I argued that a global recovery is underway and in the rest of the world will likely be stronger than the current official or private consensus forecast, but growth remains fragile in the United States because of problems in our financial sector.  While our situation today is quite different in key regards from that of Japan in the 1990s, the Japanese experience strongly suggests that fiscal stimulus is not an effective substitute for confronting financial sector problems head on (e.g., lack of capital, distorted incentives, skewed power structure). 

We are well into the adjustment process needed to bring us back to living within our means. Although such a process always involves an initial fall in real incomes, growth can resume quickly as the real exchange depreciates.  The idea that we necessarily are in a “new  normal” scenario with lower productivity growth seems far fetched, but continuing failure to deal effectively with the “too big to fail” banking syndrome delays and distorts our adjustment process – it also makes us horribly vulnerable to further collapses.

The fiscal stimulus enacted in early 2009 had a major positive impact, particularly as it was coordinated with other industrial countries – this prevented the global recession from being even deeper (disclosure: I testified to the need for a major fiscal stimulus in October 2008).  But a further broad stimulus at this time is not warranted and the first-time homebuyers tax credit should be phased out.  We should extend unemployment insurance and focus our future efforts on improving the skills of people with less education, e.g., through strengthening community colleges. 

Like all industrialized countries, we also need to look ahead to “fiscal consolidation” in order to stabilize our debt-GDP levels (and pay for the rising cost of Medicare).  The large contingent government liabilities implied by the existence – and potential collapse – of big banks are a major risk to medium-term outcomes.

My written testimony (with some small updates indicated) is below (pdf version).  This is now our revised Baseline Scenario.

Main Points

1. The world economy is experiencing a modest recovery after near financial collapse this spring.  The strength of the recovery varies sharply around the world: 

a. In Asia, real GDP growth is returning quickly to pre-crisis levels, and while there may be some permanent GDP loss, the real economy appears to be clearly back on track.  For next year consensus forecasts have China growing at 9.1% and India growing at 8.0%; the latest data from China suggest that these forecasts may soon be revised upwards.

b. Latin America is also recovering strongly.  Brazil should grow by 4.5% in 2010, roughly matching its pre-crisis trend.  We can expect other countries in Latin America to recover quickly also. 

c. The global laggards are Europe and the United States.  The latest consensus forecasts are for Europe to grow by 1.1% and Japan by 1.0% in 2010, while the United Sates is expected to grow by 2.4% (and the latest revisions to forecasts continue to be in an upward direction).  Unemployment in the US is expected to stay high, around 10%, into 2011.  [Update: the latest quarterly GDP data do not make us want to revise this view]

2. The current IMF global growth forecast of around 3 percent is probably on the low side, with considerably more upside possible in emerging markets (accounting nearly half of world GDP). The consensus forecasts for the US are also probably somewhat on the low side.

3. As the world recovers, asset markets are also turning buoyant.  Recently, residential real estate in elite neighborhoods of Hong Kong has sold at $8,000 US per square foot.  A 2,500 square foot apartment now costs $20 million.  Real estate markets are also showing signs of bubbly behavior in Singapore, China, Brazil, and India. 

4. There is increasing discussion of a “carry trade” from cheap funding in the United States towards higher return risky assets in emerging markets.  This financial dynamic is likely to underpin continued US dollar weakness.

5. One wild card is the Chinese exchange rate, which remains effectively pegged to the US dollar.  As the dollar depreciates, China is becoming more competitive on the trade side and it is also attracting further capital inflows.  Despite the fact that the Chinese current account surplus is now down to around 6 percent, China seems likely to accumulate around $3 trillion in foreign exchange reserves by mid-2010.

6. Commodity markets have also done well.  Crude oil prices are now twice their March lows (despite continued spare capacity, according to all estimates), copper is up 129%, and nickel is up 103%.  There is no doubt that the return to global growth, at least outside North America and Europe, is already proving to have a profound impact on commodity markets.

7. Core inflation, as measured by the Federal Reserve, is unlikely to reach (or be near to) 2% in the near future.  However, headline inflation may rise due to the increase in commodity prices and fall in the value of the dollar; this reduces consumers’ purchasing power. 

8. This nascent recovery is partly a bounce back from the near total financial collapse which we experienced in the Winter/Spring of 2008-09.  The key components of this success are three policies. 

• First, global coordinated monetary stimulus, in which the Federal Reserve has shown leadership by keeping interest rates near all time lows.  Of central banks in industrialized countries, only Australia has begun to tighten. [Update: and Norway, obviously affected by rising oil prices]
• Second, global coordinated fiscal policy, including a budget deficit in the US that is projected to be 10% of GDP or above both this year and next year.  In this context, the Recovery Act played an important role both in supported spending in the US economy and in encouraging other countries to loosen fiscal policy (as was affirmed at the G20 summit in London, on April 2^nd, 2009).
• Third, after some U-turns, by early 2009 there was largely unconditional support for major financial institutions, particularly as demonstrated by the implementation and interpretation of the bank “stress tests” earlier this year.

