What happened to the global economy and what we can do about it
Day: October 6, 2008
My co-author, Simon Johnson, will be on C-SPAN’s Washington Journal show tomorrow (Tuesday) morning from 7:30 to 8:30 in the morning, U.S. Eastern time. He’ll be discussing – what else? – the global credit crisis. It’s a call-in show, so you’ll be able to submit questions live.
Update: You can see now watch the show online here.
Let’s say you face a pervasive loss of confidence in your financial institutions, the stock market just fell 7 percent, depositors are (needlessly) rattled and a certain small country is talking about something that sounds ominously like a significant default (it’s Iceland on line 2). What do you do?
Your instinct might be to go for a broad bold package of measures, throwing a great deal resources in to strike at the root causes of the problems at the same time as addressing some of the more painful symptoms. But that is because (and part of why) you are not a leading economic policy official in a G7-type industrial country.
These officials are outstanding individuals, who take their jobs seriously, work hard, have the highest standards on all dimensions, and are very smart. But they have been trained, just as their mentors were, and their mentors before them, to make macroeconomic policy in small steps. The best way to unsettle the markets, they have learned, is to be overly bold. Macro management, the mantra holds, needs a steady hand and an unblinking eye. And policy changes should be incremental: 25 basis points (that’s 0.25%) is a much favored step in interest rates, up or down.
All of this is completely reasonable and makes a lot of sense in ordinary times. And the times have been ordinary on almost every day over the past 60 or so years. In fact, if you spend time with long-time practitioners, they are hard pressed to find a close parallel to the circumstances of the past 3 weeks.
And this is the point. Someone who has had every kind of experience in the US market over the past 35 years, up and down, boom and bust, is in all likelihood not at all prepared for the situation we now face. What we are seeing now in the United States and, just as amazing, in Western Europe is the kind of situation that, in our lifetimes, has only been seen in middle-income “Emerging Markets” open to capital flows.
It is, of course, the capital flows that make the difference. If you build an economy in which financial services are large relative to other economic activity and have a high ratio of debt-to-equity (check that box for the US and Western Europe), you are vulnerable to “jumps” downward in confidence. Of course, you can also get confidence to jump upwards, but this is not so easy. (This is the fish soup problem.)
Now, I do think that officials in the G7 and other rich countries will eventually figure out what they need to do. They will take their time, organize big packages (along the lines we are suggesting, at least roughly), and they will show up eventually with overwhelming financial force. But the odds on this happening soon are slim. They need more discussion among themselves (which they do a lot), more analysis (they read everything), more reports (very important for shifting the consensus) and – above all – much more by way of downward movement in markets. We will get there, but not tomorrow and, I’m afraid, not this week.
Days to the election: 29
One week ago, the House rejected the bailout bill and the Dow fell more than 700 points. That fall was a major reason why public opinion shifted from heavily against the bailout to confused, and why the bill passed on Friday. On Friday, though, the Dow fell another 150 points, and today at 1 pm Eastern it’s down another 500 or so.
Before panicking, though, we have to consider what this means. Broadly speaking, we are faced with two related crises, each of which is approximately represented by a different market. The first is a global economic slowdown that people have been talking about for months. The second is the acute credit crunch that hit after Lehman went bankrupt on September 15.
Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.
Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people’s investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don’t cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll. (See the posts tagged “real economy” for a couple examples of this.)
Now the credit and stock markets are related, because when the credit market freezes up, people’s expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. (As Simon advised me, if you write a post entitled “your money is not going to go poof,” as I did, 20% of your readers won’t see the “not.”)
So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble – given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.
As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy.
Since launching a week and a half ago, we’ve gotten far more attention and input than we expected. Thank you for your attention, your participation, and your comments. In addition to some of the comments I answered directly on the post in question, I answered some more below. I’ll try to do this periodically. I apologize if I didn’t get to your question; there are just too many to respond to all of them.
Update: I’m restructuring some of the blog to use fewer pages, so I copied the contents of the old page below. To do this I had to copy-and-paste the comments, but they are all still there.
For reasons of space, I’ll have to paraphrase some of the questions.
1. Why not use the bailout money to buy houses outright, which will also prop up the mortgage-backed securities everyone is worried about?
Continue reading “Financial Crisis – Reader Questions, 10/6/08”
Our weekly baseline scenario is divided into three parts: updates since last week; our analysis of the current situation; and our policy proposals. First-time readers should begin with the analysis and continue with the proposals; returning readers may want to just read the updates and the proposals. (Or download the complete baseline in PDF.)
Despite what seemed at times to be a week filled with news, we think events remain track within our Baseline Scenario from last week. A big global contraction of credit is underway and a severe recession is in the cards almost everywhere. Governments continue to respond too slowly and too partially to this. Europe in particular remains largely in denial (amazing though that may seem after 10 days of bank failures).
Overall, however, our message remains reassuring. Policy can turn the situation around quickly, if it is applied in a decisive manner (see our policy proposals). We are optimistic that political leaders will eventually rise to the occasion.
You have probably heard the term, “Living on Internet Time,” which means to experience life at a hectic pace. I’m afraid we are now living on Financial Market Time, which is like Internet Time, but with teeth. It would be better if political leaders could step up sooner rather than later.
Editor’s Note: The original version of this document was a separate page with a link from the short blog post above. I have since consolidated the long document into this blog post. It follows after the jump.
Lech Walesa, electrician turned President of Poland, famously quipped that, “it is easier to make fish soup from fish than vice versa.” He was talking about moving from quasi-socialism to a more market-based economy, but the same thought struck me when I read today’s announcement that the British Chancellor of the Exchequer will soon put in place a bank recapitalization scheme.
My first reaction was positive, particularly as this is something we have been arguing for. But then I began to wonder if the scale would be sufficient, if it would be combined with measures to restructure mortgages for people with negative equity (an important upcoming issue for the UK), and if it would be supported with a sufficient fiscal stimulus.
I don’t know if the market was having similar thoughts, but as I write (very early on Monday, Oct. 6) it seems like more people are thinking in terms of a global recession scenario (e.g., oil is approaching $90 per barrel). Once people see the need to deleverage (reduce the amount they borrow) and reduce their risks, it is hard to get them to go the other way. Measures that would have been preemptively brilliant 6 months ago, may now have very little or zero effect.
Increasingly, it seems like only a decisive package of measures will turn things around. And even then, such a package may not be easy to adopt until the situation is considerably worse than it is today.
Days to the US Presidential Election: 29.
The Baseline Scenario 