A lexicon of woe for today's dismal science

Buzzwords, phrases, and theories at the heart of the economic crisis

By Greg Robb, MarketWatch

Last update: 7:22 p.m. EST Dec. 12, 2008

WASHINGTON (MarketWatch) -- Economic theory is born, and tested, in the crucible of recession and crisis.

During today's cataclysm, the big questions center on how far the economy will fall, what is the best way for policy-makers to respond, and even more critically, what direction leaders should head.
At the same time, economic milestones of the past, like Sweden's banking crisis and the Japanese meltdown, are receiving more attention. Scholars and decision-makers seek to draw new lessons from the historic record while a new chapter is being written.

And with that, an epic debate rages about a new age for the dismal science, prompting ordinary people to get familiar with economic concepts that are often arcane and controversial.

Terms of the debate alone are enough to leave most investors bewildered. To cope with the process, here is a guide that sheds light on some hot buzzwords and topics being debated among policy-makers and pundits alike. But investor, beware. The concepts mean different things to different people, depending on their perspective -- and agenda. You'll hear them being used more and more to advance an argument, and now you'll be better able to get their meaning.

This is the Federal Reserve's fancy way of describing today's economic environment without resorting to expletives. In comic book terminology, it is a hurricane of havoc. The fragile banking sector is weighing on growth, pushing down GDP. This is making the banking sector even more fragile reinforcing the downward trend. It is the top reason policy-makers are pumping billions into banks. Stability is essential to keep the hurricane from blowing everything away.

Capitalism: It's evolving

In the wake of the government's $700 billion mandate to save the banking industry and the pleas of auto companies for their share, many politicians are scrambling to reaffirm their faith in free-market capitalism. But American capitalism has never been as pure as the driven snow. Since the late 1880s, the U.S. economy has evolved into something more like "nanny capitalism," as companies that mess up can come to the government for help, says Dean Baker, co-director of the Center for Economic and Policy Research, a liberal think-tank. The idea of a state absolved from entering the corporate realm exists only in fantasy. "There isn't a world," says Baker, "where the economy is independent from the government."

China: Prosperity or peril?

Americans seem to believe without question that China is the big winner in the current crisis. After all, it appears flush with cash and is the top buyer of Treasury debt. There's more to China than meets the eye. After one long boom since 2002, China's economy now appears to be slowing more than expected, says Brad Setser, an economist with the Council of Foreign Relations. This slowdown will be a "test for the Chinese how strong its institutions are," he says. China has announced a $586 billion stimulus package but only $120 billion of it appears to be "new money." Not such a great start. And the Chinese government's penchant for secrecy makes it difficult to get a good read. John Makin, a scholar at the American Enterprise Institute, just returned from China and he discovered "nothing but closed factories."

Creative destruction: A paradox for our times

A core tenant of free-market economics that innovation should be allowed to destroy the value of established companies and jobs. Think what digital cameras have done to photo-clerks. The idea was popularized by the late Harvard economist Joseph Schumpeter and trumpeted often by Alan Greenspan. It is the premise for the school of thought that takes a hands-off approach to the downturn, regardless of its severity.

Deflation: Can it happen here?

Deflation is the mirror condition of inflation. That is, generally falling prices, and it's just as big a danger. It's especially harmful on households with high debt burdens. Galbraith says the U.S. is experiencing asset-price deflation, not general deflation -- but the difficulties are similar. Fed officials say they have a playbook for deflation that was famously laid out by Fed chief Ben Bernanke in 2005. But that speech at the National Economists Club titled, "Deflation: Making Sure 'It' Doesn't Happen Here." The speech earned Bernanke the nickname "Helicopter Ben," a play on Milton Friedman's famous line that the government could print money and throw it out of helicopters to end a depression.

Depression: When do we put a more dramatic label on recession?

In general terms, a depression is a severe recession. But how severe? The old saw is that a recession is when your neighbor loses his job and a depression is when you lose your job. The distinction is murky. Don't look to the National Bureau of Economic Research, the official umpire of recessions, for help on this. They refuse to get involved. David Owen, an economist at Dresdner Kleinwort, suggested a recession turns into a depression if it lasts more than three years. Most Western recessions last only a single year. Some last two years. Only one has lasted longer that wasn't the result of war. They rarely last longer than that and only one -- the Great Depression -- was not the result of a war. We are still a long way from repeating that depression, economists say. Between 1929 and 1932, GDP fell by almost 30% in the U.S. The unemployment rate topped 23% in 1932.

Globalization: Inextricably linked around the planet

Today's international-economic stakes are higher than ever. The increased interaction between nations, principally trade and investment flows that developed after the fall of Communism. Russia, China and India have joined the global economic system. Globalization was great on the way up. It seems pretty miserable on the way down, says Ed Yardeni, president of Yardeni Research. Economists are now coming face-to-face with the likelihood that economic weakness can spread quickly in the new system. "The more inter-connected the world has become with more complicated supply chains, the more likely a recession can spread across economies and across companies and sectors," wrote David Owen, economist at Dresdner Kleinwort

Japan: A landmark banking crisis

Economists are focusing attention on Japan, which remains in the intensive care unit after its banks succumbed to bad loans in 1989. The bursting of Japan's twin bubbles in equity and real estate led to a "lost decade" of stagnation. Desmond Lachman, an analyst at the American Enterprise Institute who is a former official of the International Monetary Fund, said projected losses from the U.S. banking crisis are approaching $1.4 trillion, or 10% of GDP; Japan's crisis cost 14% of its GDP. "Our problem is now assuming the same proportion," Lachman said. Key lesson: The Japanese government is widely criticized for remaining in denial about its crisis for far too long. As a result, Ben Bernanke and Henry Paulson have struggled to head off unnecessary damage.