9. However, the same policies that have helped the economy avoid a major depression also create serious risks – in the sense of generating even larger financial crises in the future.

10.  A great deal has been made of the potential comparison with Japan in the early 1990s, with some people arguing that Japan’s experience suggests we should pursue further fiscal stimulus at this time.  This reasoning is flawed.

11.  We should keep in mind that repeated fiscal stimulus and a decade of easy monetary policy did not lead Japan back to its previous growth rates.  Japanese outcomes should caution against unlimited increases in our public debt.

12.  Perhaps the best analysis regarding the impact of fiscal policy on recessions was done by the IMF.  In their retrospective study of financial crises across countries, they found that nations with “aggressive fiscal stimulus” policies tended to get out of recessions 2 quarters earlier than those without aggressive policies.  This is a striking conclusion – should we (or anyone) really increase our deficit further and build up more debt (domestic and foreign) in order to avoid 2 extra quarters of contraction?

13.  A further large fiscal stimulus, with a view to generally boosting the economy, is therefore not currently appropriate.  However, it makes sense to further extend support for unemployment insurance and for healthcare coverage for those who were laid off – people are unemployed not because they don’t want to work, but because there are far more job applicants than vacancies.  Compared with other industrial countries, our social safety net is weak and not well suited to deal with the consequences of a major recession.

14.  The first-time home buyer tax credit should be phased out.

15.  GMAC should not receive a further infusion of government money.  It should be turned down for any kind of additional bailout; as with CIT Group earlier in the summer, this would force a negotiation with creditors and some losses for bondholders (most likely through a pre-packaged bankruptcy process).  This would not cause a general financial panic; probably it would actually strengthen the overall process of economic recovery, as it would move incentives in the right direction.

16.  The lack of skills among people who did not complete high school or who did not attend college is a critical longer term problem in the United States.  The impact of the recession will exacerbate the problems in this regard.  We should respond by further strengthening community colleges, allowing them to offer more vocational skills classes and to provide a viable way for more people to work their way into four-year colleges.

17.  America is well-placed to maintain its global political and economic leadership, despite the rise of Asia.  But this will only be possible if our policy stance towards the financial sector is substantially revised: the largest banks need to be broken up, “excess risk taking” that is large relative to the system should be taxed explicitly, and measures implemented to reduce the degree of nontransparent interconnectedness between financial institutions of all kinds.

The remainder of this testimony reviews current U.S. macroeconomic issues in broad terms, assesses the lessons of Japan’s experience in the 1990s, and make proposals for further essential reform (both fiscal and financial).

Current U.S. Issues

To be a strong global leader in the future, America needs to generate an environment where entrepreneurship, technological innovation, and immigration ensure that the nonfinancial private sector can continue to propel the US economy. 

It is premature to argue that the US economy has stumbled into a “new normal” paradigm that involves slower growth.  The factors that drove our growth over the last 150 years, particularly entrepreneurial startups and the commercialization of invention, remain despite the crisis.  Indeed, these drivers of growth may become even stronger in the future, if we can reduce the wasteful financial sector activities that grew since the 1980s (and really flourished over the past decade) and allocate resources to more productive activities in the future.  

America needs a new framework to harness that growth.   That framework needs to address the following problems with our current economic structure.

Problem 1:  With the recent financial sector bailouts, we have sent a simple message to Americans: The safest place to put your savings is in a bank, even if that bank is so poorly managed, and has such large balance sheet risks, that just six months ago it almost went bankrupt.

Despite being near to bankruptcy six months ago, Bank of America credit default swaps now cost only 103 basis points per year to protect against default, and the equivalent rate for Goldman Sachs is a mere 89 basis points.  Goldman Sachs is able to borrow for five years at just 170 basis points above treasuries.  This is not a sign of health; rather it indicates the sizable misallocation of capital promoted by current policies.  American’s leading nonfinancial innovators would never be able to build the leverage (debt-asset ratio) on their balance sheet that Goldman Sachs has, and then borrow at less than 2% above US treasuries.  The implicit government guarantee is seriously distorting incentives.

Problem 2:  We have not changed the incentive structures for managers and traders within our largest banks.  Arguably these incentives are more distorted than they were before the crisis. So the problems of excessive risk taking and a new financial collapse will eventually return.  Financial system incentives are a first-order macroeconomic issue, as we have learned over the past 12 months.

