Moral Hazard and US recession

The past few weeks have seen an ever increasing chorus of voices among the academia and political establishment in the US about the need to do everything possible to prevent a recession. The recipes being suggested to save Wall Street and Main Street include the full spectrum of monetary and fiscal policy options. The irony in the situation that appears to have been largely missed is that, the same distinguished voices (eg Lawrence Summers) calling for aggressive government intervention now had argued vehemently against similar action under much the same conditions a few years back in East Asia and Latin America. This selective amnesia, apart from conveying an impression of hypocrisy, also generates significant moral hazard concerns.

The Director of the Harvard University's Center for International Development, Prof Ricardo Hausmann puts in perspective the ongoing debate about combating recession and a financial meltdown,
"Main Street consumers have overspent and over-borrowed and are unable to meet their obligations. The fact that households may have so behaved because they were enticed by “teaser loans” does not change the facts; it only assigns blame. Consumption has been above sustainable levels and needs to adjust down, whatever view one has about the responsibility of adults over their financial decisions. The adjustment of private consumption to sustainable levels is necessary, but is likely to have a negative influence in the short run on the growth of aggregate demand, of which it represents more than 70 per cent. It is hard for this adjustment to take place without bringing down the rate of growth of gross domestic product, possibly to negative numbers."

There is surely no painless way to shed off all the excesses and imbalances accumulated during the consumption orgy and the "irrational exuberance" in the equity and real estate markets during the past decade. As Prof Hausman says, any effort to alleviate the pain and misery arising from the situation should not involve "giving the US consumer more rope with which to hang himself". Any policy should seek to temper the unsustainable consumption and eliminate the solvency problems, without any long term effect on the US economic growth.

Prof Hausman's last word is instructive, "It should stop behaving as the whiner of first resort, ready to waste all its dry powder on a short-sighted attempt to prevent a 2008 recession. Many poorer countries with weaker markets and institutions have survived and benefited from an adjustment that involves a year of negative growth. Faster bank recapitalisation, fiscal investment stimulus and international co-ordination should be first on the ­policy agenda."

Update
Ken Rogoff brings out the hypocrisy in the prescriptions being given for tiding over the US recession, "The US treasury strongly encouraged Asia to tighten fiscal policy during its 1990s crisis. But today the US Congress and president are tripping over themselves to adopt an ill-advised giant fiscal stimulus package, whose main effects will be to tie the hands of the next president in simplifying the US tax code and closing the budget deficit.

Americans firmly told Japan that the only way to clean up its economy was to purge insolvent banks and regenerate the financial system through Schumpeterian "creative destruction." Today, US authorities appear willing to contemplate any measure, no matter how inflationary, to insure that none of its major banks and investment houses fails.

For years, foreign governments complained about American hedge funds, arguing that their non-transparent behavior posed unacceptable risks to stability. Now, many US politicians are complaining about the transparency of sovereign wealth funds (big government investors mainly from Asia and the Middle East), which are taking shares in trophy American assets such as Citibank and Merrill Lynch."