The null hypothesis is that we have new fertile ground here: that the Reagan agenda was a failed one and that a new paradigm, more statist and government dependent must replace it. The Reagan vision was that lower marginal tax rates would raise the return on capital of business and capital mobility would both raise our economic growth rate and contain inflation. Before we reach the heady conclusion that Reagan’s vision is obsolete, we must analyze more carefully why the economy is now under-performing.
First among them is the legacy of debt from a series of asset bubbles. These asset bubbles were created by monetary policy. The Greenspan years at the Federal Reserve were ones in which the Federal Reserve made no judgment as to whether markets were speculative; it was confident that it could pick up the pieces after the collapse. As we now know, the central banker’s confidence was misplaced. The consumer balance sheet is stretched and only time will correct it.
Second, the banking crisis of 2008 was avoidable. Intelligent policymakers learn from their mistakes. Part of the Reagan revolution was deregulation of the savings and loan industry; complete with an increased government deposit guaranty and expanded investment authority to include commercial real estate. In 1992, we would recognize a $225 billion bailout of the industry. William Seidman was head of the FDIC in the Reagan and George H.W. Bush administrations and led the Resolution Trust Corporation to liquidate the failed thrifts. In his book “Full Faith and Credit,” Seidman states, “Thrifts do not operate in the free market that is essential to competition, but in a market underwritten by the full faith and credit of the U.S. government and its insurance funds. When the play of the market cannot regulate activity, government controls must operate instead or there will be no control at all, with disaster sure to follow.” And it did.
Finally, Hyman Minsky, economist and author of “Stabilizing an Unstable Economy” argued that new financial products have always been associated with financial instability in the next recession. His evidence: the growth recession of 1966-67 (jumbo certificates of deposit), the Penn Central bankruptcy in 1970 (commercial paper), the collapse of Franklin National Bank in 1975 (eurodollar), and Drysdale Government Securities and Lombard-Wall in 1980 (repurchase agreements). He noted that financial innovation tends to develop around efforts to avoid the in-place regulation of its time.
Financial innovation factored heavily into the crisis of 2008: subprime mortgages, collateralized debt obligations (CDO; financial engineering of subprime mortgages), and credit default swaps (insurance to protect against default). The Great Crash of 1929 was partially attributed to “equity trust”; pools of stock that unfortunately owned shares in other pools of stock. The added complexity in ownership created valuation difficulties and illiquidity in 1929, much as was our experience with the CDO in 2008.
It should be clear that the crisis of 2008 was avoidable and that attention to the history of financial innovation and appropriate regulation of these products was critical and that we failed in that task. We most certainly should conclude that the country would benefit from financial reform and product simplification. We can say that Wall Street hijacked the Reagan Revolution, but we cannot say that Reagan’s vision of small government and low taxes is flawed.
But the truth is that we cannot have either the Reagan vision of the political right nor can we have the large government vision of President Obama and the political left. We have destroyed our balance sheet and our budget deficits will accommodate neither.
At some point in the future, when our debt is contained, we will once again be afforded the luxury of whether we want tax cuts or more government spending. But under the current conditions there is no choice – the fertile ground is in the middle and our debate should focus on trade-offs and compromise.