Obvious Failure of Stimulus Becomes Obvious Even To Economists

Where do Keynesians go now that even public radio is talking about the failure of one of history's costliest Keynesian stimulus efforts?

At City Journal, Guy Sorman notes how quickly the managed-market winds have shifted. When the credit unwind started, the papers, the TV and the newsweaklies declared capitalism dead in just a little less time than it took for Kent Brockman to declare his loyalty to the Space Ants. Less than two years later, you can't buy good press for the stimulus; the economy is frozen solid in August; the nation is rediscovering—despite the herniated efforts of local, state and federal government—the virtues of thrift; and if you search for Keynes on the interwebs, all you turn up are headlines like "How Dr. Keynes killed the patient."

But here's the tell: We're already starting to see the first of the "Today's Keynesians are misreading Keynes" walk-back arguments.

As an idea, neo-Keynesianism is dead. (As public policy, of course, it will live forever.)

Sorman checks in with just-emerging-from-their-bunkers free market economists,  including University of Chicago's Eugene Fama and Columbia University's Charles Calomiris – the latter of whom gives a nice list of all the ways that the supposedly unforeseen 2008 crisis fits into the pattern of "all banking crises that we have known about since the fifteenth century".

Fama provides a new wrinkle on recent discoveries about where and when the bubble began to pop:

The nature of recessions is important because of what may be the free-market economists' most surprising contention: that the recession triggered the financial crisis, not the other way around. Fama argues that the recession started as early as 2007, with consumers starting to spend less, borrowers falling delinquent on their loans, and homeowners who lacked a vested interest in their houses beginning to walk away from their mortgages. So the complex financial derivatives at the heart of the financial meltdown were not its cause but its victims. "For 25 years, before the current recession," Fama points out, "the derivatives worked well in lowering the cost of capital."

What has Fama learned from the crisis, then? "I learned a lot about government overreactions but not much about recessions," he tells me. Confronted with a sharp economic downturn, governments face political pressure to act; stimulus spending and other state interventions seem sensible, even when the history of past crises suggests otherwise. Worse, the new public debt and regulations then hobble economic recovery. Rebounding from the post-2007 recession would have been quicker, Fama believes, if the government had mostly let free markets clean up the mess, reestablish true prices, and select the enterprises able to survive.

Whoa, there, pardner! Whaddaya mean "mostly"? John Cochrane, another Chicago economist (and a suspect figure by virtue of his still believing that the great  "Great Moderation" really existed anywhere except in Linus' imagination) explains that we just needed smarter, better targeted interventions:

"The banks probably had to be saved," Cochrane tells me, "but the problem was that the salvation followed no pattern." Some institutions, like Bear Stearns and Wachovia, were rescued; others, like Lehman, were not. It became impossible to know what the government was going to do next. "If governments couldn't be predicted, nobody could be trusted any more," Cochrane explains. Credit froze.

I have an alternative explanation: Credit froze because all over the country defaults on mortgages, car loans, student loans and credit cards were reaching historical highs. Letting Lehman die was Henry Paulson's single act of courage, and he followed it up by doing what he does best: soiling his Depends and scaring the children with wild tales about the bank failures, derivative defaults and lover's lane murderers that would be unleashed if the taxpayers didn't give a trillion dollars to the largest banks on the planet. The entire ethical structure of the free market was destroyed so that Sheila Bair could be spared the inconvenience of euthanizing crippled, syphilitic ghouls like Citigroup and Bank of America.

With only two years' distance the TARP and the ARRA stimulus (and all the already forgotten lesser stimuli like the $400 billion Federal Housing Finance Regulatory Reform Act of June 2008) can be seen as one of the great public tragedies of our time. But at the end of a tragedy, the survivors learn something and move on. That's what's happening now. With any luck in the mid-term elections, Tim Geithner, Larry Summers and the rest of the Obama economic bureau may soon become the unemployment statistics they deserve to be.  This is good news. Sorman lays out the beginnings of an important reappraisal.