Obama’s Gorbachev Moment

By Peter Boone and Simon Johnson

Peter Boone is chairman of Effective Intervention, a charity based in Britain, and a research associate at the Center for Economic Performance, London School of Economics. Simon Johnson, a professor of entrepreneurship at M.I.T.’s Sloan School of Management, is the former chief economist at the International Monetary Fund.

A superpower faces serious economic decline. People become increasingly nervous about the government’s ability to make good on its obligations, and the country’s broader global role comes into question. Recent foreign wars have not gone well. Citizens ask: Can we really afford to project the same degree of worldwide influence as in the past?

Into this difficult situation steps a dynamic young leader, with strong popular support, high expectations and a positive international image.

His name is Mikhail Gorbachev, and the moment is the Soviet Union in 1985.

Mr. Gorbachev, of course, did exactly the wrong thing. He borrowed abroad, printed money to finance budget deficits and declined to undertake fundamental reform. You know how that ends.

President Obama’s team has successfully halted what could have been a major financial meltdown, primarily through a combination of sensible fiscal stimulus and a huge amount of unconditional support for the banking system. The risk is they will rest on this success, and fail to undertake the fundamental reform that we now need.

How can President Obama avoid following in Mr. Gorbachev’s footsteps?

First, deal with our structural problems.

The most important is the need to end dangerous rent-seeking — pursuing explicit and implicit government subsidies — in the financial system. This distorts incentives, leads to crazy risk-taking episodes and ties up resources in unproductive uses. America needs to refocus on sectors that can generate real value — think nonfinancial technological innovation, which is our traditional strength.

Unfortunately, the current policy of low short-term interest rates — which helped break the financial panic — now feeds our bad financial habit. Anyone still creditworthy can take out a low-interest rate loan in American dollars and make money buying assets overseas. Stand by for another financial bubble masquerading as a “shift in fundamentals” — probably someone will soon try to sell you on “China rising” or a broader “new emerging market model.”

You know the outcome already: A few “financial wizards” and their bosses will get another rich take; we’ll get another big bill to pay.

To stop this potential bubble we need to raise interest rates as soon as feasible, i.e., exactly what the Federal Reserve didn’t do as it tried to reflate after the dot-com bust earlier this decade. Such a change in interest rates would imply letting some banks fail, as they make less money when short-term interest rates go up relative to long rates. We therefore urgently need measures to ensure no systemically important institution can ever again be “too big to fail”.

Second, we need to take the bitter pill of fiscal consolidation.

Stop asking the Chinese to buy our debt. Rather, announce a credible path to bring down the fiscal deficit in 2010 towards 5 percent of gross domestic product. President Obama should lay out how to achieve a more nearly balanced budget by the end of his first term — particularly stressing the need for new sources of revenue. The American state is fiscally underdeveloped, given what we are trying to achieve at home and abroad. This needs to be explained clearly and repeatedly by our top leadership.

Third, we have to stop hoping the Saudis will bail us out.

Let them do as they please with their resources, and let us take serious efforts to end our dependence on oil. Committing to gradually but steadily rising taxes on petroleum products will reduce demand, encourage substitution and produce a great deal of new innovation — as well as more government revenue. This is a top priority for national security, as well as good economics.

If the choices in such situations were easy or palatable, Mr. Gorbachev would still be in power.

Comments are no longer being accepted.

Lonely Pedant June 4, 2009 · 9:08 am

Mr. Gorbachev also had to contend with calamitous drops in the price, and then production, of crude oil, whose export was the Soviet Union’s chief source of hard currency.

Nevertheless, an interesting comparison. Fine piece!

David Kleinberg-Levin June 4, 2009 · 9:26 am

These recommendations make sense, but too many Americans cannot see the larger picture & resist the necessary measures.

DMR June 4, 2009 · 9:44 am

When Gorbachev took office, it was year 6 of their war in Afghanistan. They lost in year 9.

Old Nick June 4, 2009 · 10:13 am

Just one modest point:

The piece states (and it took two journalists to say it):
“Let us take serious efforts to end our dependence on oil.”

The answer: raise the tax on oil!

Oh, well, perhaps something serious will come along…..

David June 4, 2009 · 10:26 am

The key phrase here is “given what we are trying to achieve at home and abroad.”
Our political system promises to satisfy a menu of “wants”, achieving majority consensus by neglecting a realistic projection of costs.
Only after you have bought and consumed your meal do you find out the price.
At that point those who sold you the meal look at one another, like Boone and Johnson do here, and say, “We know we promised no new taxes, but let us explain to you once again about free lunches and unicorns.”

