How to Waste a Crisis

Harold James, Professor of history and international affairs at the Woodrow Wilson School, Princeton University and Professor of history at the European University Institute, Florence.

The global financial crisis is reaching a bottom, and yet political frustration is growing, because the low point of the collapse seems to offer a last opportunity to promote dramatic change, and that opportunity may be missed. Last year, President Obama’s chief of staff Rahm Emanuel remarked that a good crisis should never be wasted. Disaster is an opportunity for thinking of ways to make the world fundamentally better – and also prevent future crises. People do a great deal of thinking, but sometimes they think so much that they come up with contradictory responses.

Indeed, what really makes a crisis profound is precisely the broad variety of differing diagnoses and different remedies. The political passions aroused by the clashes of interpretation often make the crisis seemingly insoluble. It was those conflicts, rather than some technical flaw in the operation of the economy, which made the Great Depression of the 1930’s such a dismal and destructive event.

Responses to a crisis fall into two categories. The first type aims at an institutional reordering, so that inefficiencies and perverse incentives are removed, and the economy functions more smoothly and efficiently. The second, more radical approach, tries to improve not the economy but the way people themselves go about their lives.

No institutional solution is purely neutral in its effects on relative incomes – and it is relative income and wealth around which political debate typically revolves. Bailout operations invariably bring bitter controversy because they help some but not others. Rescuing automobile producers looks good to their employees and suppliers. But the costs must be borne by everyone, including firms that are not rescued – probably because they operate more efficiently – and are put at a competitive disadvantage as a result.

Such rescues, in short, appear to help big companies with bad managers. Small businesses will always complain that they do not have the organizational clout to extract public funds from governments. And bank bailouts, involving the direct use of public money to recapitalize failing institutions, are even more costly and politically unpopular.

Advocates of monetary stimulation sometimes argue that it is preferable because it is more neutral in its distributional effects, and that its benefits are spread more widely. But monetary stimulus is often in reality just as selective as bailouts.

The analogy popularized by the great monetarist economist Milton Friedman was that the central bank could always deal with deflationary problems by dropping money from a helicopter. But, in the real world, not everyone is underneath the helicopter when it makes the drop. In fact, it is likely that the helicopter pilot will hover over friends and relatives when dropping the money. And even if the pilot is completely non-corrupt, the crowd on the ground will always assume that there is some hidden and partisan plan.

That has been precisely the problem with the aggressive provision of liquidity, quantitative easing, and the reduction of central bank interest rates used to address the current crisis. In today’s credit crunch, as in the Great Depression, central banks lend at practically zero interest rates. Depositors are paid almost nothing on their deposits. But when businesses and consumers try to borrow, they find that it is very costly, if not impossible. Lenders (the bankers) are suspicious, worried about creditworthiness, and demand high risk premia. As a consequence, in most countries, credit is still contracting.

In practice, it is only banks that have access to cheap borrowing, so they can reconstitute their balance sheets by borrowing cheaply and lending expensively. This is why banks suddenly look so unexpectedly profitable. But the contrast between bank profitability and the woes of everyone else turns up the political heat on the central banks, which have to explain why it is only their “friends,” the banks, who are standing under the helicopter when it drops money.

Frustration with the complexities of trying to provide ready fixes leads to attempts to find even more radical solutions. Some try to deal with basic human proclivities, and to modify behavior to make people better. It is in times of crisis that Utopian ideas about ways of guaranteeing human happiness flourish, often claiming some scientific basis.

For example, long before the financial collapse, experimental economists joined psychologists in attempting to measure varying propensities to greediness. Some evidence suggests that there is a link between the level of dopamine, addiction, and greedy behavior.

Since a common diagnosis of the problems generated in the financial services business holds that human greed is to blame, a German think tank recently suggested that people with a genetic proclivity to high dopamine levels should be barred from taking leading positions in financial institutions.

But such apparently attractive strategies aimed at making better people turn out to be exclusionary – and based on rather arbitrary testing. If implemented, the German proposal would most likely exclude behavior that involves acceptable risk, as well as sidelining those who take wild and inappropriate decisions.

Both the institutional and the behavioral responses to a crisis are fundamentally problematical.  The search for technical solutions leads to political polarization, and may produce stalemate. The search for deep human roots of the crisis, by contrast, leads to attempts to change human nature, which are futile – and also inherently much more dangerous.

Project Syndicate

Post-Crisis World Institute