Hadi Esfahani is professor of economics at Illinois and the new director of the Center for South Asian and Middle Eastern Studies at Illinois. His areas of expertise include theoretical and empirical issues in the political economy of development: the role of country institutions in the formation and reform of fiscal, trade, and regulatory policies. Here he discusses the global economic crisis and its worldwide impact.

Many Americans were incensed at the $700 billion bailout plan passed by the U.S. and the help given to the “Big 3” automakers.  But what would have happened to world markets if companies like AIG or the auto industry weren’t “bailed out” by Congress? What is at the root of the current crisis?

The bailout was necessary. Without continued functioning of major banks and financial institutions such as AIG, many other firms might have collapsed and many people would have lost access to credit and insurance. Most financial assets would have also been hit harder, inducing consumers and investors to curtail their expenditures further. This would have deepened the recession significantly because, with the decline in demand, many more firms would have been forced to layoff their workers or to shut down altogether.

The immediate blame for this situation largely goes to the government and to the Federal Reserve under former Chairman Alan Greenspan, for poor handling of policy and regulations. They missed signs of major weaknesses in the system. They ignored the regulatory changes that were needed in response to the developments in the financial markets. Some other players in the process such as the credit rating agencies and the Securities and Exchange Commission (SEC) also share the blame because they failed to recognize the problems that were emerging under their watch.

The widespread failure of the policymakers to take precautionary actions and prevent the disaster suggests that the roots of the problem must go deeper. I think one fundamental factor is the simplistic ideology that government regulation is inherently bad and markets must always be free. Of course, there is a great deal of merit in the idea that free markets are the best means of encouraging innovation and bringing about prosperity. However, unfettered markets do not always work well and innovations that they induce can sometimes be socially destructive. So, they need regulation. This idea is well understood in the case of new medical procedures and drugs, which have to go through lots of testing and follow regulatory procedures before they are allowed to enter the markets. Even then, their use remains highly regulated. For example, most drugs can be used only under supervision of physicians, who themselves must be certified. However, this idea has not been accepted in the case of new financial products that can be harmful to the economic system, but are nevertheless employed by market participants who benefit from them. Subprime lending and mortgage derivatives, for example, were viewed as innovations that could benefit many lender and households. The idea was that if there was any problem with those instruments, it would be the concern of the lender and the borrower. So, if they find it in their interest to use the instrument, it must be beneficial to them. In other words, many policymakers had come to believe conveniently that there was no case for regulatory intervention and leaving the market to itself was the best thing to do. I say conveniently because there many theoretical and empirical reasons that cast doubt on such a belief. But, they were ignored and the people presenting them were dismissed largely because the dominant simplistic ideology dictated otherwise.

Another fundamental factor behind the current systemic crisis is a major dilemma in America's economic and political system. This system has many points of strength and has managed to self-correct and grow over the past two centuries. However, this same strength enables most people to take it for granted and focus on their own lives. They forget that the system cannot be maintained and enhanced without active participation of informed citizens who hold the public officials responsible. Widespread complacency gives an opportunity to those in a position of power in government and business to pursue their own agendas, sometimes recklessly, until the system plunges into a major crisis.

I am confident that we will recover from the current crisis, though we are paying a high price for the past mistakes. To minimize the chances of another major crisis, we need to better educate ourselves about the intricacies of our complex economic and political system, to enhance the culture of citizen responsibility, to participate in public life more actively.

There is a stimulus package that Congress recently passed just short of $800 billion. Is this an effective measure to bring the economy back toward growth? If not, what would you recommend as a course of action?

We do need a major stimulus package, and it must be put into effect quickly. However, the details of the package also matter. We need to spend on projects that raise the aggregate demand for goods and services and, at the same time, raise our economy's productivity in the future. But, it is not easy to identify such projects and to make sure that in the haste to spend, we do not end up wasting a lot of resources. These are contingencies for which the government should have prepared itself, but nothing of this sort was done essentially because of the complacency and ideological factors that I mentioned before. The same factors also seem to prevent the stimulus package from focusing more on projects that are likely to be worthwhile, such as spending on public schools and helping the states to meet their basic expenditure needs and to stop laying off workers who are needed for maintaining public services. Without such expenditures, the public sector will be exacerbating the rising unemployment problem and fuel the crisis rather than alleviating it. Efforts to repair and improve the crumbling parts of the economy's infrastructure can also be very useful.