It looks like the “Reagan Revolution” essentially ran up the deficit, strategizing that if Repubicans spent all the available money, there’d be none left for liberals to sanely expand their programs. It seemed to work until Bush showed them that we could still spare another trillion for a war, and yet another trillion for TARP. The current administration has taken that logic a step further, such that it now looks like a virtual suicide pact.
We appear to be at the point where our ability to repay our loans is nearly impossible, so we decide to throw a monster open house party and drink our cares away.

The alternative is to admit that we can’t afford everything we “want”, and to scale way back on our expectations. But that kind of mature responsibility is not just lacking in our politicians. More fundamentally, it is lacking in the population which elects them, and lacking in the zombie culture this country has descended to.

Ed Jones June 4, 2009 · 10:52 am

Noble ambitions but politically unrealistic. Unfortunately, the only policy options that are politically realistic are also woefully inadequate. Welcome to California.

Levi June 4, 2009 · 12:35 pm

Very good article. More people need to be publishing these thoughts.

“Old Nick” – Your comment made no sense. Did you read the next line?

MARK KLEIN, M.D. June 4, 2009 · 12:56 pm

My heart sank last night listening to Obama justify our hopeless Soviet style war in Afghanistan. We are exactly where the Soviets were 10 years before it suddenly imploded. America vanish? Recently a well known pundit predicted a Republican presidential victory in part based on Texas and Alaska peacefully seceding by 2112!

Wonks Anonymous June 4, 2009 · 1:41 pm

So we give the banks free money and, rather than use it to lend to people with productive ideas, they use it to buy up foreign assets.

And your solution to this is to raise interest rates when we are at about 10% unemployment and negative economic growth?

Meanwhile we have a large deficit but we also have a huge domestic savings glut. Americans are trying to save, putting money in the banks and getting zero or negative returns because the banks are treating it all as free money and using it to build up their balance sheets or speculate in foreign assets – see above.

And your solution is to cut government spending when we are at about 10% unemployment and negative economic growth?

I would propose that we need a new banking system:

//wonksanonymous.com/2009/05/09/save-free-enterprise.aspx

And that we need to finance the deficit by direct market of small denomination government bonds to the public:

//wonksanonymous.com/2009/02/17/recovery-bonds.aspx

But I was never trained in finance.

tehdude June 4, 2009 · 1:49 pm

Good show on recommending higher interest rates, did not expect to see that on a liberal sight.

When I was an undergrad, the econ majors were still denying that inflation existed…

Joe P June 4, 2009 · 2:08 pm

Interesting comparison. But saying that Gorbachev would still be in power had he made different economic decisions ignores the influence of the “outer empire” and Gorbachev’s refusal to use coercion, which many have argued was the key reason for the fall of the U.S.S.R. But an interesting analysis nonetheless.

Patrice Ayme June 4, 2009 · 2:30 pm

All of Obama’s choices have been the easy ones, so far. But the road is hard, and will require hard choices, exactly the type of choices Gorbachev was incapable of taking.

The wars in Iraq, Afghanistan and Pakistan are just expensive campaigns of recruitement for Muslim fundamentalism of the aggressive type, and are, of course draining.

But Obama thinks he has shown himself as a tough guy by sending 17,000 more men in Afghanistan. He may as well have send 17,000 ducks to the Taliban for the hunting season , because proper anti insurrection methodology would require to send millions (!)

And so on. It is easy to be a servant of the plutocracy, dressed in $1,000 suits, it is hard to change the course of civilization with really different ideas.

Patrice Ayme
//patriceayme.wordpress.com/

Mark T June 4, 2009 · 2:48 pm

Sorry. The authors paint a very misleading picture of the collapse of the Soviet Union. First, it was heavily driven by ethnic separatism. Second, although totally ignored by the authors, but as was well recognized at the time, the Soviet Union was the paradigmatic example of a state whose public sector corrupted and devastated economic productivity, leaving the state unable to finance the needed military expenditures. I am amazed that the authors use the collapse of the Soviet Union as a lesson on the need to increase taxation and reduce profit seeking.

