The US has developed some features more typically seen in an emerging market, including disproportionate power and system-threatening activities in the finance sector. In fall 2007, the US (and the world) experienced the kind of precipitous fall in credit, output, and employment that was, in modern times, seen only in “emerging market crises”. Our first Baseline Scenario was controversial and largely dismissed when it first appeared on September 29, 2008, but many of its arguments and policy recommendations have now been absorbed into official thinking (at least in the US).
Is the US out of the emerging market-type woods? Can we now rule out the possibility of a great depression? Such a severe economic outcome is not currently our baseline view (e.g., as discussed in this NBR interview), but it is still a downside scenario that needs to be taken seriously – and, at least in our interpretation – this is also the view of Bernanke’s Fed (see our piece on Sunday and the profile in yesterday’s Washington Post.)
Why is a depression scenario still on the table?
The problem is not the potential degree of insolvency of banking per se. And it’s not only about the way financial markets operate. Nor is it just about how the market for credit default swaps (created by and for big finance) is proving – once again – to be a powerful, potentially self-fulfilling mechanism for betting on financial institution failure.
Rather, the danger in this situation arises primarily from the attitude and approach of the US Treasury. We are supportive of this Administration on many issues, and I applauded the ideas and actions of Treasury around the G20 last week. But I don’t think Treasury understands the potential speed with which the crisis can again become more severe – moving back into another phase of chaotic jumps in financial distress around the world.
The most compelling evidence for lack of readiness comes from those who are now most articulate in Treasury’s defense. “Congress will not provide any more money” and “you must recognize the political constraints” are sensible points. But think about what they also imply. Treasury is not making the case, full-time and flat-out, for more funding – on a contingency basis – from Congress. At least from my conversations on Capitol Hill, I see no signs that this is Treasury’s top priority. In fact, I would go further and be blunter: no one is ready.
I recognize that this would be a hard sell. And I understand that the mood is shifting away from bailouts and towards attempting to manage some sort of debt-for-equity swap; which seems to be what the WSJ is heavily hinting at this morning. But if you’ve taken nationalization off the table and you have very little cash remaining for anything bailout/rescue-related, you are vulnerable to runs.
The only way to stop speculators is with massive financial firepower (you must be able to scare them; no one way bets on bank defaults) and a credible set of policies that show things are going to turn around (act at the system level; don’t try to handle the banks piecemeal). Don’t let bankers’ past misdeeds (or current power) and market panics ruin the economy and so many people’s lives. Go get the money from Congress – Capitol Hill is full of responsible and responsive people, but the Administration has to make the case, at the highest levels and in the most persuasive manner that saving the financial system from collapse is our top priority.
Don’t make the mistake of Hank Paulson who, until September 17th, always assumed he had more time to prepare (or just prevaricate). When the crisis is upon you, there is no time.