Recent Federal Reserve (Fed) flow-of-funds data show a sharp rise in federal government and Fed liabilities. President Dimitri B. Papadimitriou and Research Scholar Greg Hannsgen examine the holders of these new liabilities and outline the likely effects of these debts on the U.S. economy. They dispel concerns that the surge in government liabilities (especially money) will cause a large increase in inflation, and focus on the badly needed improvement of private sector balance sheets, which will take some time to rebuild. And since default on debts that are backed by the full faith and credit of the United States is virtually impossible, these assets are safe (many U.S. sectors, as well as China, have been buying Treasuries). Moreover, increased deficits and their impact on balance sheets will eventually help stabilize the U.S. economy.

The Federal Reserve’s response to the current financial crisis has been praised because it introduced a zero interest rate policy more rapidly than the Bank of Japan (during the Japanese crisis of the 1990s) and embraced massive “quantitative easing.” However, despite vast capital injections, the banking system is not lending in support of the private sector.

Senior Scholar Jan Kregel compares the situation today with the 1930s and finds an absence of “New Deal” measures and institutions in the current rescue packages. The lessons of the Great Depression suggest that any successful policy requires fundamental structural reform, an understanding of how the financial system failed, and the introduction of a new financial structure (in a short space of time) that is designed to correct these failures. Today’s economic crisis could have been avoided if increased household consumption had been financed through wage increases, and if financial institutions had used their earnings to augment bank capital rather than bonuses.

We are in the shadow of catastrophe and at the beginning of a long, profound, painful, and irreversible process of change, says Senior Scholar James K. Galbraith. We need to come to grips with the crisis, fast, but two ingrained habits are leading to our failure to do so: the assumption that economies will eventually return to normal on their own, and the belief that recovery runs through the banks rather than around them.

Galbraith suggests the following measures, all of which are needed now: make economic forecasts realistic, audit banks more honestly, introduce effective financial regulation, keep people in their homes, and increase public retirement benefits.

The author assesses the various schemes to alleviate the credit crisis in terms of the “business as usual” and “good bank” models. In the business-as-usual model, the government, as lender of last resort, runs the risk of becoming insolvent. Moreover, the problem has been misdiagnosed as liquidity risk by policymakers. The good-bank solution also runs the risk of making governments insolvent and turning an already severe recession into a depression worse than that in the 1930s.

Karakitsos believes that the good-bank model can be salvaged, with one modification: separating the cross-holdings of the personal sector from those of the financial sector, thus containing the damage. In this way, the economy is shielded from falling into depression and recovery is ultimately ensured. 

Rather than bailing out speculators, careless investors, and banks, the authors’ new policy initiative recommends that central banks target the net wealth of the personal sector (net wealth is at the heart of the transmission mechanism between asset prices and debt, and consumption). A net wealth target would not impede the free functioning of the financial system. Rather, it would help to control liquidity and avoid future crises, without interfering with the financial engineering of banks.

In an asset-led business cycle, a central bank is well advised to have two targets: inflation and the output gap. In a highly leveraged economy like the United States that is experiencing a credit crisis, monetary policy should also include mild wealth targeting in order to stabilize the economy around potential output.

In this report, the authors present new evidence on the pattern of economic inequality in the United States. They find that the LIMEW and two official measures of inequality indicate higher inequality in 2004 than in 1959. According to the LIMEW, the surge in inequality between 1989 and 2000 reflects the large increase in income from wealth for the top rungs of the economic ladder. The authors’ findings suggest a rather bleak picture for the lower and middle classes in terms of sharing the economic pie.

According to all measures, base income and income from wealth contributed positively to the increase in inequality, while net government expenditures and taxes moderated that increase. The principal reason for the decline in inequality during the latest subperiod (2000-04) was the fall in income from nonhome wealth in response to the bust of the financial markets rather than a reduction in earnings inequality or changes in government redistributive policies.

Senior Scholar Jan Kregel reviews the history of U.S. financial regulation and finds that prudential regulation no longer has a direct impact on system liquidity, thus eliminating the traditional transmission mechanism for monetary policy. The Financial Modernization Act of 1999 resulted in the creation of new capital market institutions such as hedge funds and private equity funds, without appropriate regulation. There is no longer any precise relation between financial institutions and functions, so the first decision is whether to base reregulation on institutions, functions, or products.

U.S. legislator and regulator responses to previous financial crises have not led to sustainable financial stability. The United States is now facing, for the third time, the choice between a segmented or a unified banking system. Germany, for example, rejected separation of commercial and investment banks, and maintained universal banking without financial crisis.

The Summary updates current Levy Institute research, with synopses of new publications, accounts of professional presentations by the research staff, and an overview of Levy Institute events.

In this issue, Levy scholars conclude that the world’s economy will not achieve balanced growth and full employment unless the associated institutions replace their total reliance on market forces with an entirely new framework. There must be a worldwide recovery of output, they say, combined with sustainable balances in international trade. Our scholars also find increasing inequality in the United States and call for the Obama administration’s fiscal stimulus package to improve the broader economic well-being of the poor and the middle class, while also creating jobs. Moreover, the fear of large deficits is without merit, so we can afford any necessary spending or bailouts. In addition, a bolder Obama stimulus plan would have the government serve as employer of last resort.

Organized by The Levy Economics Institute of Bard College with support from the Ford Foundation

On April 16 and 17, top policymakers, economists, and analysts will gather at the Ford Foundation’s headquarters in New York City to offer their insights into and policy guidelines for the extraordinary challenges posed by the current global financial crisis. Topics will include: current conditions and forecasts; macro policy proposals by the Obama administration and others; the rehabilitation of mortgage financing and the banks; financial market reregulation; proposals to limit foreclosures and modify servicing agreements; regulation of alternative financial products (derivatives and credit fault swaps); the institutional shape of the future financial system; and international responses to the crisis.

For further information, visit www.levy.org.