What happened to the global economy and what we can do about it
Day: October 20, 2008
Besides the questions we get in comments, we got a bunch in email last week because of our op-ed in the Washington Post. (By the way, I’m behind in responding to comments on the blog, so if you see one you can answer, by all means go for it.)
Here are a few.
1. Is mark-to-market accounting part of the problem? Should it be replaced by discounted cash flow valuation?
South Korea was one of the major casualties of the 1997-98 “emerging markets” crisis. I put “emerging markets” in quotes because, at the time, Koreans were very proud that their country had the 11th-largest economy in the world. Today it is 13th, by nominal GDP.
Yesterday South Korea announced its version of the bailout plan that is sweeping the world – $30 billion in foreign currency reserves made available to its banks, and a $100 billion guarantee on new foreign debt of its banks. But in Korea, the stakes are higher than in the US and other G7 countries. Korea is another of those countries whose banks’ have a disproportionately high level of foreign currency obligations. Rolling those over suddenly got a lot harder in the last month, for reasons we all know; now as creditors fear that banks may not be able to pay them off, the currency declines, making them even harder to pay off, and so on. The central government has $240 billion in foreign currency reserves, but that may or may not be enough to support its banking sector, which has $235 billion in foreign liabilities.
Korea is important not just because my family is from there, but because it is so big, economically – three times as big as Iceland, Hungary, and Ukraine put together in GDP terms. If the crisis spreads to countries of Korea’s scale, it’s not clear that the IMF has the resources to bail them out (and an IMF bailout would be enormously unpopular in any case).
The TED spread is down again today to 3.20 (down from 4.64 at its peak ten days ago). This means that banks are beginning to lend money to each other, which means we are less likely to see serial bank failures and a complete collapse of the financial system. This is good.
However, all is not rosy. Mortgage rates unexpectedly shot up last week – from 5.87 to 6.38 percent for a 30-year fixed-rate mortgage in the US – in a demonstration of the law of unintended consequences. Apparently, what happened was this. During the panic, investors lent money only to the US government, not to banks. However, since the nationalization of Fannie Mae and Freddie Mac, they have been regarded as as safe as the US government, and hence benefited from abnormally low funding costs. As banks become more attractive places to lend money – particularly because of the government guarantee on new senior debt, which means existing debt gets safer (banks can issue new guaranteed debt and use it to pay off the existing debt) – Fannie and Freddie become relatively less attractive. So their borrowing costs go up, and because they play an enormous role in the US mortgage system, mortgage rates go up.
The short-term jump is probably not something to get too worried about, since it basically corrects an anomalous feature of the last few weeks. However, it points out a larger problem. The Fed and Treasury are like firefighters. They decided that the top priority was preventing a collapse of the financial sector, and I agree with that priority. But now that banks are beginning to lend to each other, the next priority is resuscitating the real economy, and for that banks will have to lend to real people and real companies. We aren’t there yet.
The Baseline Scenario 