Keynesianism: Man behind monetary policy

A liquidity trap (see below) is precisely the situation studied by John Maynard Keynes, the father of modern macroeconomic theory. His answer was that government has to step in and do the spending. Monetary policy is simply "pushing on a string" in the situations, Keynes said. There are opponents of this theory. Galbraith called them "un-teachable." Keynesian economics "does describe the way the world works," Galbraith said. But there is a nagging body of belief that it was World War II that ended the Great Depression, not any fiscal program.

Liquidity trap: Where we are now

Go outside and take a look around. It might be hard to tell, but we're in a liquidity trap, most economists agree. Think of it as a roach motel. The Fed is pumping up reserves into banks, but as with a roach motel, what goes inside never comes out. People do not want to borrow, even with lower interest rates. So far, the Fed monetary policy has been like pushing on a string. Some say they're pushing into a liquidity trap. "There is a good case we're in it now," says James Galbraith, a professor of finance at the University of Texas. The term is a kind of pejorative for Fed officials because it suggests policy is powerless.

Monetarism: Freedom fighters seeking to hold the line

This is the free market theory that came into vogue under President Reagan but it really began to influence policy under President Bill Clinton. Monetarists believe that the free market should be unfettered by regulation. It was championed by Milton Friedman. Its influence may have reached its zenith now that there is a financial crisis and the government is no longer seen as quite the same joke as Reagan's quip "I'm from the government, I am here to help." Monetarists don't like bailouts. Capitalism without failure is like religion without sin, says one prominent monetarist, Alan Meltzer, a professor at Carnegie Mellon.

Moral hazard: Running amok across the land

Moral hazard is an economic term that describes the general notion that people with insurance tend to take greater risks with their insured property. But the same holds true on a larger scale. If you rescue a bank, they will take even more risks next time or operate under the assumption that you will bail them out again. Experts say that the government actions to rescue the financial markets have already loosed a virulent new form of moral hazard on the land that will be difficult to get back in the bottle. Just look how top executives of failed brokerages want millions of dollars in bonuses and AIG feels free to use bailout money for deferred compensation for top executives.

Protectionism: Stopping the return of beggar-thy-neighbor policies

The broad name for trade barriers that defend domestic industries at the expense of foreign competitors is once again part of the debate. With all the major developed economies in recession at the same time (for the first time since World War II), governments are coming under renewed pressure to resort to trade restrictions and tariffs. It was a critical problem during and after the Great Depression. One big fear is that China will give special perks to its export sector. That's gotten fresh attention in recent days as the Chinese currency has fallen sharply.

Quantitative easing: The Fed's new tool-kit

Investors are used to monetary policy being conducted by targeting short-term interest rates. But with the Fed's target rate at 1%, the Fed is has had to stretch its tool kit for new ways to spur growth. Quantitative easing is very scientific word for when a central bank turns on the printing press to try to pump up the economy. It became famous when Japan adopted the strategy after its interest rates sank to zero. Some forms of the practice are buying mortgage backed securities, a step announced by the Fed recently. But U.S. government officials bristled at the suggestion a quantitative easing has begun. They argue that the strict definition is to add to reserves to affect bank behavior.

Regulatory capture: The core problem for Washington?

Lawmakers already are determined to re-regulate Wall Street in the wake of the financial crisis. But experts say these efforts may be in vain unless some cure is found for regulatory capture -- when regulators eventually come to champion the industry that they are supposed to oversee. This was one of the most important, subtle -- and insidious -- causes of the financial crisis. Case in point: In the run-up to the subprime mortgage crisis, federal regulators acted with a soft touch even after Congress passed laws designed to reduce mortgage fraud. When regulators don't regulate, troubles flourish. No clear fix exists for the problem.

Socialism: A lightning rod and a way of life

Calling someone a Socialist is a trendy insult in Washington. This is curious because many economists believe the Treasury giving capital to banks has tipped the U.S. further into state socialism, defined by Webster's as "an economic system with limited socialist characteristics that is affected by gradual state action and typically includes public ownership of major industries." Treasury officials cringe when asked about whether the TARP plan is a form of socialism. Phillip Swagel, an assistant secretary who advises Paulson on "all aspects of economic policy," recently spent more than five minutes trying to make the case that the Troubled Asset Relief Program, or TARP, doesn't count as socialism. His rationale: Because the TART is "necessary and temporary." And for the record, he never actually uttered the word socialism. The move towards state socialism is no joke. Chandler, the foreign-exchange analyst at Brown Brothers Harriman, argues that the U.S. is moving toward National Socialism -- made infamous in Germany in the 1930s with disastrous results.

Swedish crisis of '92: Intervention with strings attached

Sweden was also a victim of a banking crisis, theirs in 1992. Sweden is widely considered to have been more hard-line than Japan. The government consolidated banks -- 525 before the crisis to 124 by the time the dust settled. Stockholm also purchased troubled assets. Sound familiar? Some analysts have been urging the U.S. to adopt the Swedish model for solving its crisis, which was much tougher-love than Paulson's current plan of injecting capital into banks with few strings attached. While Sweden came to the rescue of its banks with some heavy conditions, "Japan did not want to acknowledge the bad state of its banking system and the banks took government cash and sat on it," Galbraith says. "In the Swedish case, the bank losses were recognized up front." Still, it took Sweden 20% of its GDP to resolve its banking crisis.

Greg Robb is a senior reporter for MarketWatch in Washington.