The problem with the United States economy is that it now competes on a global platform burdened by relatively high wages and compliance costs while its political and media elite continue to promote a culture of entitlement that was only sustainable when the competition was much weaker. The gap between the reality and the myth is what fuels class warfare.

E-VEBLEN June 4, 2009 · 3:00 pm

Generally agree with the points you make on fiscal consolidation. This is arithmetic. The hard part appears to be the politics, and, underneath Bernanke’s warning is the fear that, at some point, arithmetic will overtake the politics.

However, I strongly take issue with your characterization of the Fed’s have kept short-term rates low long after the trough in November 2001. In fact, U.S. payrolls continued to shrink for another 20 months beyond that trough, and real compensation rates remained depressed and robust productivity growth (as a result). In real time, raising rate risked upsetting a relatively tepid and jobless recovery with almost no signs of wage-push inflationary pressures.

We appear to be headed toward the same kind of mis-phasing of product and labor markets at some point in the near term. Assuming that could be the case, are you willing right now to commit the Fed to raise the target funds rate once the product market shows some improvement, independently of what labor markets are showing?

The idea that “loose money” and “global saving gluts” CAUSED the financial crisis is preposterous. But it is repeated glibly by many economists and just about everyone else and, over time, will lead us to forget how toxic is the mixture of seminal lunacy and unmanageably large financial institutions that control the payments system.

Art June 4, 2009 · 5:36 pm

Mark T., the parallel between the Soviet Union as, to quote you, “the paradigmatic example of a state whose public sector corrupted and devastated economic productivity,” and the United States, where, to quote the authors, “dangerous rent-seeking — pursuing explicit and implicit government subsidies — in the financial system … distorts incentives, leads to crazy risk-taking episodes and ties up resources in unproductive uses,” bears close examination.

Walter G June 4, 2009 · 7:16 pm

So let me get this straight: financial companies lobby the fed for loans which are not used to invest at home, but are spent abroad? And on top of that, not only is the government’s money tied up for x amount of time and only makes pennies of interest when paid back, but this has the potential of reflating another bubble that the US will have to step in and fix again? Make them clowns invest in non-Apple technological companies (I can’t help myself, sorry), so we can become a 21st century nation as opposed to helping China, India, and Russia leapfrog us. What is that all about? Throw the money-changers out of the temple.

kenny September 23, 2009 · 12:46 am

this guy must be an economist. what does he propose we substitute for cheap oil?

Steve September 25, 2009 · 4:38 pm

Obviously the two journalists that wrote this article have no understanding of history nor economics. The Soviet Union had a state controlled economy which ran without market forces, competition, supply and dement, property rights, there were no free markets. The country was dependent of its resources and its internal order book which had no mechanism to coup or deal with economic forces. This article is comparing apples to oranges. The Soviet Union imploded because Mr. Gorbachev wanted it to implode, he understood that market forces and free markets in an economy are good and necessary. Unless Mr. Obama is planning to turn our country into a communist dictatorship, which I honestly believe that he is not, then we’ve nothing to worry about.

Scott April 15, 2010 · 8:36 am

@ Steve:

Although your point that the comparison with the Soviet Union is apple to oranges is valid, I would hardly say Gorbachev WANTED the USSR to collapse. If you look at the history from that period, it was Yeltsin who engineered the collapse, with Gorbachev merely signing off on it following his lame duck status after the failed KGB coup attempt.

Also, though the exact comparison itself is inaccurate, I think the author’s point still stands. America has become just as dysfunctional politically (if you consider the true state of political affairs from local to federal levels today) and our economy has also just taken a severe blow. Combined with our unnecessary wars in Iraq and Afghanistan (which are all too similar to British and Soviet occupations), we need to implement some serious reform as a nation or face harsh consequences.

Malcom Reynolds October 20, 2010 · 7:33 pm

That article was most excellent. It was both accurate and well written. My compliments to the author. I believe the points and issued raised here are a sound warning to us all. We need to get back to our roots, so to speak, and start doing what has worked for us in the past. Else we are in for more financial trouble.

jon banquer December 9, 2010 · 8:15 am

Umm, Steve ?

“The Soviet Union had a state controlled economy which ran without market forces, competition, supply and dement, property rights, there were no free markets.”

That describes China to a T. And yet they are kicking US butt. Please don’t hand me the “oh no, they are capitalists now” nonsense. I live here. One or two layers deep *everything* in China is the government.

I’m not promoting that as a model but your naive faith in the neocon economics primer is amusing.