Today bank management is strongly incentivized to take large risks in order to raise profits, increase bank capital, and pay large bonuses to “compete for talent”.  Since they have access to a pool of funds effectively guaranteed by the state through being “too big to fail”, there is the potential to make large profits by employing funds in risky trades with high upside.  Such activities do not need to be socially valuable, i.e. it could be that the expected return on the investments is negative, but as the downside has limited liability, the banks can go ahead.

Problem 3:  We have not changed the financial regulatory framework in a substantive way so as to limit excessive risk taking.  The proposals currently proceeding through Congress are unlikely to make a significant difference.

Problem 4:  The policy response to this crisis, with very low interest rates and a large fiscal stimulus, is merely a larger version of the response to previous similar crises.  While this was essential to stop a near financial collapse, it reinforces the message that the system is here to stay.  

Problem 5:  The public costs of this bailout are much larger than we are accounting for, and people who did not cause this crisis are ultimately paying for it.   Taxpayers and savers are the big losers each time we have these crises.  We are failing to defend the public purse.  

Our financial leaders have emphasized that our banks are well capitalized, and no new public funds are likely to be needed to support them.  This is misleading.  The current monetary stance is designed to ensure that deposit rates are low, and the spread between deposit rates and loan rates is high.   This is a massive transfer of public funds to the private sector, and no one accounts for that properly. 

It is striking that the Chairman of the Federal Reserve himself, in a recent speech, stated that no more public funds were needed to bail out banks.  His institution continues to provide massive transfers to the banking system through loose credit and low interest rate policy.  That credit could instead go to others; the Federal Reserve has chosen to transfer those funds to banks.  This policy was used in the past to recapitalize banks (e.g., after 1982), but we have now a very different financial sector – with much more capacity to take high risks and a greater tendency to divert profits into large cash bonuses.

Today, depositors in banks earn little more than the Federal Funds rate and are effectively financing our financial system.  We are giving them very low returns on their savings because the losses in the financial system were so large in the past.  This is essentially public money – it is the pensioners, elderly people with savings, and other people who have no involvement in the financial system, that are being required to suffer low returns to support the banks. 

We Are Not Japan

After the bursting of its real estate bubble, at the end of the 1980s, Japan faced a serious problem in its financial sector.  This fact has inspired many people to look for parallels with the current US situation, and – in some cases – to draw the implication that we should pursue further large-scale fiscal stimulus today.

There is a cautionary tale to be learned from the Japanese experience – on the need to promote, rather than to prevent, appropriate macroeconomic adjustment.  But this does not encourage a further expansion in the budget deficit at this time.

The property bubble and general credit bubble in Japan were actually much larger than what we recently experienced in the U.S.  The implied price of the land in the Emperor’s Palace, in central Tokyo, was worth more than all of California (or Canada) at its peak.  Land prices collapses and never recovered.  US house and land prices never got so far out of line with the earning capacity of homeowners.

The Japanese stock market rose to price-earnings ratio of around 80 (depending on the exact measure), also as a direct result of the credit bubble.  The US did not experience anything similar in the last few years.

Japan was – and largely remains – a bank-based finance system.  And their nonfinancial corporate sector was generally much more indebted (often using borrowed money to buy land, but also over-expanding their manufacturing capacity) than was the case in the US.  Total Japanese corporate debt was 200 percent of GDP in 1992 – more than double its value in 1984. The implication was a long period of disinvestment and saving by the corporate sector – in fact, this change from the 1980s to 1990s explains most of Japan’s increased current account surplus after the crisis.  Since Japanese corporates had accumulated too much capital, they exhibited low returns in the post-crisis period.  The US has strong bond and equity markets, and our corporate sector is not heavily indebted – so the cash flow of the nonfinancial sector should bounce back strongly.

In contrast to Japan, the US consumer has much more debt and saves less – in fact, on average over the past decade, the our household sector has saved roughly nothing (partly due to the effects of rising wealth, from higher house prices).  This sector will be weak in the US.  In contrast, in Japan during the 1990s there was no significant increase in household saving (and thus no contribution from this sector to their current account surplus.)

The obvious solution for any country in the situation faced by the US is to let the economy adjust, which implies and requires that the real exchange rate depreciates – so our exports go up, our imports (and consumption) go down.  This is a level adjustment downward in our GDP and standard of living, but then growth will resume on this new basis.

In contrast, Japan did not grow largely due to their over-investment cycle (in real estate, but also plant and equipment).  This created a much more difficult adjustment process, which worked for manufacturing primarily through depreciation of installed capacity and a gradual movement of production off-shore (e.g., to China and other Asian countries).

