Day: October 1, 2008

Wake Up and Smell the European Coffee

At a Brookings panel today and even more so on a LA-based NPR radio show (“To the Point,” KCRW) just now, the impact on the “real economy,” i.e., people and businesses outside the financial sector, was the issue of the day. And people are beginning to understand the serious consequences of our financial system problems, with or without the Paulson Plan becoming law this week.

Here’s what I suggested at Brookings this morning, for the US, which is pretty close to what is in our Baseline Scenario, First Edition:

  1. Tell everyone that their deposits are safe. Explain that no one has ever lost a penny when the FDIC has been involved and, de facto, they always pay all depositors, even those with over $100,000. I recommend removing the deposit insurance cap. In other words, do what it takes to stop the run.
  2. Then work on bank recapitalization, right away (I think you can see the consensus moving in this direction already this week; I’ll try to post on the emergent schemes tomorrow)
  3. And deal directly with the underlying troubled mortgages (again, I hear ideas emerging fast; give that a couple more days before I do a survey)
  4. And get ready to provide a substantial fiscal stimulus. But don’t even think about this unless you have done 1, and much of 2 is in place, and the programs to deal with 3 are on their way.

Perhaps the overlooked issue of the week was the speed with which the crisis is clearly going global, with now a long list of European countries having banks in trouble. Europe also needs to stop the run on their banks before it gets out of hand.

One sensible way to do this would be with a large Europe-wide fund to inject capital and receive preferred equity in banks, on terms advantageous to taxpayers. Yes, this is point 2 above, on steroids. Of course, they have to deal with underlying domestic mortgages in Ireland, the UK and Spain (but not yet in other countries). The danger in Europe is that they don’t have as much fiscal space as the US (so point 4 is an issue) and their central bank is stuck with a mandate (i.e., just worry about inflation) that would have been nice to have in the 1970s, but may not be quite so appropriate today.

The severity of the global recession is going to depend, in large part, on the speed with which governments in Europe can organize swift, comprehensive and decisive support for their banking systems.  And, following that, it will depend on exactly how the process of deleveraging (this is jargon essentially, meaning reduced lending by the financial sector) is handled.

The latest news from Europe (timely, thanks to the Financial Times): there will not be an immediate systematic rescue.  It’s the French who seem to have understood what is really going on.  Unfortunately, as of now, their European partners have not yet woken up to the new realities.  In particular, Germany and perhaps the UK seem to stand in the way of a more systematic approach.  This has dangerous implications for the US.

Days to the election: 34

Financial Crisis and the Real Economy

One of the biggest questions about the financial crisis – one heard from Capitol Hill to radio talk shows to casual conversations with friends – is why it matters for ordinary people. One major reason a significant proportion of public opinion is against the rescue plan is the general failure to make the connection between panics in the financial sector and the ordinary lives of everyday people; simply saying that the plan is necessary to prevent (or moderate) a recession smacks too much of “trust me” to be credible.

The connection is that much of the ordinary activity in the real economy relies on credit – think no further than the volume of purchases made using credit cards. (Although banks have been reducing credit limits, there is little risk for now that credit cards will stop working overnight.) And in today’s conditions, when many financial institutions are potential victims of liquidity runs, lending has virtually ground to a halt. The New York Times has an article today about the impact that the current crisis is having on local governments suddenly unable to raise money for ongoing projects such as highway repairs and hospital expansions. Across the country, local governments issued $13 billion in fixed-rate bonds in the first half of September – and $2 billion in the second half. A sudden 87% drop in a major source of municipal funding is a very real impact of the financial crisis, and one that will necessarily result in both fewer services and fewer jobs for taxpayers.