Policy Analysis: Financial Crisis and Public Policy (Article Review)

Policy Analysis: Financial Crisis and Public Policy criticizes the effectiveness the U.S. bailout of financial institutions and the policies which lead to the wealth shock the precipitated the recession. The author, Jagadeesh Gokhale, asserts that the theoretical framework for capital injections are solid-he doubts that the implementation of current strategies will be effective to short-term thawing of the credit markets or long-term growth prospects for the U.S. economy. The major impediments to the government current strategy, according to Gokhale, are that the purchase of private equities by the government does not address the problem of undercapitalized banks directly, but instead increase moral hazard and adverse selection problems. This implies that the bailouts will only hinder the ability of future generations to meet the obligations of current social entitlement programs-Social Security and Medicare- by leaving them with high debt and lower economic growth to maintain these social safety nets. Gokhale asserts that this will only lead to higher tax rates in the future or lower public expenditure outlays for social programs or a combination of both.

Gokhale places the blame on our current crisis on a host of factors including the increase in oil prices and congressional mandates to alter financial market regulations to increase homeownership. The commodity price increases prompted structural adjustment in the economy to reduce energy intensive activity at the cost of major discomfort to consumers and producers, but the easing of regulations spurred financial innovations and interdependence among financial institution participants that created a tittering house of cards for the economy to stand on. The financial sector grew in complexity and size, much of difficulty comes from the large uncertainty faced by financial institutions which the government is trying to mitigate by increasing the pool of risk-bearing investors; the taxpayers. The governments’ purchase of preferred stock instead of the “toxic” assets does not alleviate much of the uncertainty in the credit markets.

In principle the governments efforts to shore up balance sheets should increases confidence and restore credit flows, but in practice government acquisition of equity positions in private firms has resulted in further doubts as to the governments long-term intentions. Gokhale believes that the huge equity positions held by the government in private firms is nothing short of long term management control by the public sector to protect its increasing financial stake in the solvency of the institutions to whom it has provided capital to. This is evident in the restrictions on bonuses on bailout recipients which appease the public, “who unjustly blame market forces rather than prior government policy”, but do little to provide incentives for top executives to manage the vital financial sector in our economy. This implies that the talented managers will opt for other sectors to work for leaving a less competent lot to oversee the worse banking crisis in recent memory.

Gokhale points to the double shocks of commodity price increases and decreases in asset values as the main culprits in the initiation of the crisis, but also comments on the dire long-term outlook based the productivity of the labor force, consumption growth, global trade, and low taxes. According to Gokhale, “The two previous recessions (91’, 01’) occurred under sound economic fundamentals…This time around however; those fundamental forces appear to be considerably weaker”. One of the major impacts on economic health will be the retirement of the baby boomers that make up the most experienced workers in our labor force. Their departure from the labor market signals both an decrease in labor quality and an increase in government outlays in the form of Social Security and Medicare cost which “according to government actuaries, unfunded obligations to Social Security and Medicare amount to more than 40 trillion dollars” over the next 75 years. This demographic shift coupled with the huge government debt and decrease in consumption resulting from declining home and 401k values places the long-term prospects for economic growth in peril as the financial crisis is preceded by the entitlement crisis.