In addition, another major cause of Japan’s poor performance was its demographics, and the relatively lackluster growth of its trading partners in Asia due to the Asian crisis.  With its working population peaking in 1995, Japan lost a major driver of growth.  The country still has strong enterprises and decent productivity growth in the manufacturing sector, which allows them to grow.  But the pace is naturally slower than when they were “catching up” through the 1980s.  During the last ten years Japan’s has grown around the same pace as some of the continental European nations with better but also poor demographics, such as Italy and Germany (the comparison is from Q1 1998 to Q1 2008).

The Japanese policy reaction was to run budget deficits and maintain very loose monetary policy for over a decade, in an attempt to stimulate the economy and obviate the need for painful adjustment (including job losses, recognizing losses at major banks, and properly recapitalizing those banks).  Today Japanese gross debt to GDP is at 217%, and it is still rising (net debt, even on the most favorable definition, is over 110% of GDP).  The working population of Japan is now declining quickly, and so those people that are required to pay back the debt face ever rising burdens.  There is a real risk that Japan could end up in a major default, or need a large inflation, to erode the burden of this debt since their current path is clearly unsustainable. 

Japan’s policy approach from the 1990s – repeated fiscal stimulus and very easy money – is not an appealing model for the U.S. today.  All dynamic economies have a natural adjustment process – this involves allowing failing industries to decline, and letting new businesses develop where there are new opportunities. 

In fact, while Japan hesitated for over a decade to let this process work (particularly protecting the insiders at their major banks), it has finally moved in this direction.  Unit labor costs in Japan have declined sharply over the last ten years, helping making the country a more competitive exporter.  The forced recapitalization of some major banks, at the end of the 1990s, was also a move in the right direction.

The process of deflation – spoken of with terror by some leading central banks around the world today – actually makes industry more competitive, and while there are negative aspects to it (particularly if the household sector is heavily indebted, as in the US), the modest price declines seen in Japan are not a disaster.  In fact, real GDP per worker in Japan – annualized over the past 20 years – has increased by 1.3 percent per annum; while the comparable number in the US is 1.6 percent.  Over the past 10 years, real GDP per worker (annualized) increased by 1.3 percent in both Japan and the US – and now it turns out that much of the GDP gains in the US financial sector may have been illusory.

The Japan-US comparison is not generally compelling, particularly as Japan ran a current account surplus even during its destabilizing capital inflows of the 1980s.  The current US experience more closely matches the experience in some emerging markets, which have in the past run current account deficits, financed by capital inflows – with the illusion that this was sustainable indefinitely.

The long and hard experience of the International Monetary Fund (IMF) with such countries that have “lived beyond their means” – or over-expanded in any fashion – is that it is a mistake to try to prevent this process of competitive adjustment, i.e., bringing spending back into line with income, which implies a smaller current account deficit or even a surplus.  The adjustment can be cushioned by fiscal policy – and here the IMF has changed its line over the past few years, now offering sensible support for this approach.  But attempting to postpone adjustment with repeated fiscal stimulus is almost always a mistake.

Japan did not want to force its corporate sector to adjust (i.e., in the sense of going  bankrupt and renegotiate its debts), so it offered repeated stimulus.  As a result, it has become stuck with a “permanent” fiscal deficit program which is now threatening their survival as a global economic power, and will – regardless of the exact outcome – burden future generations for decades. 

Some analysts further claim that Japan’s early withdrawal of stimulus is a major factor explaining why they have not returned to robust growth rates.  It is true that Japan introduced a new VAT tax in April 1997 not long before the Asian Financial Crisis began, and the Bank of Japan raised interest rates by 25 basis points in August 2000.  Subsequent to these changes the economy slowed down. 

However, each of these measures were relatively small.  The Bank of Japan reversed course on interest rates quickly, and a negative turn in the economy was surely already in the cards – this occurred at the same time as the global economy slowed down, and a great stretch to argue that a 25 basis point move could explain the poor performance of Japan’s economy for years or decades subsequent.

As long as there are not major adverse shocks from the rest of the world, the US will experience higher savings, a fall in consumption, a recovery in investment, and an improvement in the its net exports (so the current account deficit will become smaller, or stay at its current level even as the economy recovers).  Growth will resume, driven by demographics, technical progress, and entrepreneurship.  The high level of unemployment also implies that rapid growth will be fuelled by willing workers, subject to the right skills being available.

Proposals For Change

The main threats to the recovery scenario come from the financial system, which has developed serious and macro-level pathologies over the past two decades.

We have weak bank regulation and supervision.  Politically we can’t let banks fail: they bend or lobby to change the rules in order to grow big, and then we bail them out. 

New theories of deflation and zero interest rate floors attempt to explain why we need unprecedented large bailouts – with the experience of Japan and the Great Depression of the 1930s offered as partial justification.  More likely, we are on an unsustainable fiscal path with the potential for new financial bubbles.

