are worse in one respect. During the 1920s, the middle class had little access to credit. Today the middle class is deeply in debt and must repay their debt with interest; this money they cannot spend, contributing to recessionary pressures.

Galbraith blamed corporate fraud and failed government oversight for causing the bubble. In the 1920s, failure to regulate buying stocks on margin led to more and more speculation. In the 2000s, there was a failure to regulate home purchases with debt. Naive optimism led people to believe that home prices could only go up.

Lacking oversight, financial institutions made home loans in the 2000s that could not possibly be repaid. In the old days, this would hurt financial institutions, since they would incur the costs from bad loans. But in the modern era of finance, loans are immediately sold and origination fees earned. No matter how bad the loan, banks could make money.

In both the 1920s and 2000s, excessive debt created great bubbles that could not be sustained forever. And in both cases, the ensuing crash led to bank runs, the lack of credit, and serious economic problems on Main Street.

Finally, in the 1930s, belief in the wisdom of balanced budgets kept the government from doing what was necessary to reduce the severity of the downturn. FDR did develop a spending package to create jobs; but it was too little to really help. Not until World War II did the government spend enough to get the economy moving again.

If he were alive today, what would Galbraith say about our current economic policy?

He probably would have supported the Wall Street bailout plan enacted earlier this month. Galbraith never hesitated from doing what was necessary. He recognized that the government must rescue capitalism from its mistakes. Although not desirable, it was always preferable to the misery of a depression.

No doubt, he would have supported higher taxes on the incomes of the wealthy—believing this contributed to the greed leading to our current problems. With high taxes on those earning millions per year, there is less to be gained from fraudulent and highly speculative activities. Higher taxes on the wealthy also would generate money to fund programs that create jobs for the middle class and the poor.

But Galbraith would have been critical of the policies adopted over the past year in an attempt to stem our financial and economic crisis. Tax cuts are usually ineffective in a crisis because too much of the tax cut gets saved and because tax cuts (unlike government spending programs) don’t create jobs. And he would have been skeptical that interest rate cuts could increase spending by consumers or business firms in a time of crisis.

Galbraith always preferred the stimulus of public works programs—infrastructure, education, and developing alternative energy sources—which directly creates jobs and improves our lives in many ways.

In this time of crisis, we can only hope that Washington remembers the lessons that Galbraith taught during his long, productive life.