Tax rebates are also seen as quick and good solutions. However, we had a major package of that type last year and its impact was short lived. Another dose of tax rebates is unlikely to address our current economic problems because most people have lost large chunks of their savings and are uncertain about the futures. So, rather than spending more, they are likely to save most of the rebate as a means of replenishing their savings and protecting themselves against possible future income declines.

 
It seems as though the markets in the United States are breaking records on a weekly basis. This collapse has not only been felt on Wall Street, but around the world. How much investment do foreign entities have in the U.S. markets, and how has this collapse affected the economies of foreign companies and their governments?

This is the most recent data that we have on debt is for 2007. In the middle of that year, the total value of debt owed by the U.S. government and the private sector to foreign entities was about $12.3 trillion, which amounted to almost 89 percent of U.S. GDP in that year. At the time, about $2.3 trillion of this amount was invested in US treasury securities, which has largely held its value. The remaining $10 trillion was in the form of private sector financial assets, which is likely to have lost about 30 percent of its value. So, the rest of the world has probably lost $3 trillion dollars of its investments in the U.S. as a result of the financial crisis. Perhaps more importantly, the global economic slow down has reduced the demand for exports in almost all countries and has led to major loss of jobs and income around the globe. As a result, the impact on other countries has been quite significant, especially in East Asia that has been the largest exporter and biggest creditor to the U.S. For example, while in the fourth quarter of 2008, real GDP fell by an annualized rate of 3.8 percent in the U.S., it fell by 21 percent in South Korea and 17 percent in Singapore. Japan's exports have dropped by 35 percent in the 12 months to December. For Taiwan, the corresponding drop has been 42 percent! These declines are causing major unemployment problems in those economies. China has been the largest lenders and exporters to the U.S. and seems to suffering from shock badly.

It is well known that the U.S. has a massive trade deficit with a number of countries, perhaps most notably China. What measures should President Barack Obama take to reduce this deficit? How does this deficit impact our economy?

For a number of reasons, this is by no means a good time to focus on reducing our trade deficits with other countries. First of all, the deficit is likely to decline by itself as our economy shrinks. Also, other countries that used to lend to us will start coming up with strategies to reduce their trade surplus so that they can absorb more of their production in their domestic markets. Second, we need to spend a lot more to keep the economy moving. For this purpose, the U.S. government needs to be able to borrow freely in the short run. Reducing the trade deficit essentially means curtailing our borrowing from other countries, which can be counterproductive. Third, if we try to cut our trade deficit, our trading partners may also try to curb their imports from us, which could hurt the U.S. economy. Fourth, in the globalized world in which we live, our well-being is ultimately intertwined with the fate of the rest of the world. So, to move towards economic recovery, we need to pull the rest of the world with us by continuing our imports from them. Finally, the rest of the world still trusts the U.S. more than any other economy and is willing to lend to it. There is no reason for us to refuse that offer and make ourselves and many other people in other countries worse off. Of course, in the longer run as recovery takes place, we need to save more and reduce our dependence on foreign credit. We also need to help the economic conditions in the rest of the world to improve, so that investment opportunities in those countries expand and serve as productive conduits outside the U.S. for the savings generated around the world.

A large portion of the U.S. national debt is held by foreign countries. Do you foresee the international community resisting continued investment in U.S. markets? What effect could this have on the U.S. economy?

I do not foresee any major pull back of foreign capital from the U.S. markets in the next year or so. It so happens that our financial crisis has created more serious problems in many other countries than we are facing here. As a result, U.S. markets remain relatively better bets. In the longer term, many of our current creditors are likely to create more demand in their domestic markets or elsewhere and reduce their surpluses with us. If this proceeds in an orderly fashion, it can actually be helpful in terms of job creation in the U.S. because those economies will be importing more of our products. However, our consumption per person may stagnate for a while because, in contrast with the past when we could borrow from the rest of the world and consume beyond our means, we will have to work and give up a large part of products so that it can be exported.