The following changes should be priorities.

1. Reduce the impact of financial sector lobbying on bank regulation and supervision.  Today the US Treasury is filled with former finance sector workers in key positions responsible for financial sector reform and bailouts.  This is too large a conflict of interest.  We need to close the revolving door between government and the financial sector.

2. Put far greater regulation and closer supervision on the large remaining banks that are clearly too big to fail.  These should be broken up into much smaller pieces, so we have a more competitive system. 

• When major financial institutions request additional help from the government, such as GMAC, they should be turned down.  This would force their bondholders to take a loss and lead to better incentives for the future.  It is highly unlikely that it would cause a major financial panic.  The financial system is experiencing a sharp bounce back more broadly and GMAC can likely arrange a pre-packaged bankruptcy that would actually allow its debt to rise in value.
• Banks can syndicate if they need to do large transactions. This is actually what they do for most capital raising transactions. 
• Banks should draw up “living wills” and raise additional capital as they become larger relative to the system.

3. We should also toughen our monetary policy to send a clear message that we will not maintain a pro-cyclical monetary policy which bails out banks at the end of each crisis.  The cross-liabilities on banks’ balance sheets should be reduced as far as possible to lower the risks involved with letting one fail. By doing this, we would free the hands of those running our monetary policy to take tougher actions to stop the next bubble. 

4. We need to address the inequality driven by our bailouts as a gesture to show that we will defend the public purse beyond the simple accounting in the budget. 

• Increasingly, there is discussion of taxing “excess risk taking” (reflected in high profits and bonuses) in the financial sector, particularly if that is large relative to the system.  The terms in this debate have not yet been clearly defined and this initiative could go in the wrong direction.  But we should recognize that mismanagement at major banks has created huge negative externalities both for the financial system and for the economy as a whole.  Taxing activities that generate such externalities is entirely appropriate in other sectors, and the same reasoning is likely to be applied for banking also.
• In addition, we should also require that Goldman Sachs, GMAC, and other non-banks (i.e., those operating without deposit insurance) with access to the Federal Reserve’s window pay a substantial long term annual fee to compensate taxpayers for that access.  This is a valuable insurance policy which they have – at this point – been given for free.

5. We should withdraw the fiscal stimulus over 5 years and aim for fiscal consolidation, including Medicare costs, at that time.  We should use extra spending to target specific issues that will help people improve their skills, but wind down the temporary public works programs that build jobs in the public sector. 

6. All industrialized countries need to make a substantial fiscal adjustment over the medium-run, in order to stabilize public debt levels.  The size of this adjustment depends on assumptions (and policies) regarding longer-run medical costs as the population ages and medical technology becomes more expensive.  The US and almost all other members of the OECD most likely require a fiscal adjustment in the range of 4-8 percentage points of GDP.  In that context, further unfunded or nontransparent contingent public liabilities vis-à-vis the financial sector are untenable; the Japanese experience should be taken as a warning sign in this regard.

7. For the longer-run, we should focus on measures that improve skills for people with fewer years of formal education.  Supporting the expansion of community colleges and other practical skills training is the best way forward, although this will take some time to scale up.

By Simon Johnson, Peter Boone, and James Kwak

2. The real economy begins to bottom out, although unemployment will not peak for a while and could stay high for several years.  Longer term growth prospects remain uncertain – has consumer behavior really changed; if finance doesn’t drive growth, what will; is the budget deficit under control or not (note: most of the guarantees extended to banks and other financial institutions are not scored in the budget)?

3.  More broadly, there is sophisticated window dressing in the pipeline but no real reform on any issue central to (a) how the banking system operates, or (b) more broadly, how hubris in finance led us into this crisis.  The financial sector lobbies appear stronger than ever.  The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it’s hard to see them making much progress on anything – with the possible exception of healthcare.

4. The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before late 2010.  The financial markets beg to differ – presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide.  In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed.  My advice: pay close attention to oil prices. 

5. Emerging markets are increasingly viewed as having “decoupled” from the US/European malaise.  This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble – based on a “carry trade” that now runs out of the US.  The ”appetite for risk” among investors is up sharply.  The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.

Comments welcome.

By Simon Johnson

Peter Boone, Simon Johnson, and James Kwak, copyright of the authors.

This long-overdue (and hopefully widely-awaited) version of our Baseline Scenario focuses largely on the United States, both because of the volume of activity in the U.S. in the last two months, and also because the U.S. will almost certainly have to be at the forefront of any global economic recovery, especially given the wait-and-see attitude prevalent in Europe.

