Keynes to Neoclassical to ???

Today we learned about the two most prominent models of macroeconomics and how they have both become moderately obsolete. The Keynesian model, though it held up for a number of decades, was proven to underestimate the impact of inflation. As the United States poured billions of dollars into the Vietnam War, the country was forced to send more and more money overeas and Nixon eventually severed the link between the dollar and gold imposed by the Bretton Woods system. This, in conjunction with the OPEC oil embargo in the early 70s (which was imposed over the West's aid to Israel), gave way to what has been termed stagflation. The Keynesian model seemed faulty and economists looked elsewhere. Neoclassicism, though it had been taught in universities for just as long as the theories of Keynes, finally came into vogue in the late 70s, aiding Ronald Reagan in his election.

Surprisingly, this was not all it was cracked up to be. Paul Krugman writes:

"traditionally, the U.S. government ran significant budget deficits only in times of war or economic emergency. Federal debt as a percentage of G.D.P. fell steadily from the end of World War II until 1980. But indebtedness began rising under Reagan; it fell again in the Clinton years, but resumed its rise under the Bush administration, leaving us ill prepared for the emergency now upon us"

This has much to do with lowered taxes.

From K's Economics 101

But back to the effects of neoclassical economic theory:

"We weren’t always a nation of big debts and low savings: in the 1970s Americans saved almost 10 percent of their income, slightly more than in the 1960s. It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life, culminating in the near-zero savings rate that prevailed on the eve of the great crisis. Household debt was only 60 percent of income when Reagan took office, about the same as it was during the Kennedy administration. By 2007 it was up to 119 percent"

These rational neoclassical economists informed the government and consumers that debt was, in fact, a good thing. The more the better. And now here we are, with millions of Americans foreclosed upon for their inability to pay mortgages their banks told them would work for them. The best time for instituting change is when doing so won't destabilize the system. The easiest time to institute change is when the system is already evidently destabilized. Economically, where should we go from here? (disregarding that those who destabilized the system are stronger than ever and the American people are, at best, apathetic)

The Financial Crisis: Private Greed and Government Corruption

Back in March, Matt Taibi wrote this article in Rolling Stone about how we have come to find ourselves in the worst recession since the Great Depression. Though he's hardly an economist, he closely researched the players in the crisis, and sums up the article in the first sentence:

It's over — we're officially, royally fucked

He does go into more detail, of course. Very inflammatory and harshly-worded detail, but he does so with accuracy and truth.

After a couple pages of bemoaning the collusion between powerful corporations and the government, he gets down to the heart of the crisis, writing:

The mess Cassano [AIG Financial Products division head] created had its roots in an investment boom fueled in part by a relatively new type of financial instrument called a collateralized-debt obligation. A CDO is like a box full of diced-up assets. They can be anything: mortgages, corporate loans, aircraft loans, credit-card loans, even other CDOs... The key idea behind a CDO is that there will always be at least some money in the box, regardless of how dicey the individual assets inside it are... They then convinced ratings agencies like Moody's and S&P to give that top tranche the highest AAA rating — meaning it has close to zero credit risk.... Suddenly, thanks to this financial seal of approval, banks had a way to turn their shittiest mortgages and other financial waste into investment-grade paper and sell them to institutional investors like pensions and insurance companies... What Cassano did was to transform the credit swaps that Morgan popularized into the world's largest bet on the housing boom... Cassano could sell investment banks billions in guarantees without having any single asset to back it up... Initially, at least, the revenues were enormous: AIGFP's returns went from $737 million in 1999 to $3.2 billion in 2005. Over the past seven years, the subsidiary's 400 employees were paid a total of $3.5 billion; Cassano himself pocketed at least $280 million in compensation. Everyone made their money — and then it all went to shit.

So basically, people react to incentives. Intelligent, unscrupulous bankers looked for a way to achieve higher profits, and ended up gaming the system. While they should have known that what they put in place was ultimately self-destructing, this manner of raking in the profits became all too common, involving many that didn't even realize their banks were participating in such a high-stakes game.

He continues, blasting certain members of the government for making this possible:

For years, Washington had kept a watchful eye on the nation's banks. Ever since the Great Depression, commercial banks — those that kept money on deposit for individuals and businesses — had not been allowed to double as investment banks, which raise money by issuing and selling securities. The Glass-Steagall Act, passed during the Depression, also prevented banks of any kind from getting into the insurance business... In the 10-year period beginning in 1998, financial companies spent $1.7 billion on federal campaign contributions and another $3.4 billion on lobbyists... In 1999, [Phil] Gramm [R-TX] co-sponsored a bill that repealed key aspects of the Glass-Steagall Act... The very next year, Gramm compounded the problem by writing a sweeping new law called the Commodity Futures Modernization Act that made it impossible to regulate credit swaps as either gambling or securities...

One role of the government, accepted even by many conservatives, is to proactively ensure the stability of the economy. However, virtually all Republicans and many Democrats have turned away from this practice as the lessons of the Great Depression have been forgotten and even subverted. We learned in class that a tax hits both producers and consumers, and often results in a significant dead-weight loss. This is also true of regulation. Regulation imposes constraints on companies, theoretically ensuring that they cut no corners and spend money on people to check the quality of their product. The wages given to these otherwise optional employees causes higher prices for consumers.

But both tax and regulation, properly implemented, do not result in money shoveled into a fire. Instead, they ensure the safety of the consumer, the producer, and the economy as a whole. Except President Bush named Hank Paulson the US Treasury Secretary, an executive of the financial giant Goldman Sachs. Under his supervision, money was handed out to the biggest banks in America with little stipulation as to its use, nor the imposition of regulations that would constrain further risky action. Meanwhile, the Obama administration, having named corporate crony Timothy Geithner as the Treasury Secretary, has hardly shown signs of the Change that was promised on the campaign trail.

So, one long wall of text later, a few prompts for discussion:

-What is your idea of the proper role of government in the economy? I know we have a few libertarians and Republicans here, so some diverse opinions could be interesting.

-What action should be taken now?

-Not really an econ topic, but still critical just as an aside: Assuming that you find fault with the parties outlined as responsible, what needs to change in our government, in our economy, and our society to prevent future problems.