Global Economic Outlook

The global economy remains weak across the board, with no significant signs of improvement since our last baseline. The one positive sign is that some forecasters are beginning to recognize that growth in 2010 is not a foregone conclusion. The OECD, for example, now forecasts contraction of 4.3% in 2009 for the OECD area as a whole – and 0.1% contraction in 2010.  This is broadly with our previous ”L-shaped” recovery view.

Even that forecast, however, expects quarter-over-quarter growth rates to be positive beginning in Q1 2010. (This is not a contradiction: if growth is sharply negative in early 2009, then quarterly rates can be positive throughout 2010, without total output for 2010 reaching average 2009 levels.) While most forecasters expect positive growth in most parts of the world in 2010, those forecasts seem to reflect expected reversion to the mean rather than any identified mechanism for economic recovery. The underlying assumption is that at some point economic weakness becomes its own cure, as falling prices finally prompt consumers to consume and businesses to invest. But given the unprecedented nature of the current situation, it seems by no means certain that that assumption will hold. In particular, with demand low around the globe, the typical mechanism by which an isolated country in recession can recover – exports – cannot work for everyone.

U.S. Outlook

Like the global economy, the U.S. economy only looks worse than it did two months ago, with unemployment up to 8.5% and no real indicators of an incipient recovery. (See Calculated Risk’s March summary for all the dismal details.) The causes of economic weakness are largely unchanged and widely known:

• De-leveraging by consumers (paying down debt, voluntarily or involuntarily), leading to reduced consumption and increased saving
• De-leveraging by companies, leading to reduced investment
• Reduced supply as well as demand for credit, constraining even those who want to borrow and spend
• Continuing falls in real estate prices

This combination of reduced spending and reduced credit has sharply depressed aggregate demand, creating a classic vicious cycle where reduced demand leads to reduced economic activity which leads to reduced spending power via increased unemployment and reduced corporate profits. In addition, concerns about financial system solvency are constraining the ability of financial institutions to supply the credit needed by the economy.  There will likely be a rolling wave of defaults and debt restructurings in the US and around the world over the next couple of years; this is hard to avoid and constitutes a major reason why the recovery will be slow compared with previous recessions.

The Obama administration’s responses to date can be grouped into three broad areas:  the financial sector, the real economy, and monetary policy. In each case, the administration has made great efforts that either are yet to pay off or will not pay off.

Financial Sector

The core problem is that large segments of the financial sector are insolvent, or that many market participants believe that large segments of the financial sector are insolvent. In either case, the problems are situated on the asset side of financial institutions’ balance sheets. Although banks have taken hundreds of billions of dollars of writedowns on toxic assets, the fear is that they will need to write down hundreds of billions or over a trillion dollars more as those assets continue to deteriorate in value.

In the early phases of the crisis, concerns focused on structured securities (CDOs, CDOs-squared, etc.) that experienced disproportionate losses as default percentages on underlying assets increased. However, as the crisis has spread from the financial sector into the real economy, increasing default rates are taking their toll even on plain-vanilla assets, such as whole mortgages. (Along the way, the financial sector has moved from a liquidity crisis to a solvency crisis.) Because banks’ assets are sensitive to macroeconomic conditions, it is difficult if not impossible to put a bound on their expected losses as long as there is uncertainty about how long and deep the current recession will be.

The core problem today is that there is a gap between the current book value of assets and the real value of those assets, at least as perceived by many market participants. That gap is large enough to threaten the capital cushions of at least some banks. Many people have suggested solutions to this problem, ranging from outright government takeover (followed by balance sheet cleanup and privatization) to cheap government credit insurance.

However, the Obama administration’s proposals so far have been relatively modest, perhaps due to unavoidable political constraints. The overall strategy has been to:

• Insist that the banks are fundamentally healthy, and that the market prices of their assets are artificially depressed due to a lack of liquidity in the market
• Continue providing just-enough capital on an as-needed basis to keep banks afloat, while avoiding any more aggressive measures, as was done in Citigroup’s third bailout

Note that this strategy is not internally illogical: if you believe that asset prices will recover by themselves (or by providing sufficient liquidity), then it makes sense to continue propping up weak banks with injections of capital. However, our main concern is that it underestimates the magnitude of the problem and could lead to years of partial measures, none of which creates a healthy banking system.

The main components of the administration’s bank rescue plan include:

• Stress tests, conducted by regulators, to determine whether major banks can withstand a severe recession, followed by recapitalization (if necessary) in the form of convertible preferred shares
• The Public-Private Investment Program (PPIP) to stimulate purchases of toxic assets, thereby removing them from bank balance sheets

The stress tests have two main problems. First, they are no longer credible, because the worst-case scenarios announced for the stress tests are no worse than many economic forecasters expect in their baseline scenarios. Second, the administration has as much as said that the major banks will all pass the stress tests, making it appear that the results are foreordained. It is possible that the stress tests will be used to force banks to sell assets as part of the PPIP, which would be a good but unexpected consequence.

We also do not expect the PPIP to meet its stated objective of starting a market for toxic assets (both whole loans and mortgage-backed securities) and thereby moving them off of bank balance sheets. In essence, the PPIP attempts to achieve this goal by subsidizing private sector buyers (via non-recourse loans or loan guarantees) to increase their bid prices for toxic assets. Besides the subsidy from the public to the private sector that this involves, we are skeptical that the plan as outlined will raise buyers’ bid prices high enough to induce banks to sell their assets. From the banks’ perspective, selling assets at prices below their current book values will force them to take writedowns, hurting profitability and reducing their capital cushion.

As long as the government’s strategy is to prevent banks from failing at all costs, banks have an incentive to sit the PPIP out (or even participate as buyers) and wait for a more generous plan. Again, the key question is how the loss currently built into banks’ toxic assets will be distributed between bank sharedholders, bank creditors, and taxpayers. By leaving banks in their current form and relying on market-type incentives to encourage them to clean themselves up, the administration has given the banks an effective veto over financial sector policy. There is a chance that the PPIP will have its desired effect, but otherwise several months will pass and we will be right where we started.

Ultimately, the stalemate in the financial sector is the product of political constraints. On the one hand, the administration has consistently foresworn dictating a solution to the financial sector, either out of deep-rooted antipathy to nationalization, or out of fear of being accused of nationalization. On the other hand, bailout fatigue among the public and in Congress, aggravated by the clumsy handling of the AIG bonus scandal, has made it impossible for the administration to propose a solution that is too generous to banks, or that requires new money from Congress. As a result, the administration is forced to work with a small amount of remaining TARP money, leverage from the Fed and the FDIC, and the private sector.

The Real Economy

With each month, the outlook for the real economy gets worse. It is particularly disturbing that economic forecasts are being revised downward every month as well. However, the administration has at least partially delivered on two major policy measures necessary to help restart the real economy.

The fiscal stimulus package signed in February should help, but it is simply too small given the size of the problem. After deducting the fix to the Alternative Minimum Tax (alternative for stimulus purposes), the package was only about $700 billion, of which a large part was in tax cuts of questionable impact. This will partially compensate for falling private sector demand and improve the economy from where it would have been otherwise, but it cannot be expected to turn around the economy on its own. In an ideal world, the administration would be planning a second stimulus package as a contingency measure for later this year. However, given that the bill passed with zero Republican votes in the House and only three votes in the Senate (those votes bought with major concessions), it seems unlikely that the administration will be able to get Congress to commit another half-trillion dollars anytime soon.

The housing plan announced in early March is also a positive step, albeit one that should have been implemented months before, by the previous administration. The housing plan relies heavily on cash incentives to loan servicers and second-lien holders who are willing to modify mortgages. However, only time will tell whether those incentives are sufficient to actually change servicers’ behavior on a large scale. Again, this is far better than nothing, but whether it is enough to counteract the ongoing free-fall in housing prices remains to be seen.

In addition, the Obama administration took a harder line on GM and Chrysler, rejecting their restructuring plans and giving them new, tight deadlines to work out deals with their workers and creditors (GM) or with Fiat (Chrysler). In order to pressure bondholders to make concessions, the administration is trying to signal that it is willing to let the auto companies go into bankruptcy. But from a political perspective, they seem to be in a no-win situation. A Democratic administration that lets GM go bankrupt could face a revolt from one of its core constituencies; but bailing out the auto industry will only increase bailout fatigue from an increasingly resentful Non-Bailed-Out Majority that no longer identifies with autoworkers.

Monetary Policy

With the economy still stalled and the executive branch struggling with political constraints, the Federal Reserve has seemed increasingly willing to step into the breach. As an independent agency within the government, armed with emergency powers under Section 13(3) of the Federal Reserve Act, the Fed is the one actor that can, to some extent, simply take matters into its own hands. And although everything the Fed does is wrapped in gradualist language to cushion its impact on the markets, the Fed does seem to have embarked on a new, more aggressive phase of monetary policy.

Until late in 2008, the Fed’s primary role was to provide liquidity, in the form of short-term lending to financial institutions. Since then, however, it has expanded its role in at least two directions. The Term Asset-Backed Securities Loan Facility (TALF) puts the Fed in the position of deciding where to allocate credit across the economy. And the recent decision to start buying long-term Treasury securities means that the Fed is using new approaches to create money. While there is a debate over whether this constitutes “quantitative easing” or just “credit easing,” this represents a major expansion of the Fed’s role, which we discussed in our recent Washington Post Outlook article. These actions may help create moderate inflation and prevent the onset of sustained deflation; there is also a danger that inflation will be substantially higher than expected.

Regulation

Since virtually no one is happy with the current situation, there has unsurprisingly been discussion of how the financial sector should be changed in the future. Treasury Secretary Geithner outlined his proposals in Congressional testimony, with an emphasis on the need for centralized monitoring of systemic risk, and for the power to take over any financial institution that could bring down the system as a whole.

One of the root causes of the crisis, and of the difficulty in resolving it, has been the political power and ideological influence of the financial sector, which we discuss at length in our Atlantic article. Our preferred solution is to have smaller banks. Early indications, however, are that the Geithner plan will go a different direction – allowing large banks, but giving regulators new powers over them.  The resolution authority currently being sought by the Administration – and which we support – may have unintended consequences, some of which could ultimately prove positive if handled in the right way.

On a worrying note, the Financial Accounting Standards Board recently caved in to banking industry pressure (transmitted by the House Financial Services Committee) and relaxed the rules implementing fair value accounting. In some circumstances, financial institutions will find it easier to ignore market transactions and use internal models in order to value assets on their balance sheets. We think that fair value (“mark-to-market”) accounting has played a small role, if any, in the crisis. However, the full impact of this rule change will not be known until we see how it is applied by batteries of lawyers on Wall Street and in Washington; for one thing, it could change banks’ incentives to participate in the PPIP. And the fact that the financial industry, at this moment in history, still has the power to get its way in Washington is disturbing.

U.S. Summary

On balance, we believe that the Obama administration, and Fed Chairman Bernanke, are making every effort to combat the financial and economic crisis. However, some aspects of the response, most notably the fiscal stimulus, have been underpowered. And a combination of ideological and political constraints has hampered the administration’s efforts to rescue the banking system. For these reasons, we still do not see the mechanism that will cause the economy to turn around.

In this context, we interpret the recent stock market rally as indicating that the economic decline is slowing; it does not necessarily denote that rapid recovery is just around the corner.  We would also emphasize that credit markets are pricing in a substantial risk of default for some leading brand names, both in financial services and manufacturing – as the system stabilizes and bailouts become harder to justify, the probability of default for large companies may continue to rise.

International Issues

The lead-up to the recent G20 summit exposed some of the tensions between the U.S. (and the U.K.) and Europe when it comes to economic policy. To generalize for a moment, Europe (led by Germany and France) favors less fiscal stimulus spending, more fiscal discipline, and lower inflation risk; the U.S. favors more stimulus and more expansionary monetary policy, at the risk of higher inflation.

We favor the U.S. position, for a simple reason. Not only is the current global recession very severe, but it is unlike any we have seen before, and therefore we cannot rely on historical patterns to tell us when and how the recession will end. In that context, and with unemployment climbing virtually everywhere, it makes sense to do more rather than less to turn the economy around. The European position is that their more advanced social welfare systems will both limit human misery and provide an automatic fiscal stimulus, both of which are true. However, European economies are just as vulnerable as ours to a prolonged period of deflationary stagnation – a risk that, unlike Ben Bernanke, they seem willing to take.

Given this divide in opinion, there was no chance for a meaningful resolution at the G20 summit. However, the G20 did have some notable achievements. First, increasing funding for the IMF to $1 trillion gave it the capacity to actually bail out multiple mid-size economies, which may become necessary as the recession progresses. Second, by eliminating Europe’s de facto control over the IMF (and the U.S.’s de facto control over the World Bank), the summit gave other members of the G20 more of a stake in helping develop and support concerted international solutions to the economic crisis. While this could take months or years to pay off, it is an important first step.

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Previous editions of Baseline Scenario:

• September, 2008 (first edition): http://baselinescenario.com/2008/09/29/the-baseline-scenario-first-edition/
• October 2008, 2^nd edition: http://baselinescenario.com/2008/10/06/the-baseline-scenario-2nd-edition/
• Mid-October: http://baselinescenario.com/2008/10/13/baseline-scenario-101308-analysis/ and http://baselinescenario.com/2008/10/13/baseline-scenario-101308-policy/
• Late October: http://baselinescenario.com/2008/10/19/baseline-scenario-102008/
• November: http://baselinescenario.com/2008/11/10/baseline-scenario-111008/
• December: http://baselinescenario.com/2008/12/15/baseline-scenario-121508/
• February: http://baselinescenario.com/2009/02/08/baseline-scenario-2909/

More on Europe

The European crisis, why the Europeans are not coping, and what to do about it

http://baselinescenario.com/2009/02/22/the-choice-save-europe-now-or-later/

http://baselinescenario.com/2009/01/05/eurozone-hard-pressed-2-fiscal-solution-deferred/

Our original European stabilization fund proposal:

http://baselinescenario.com/2008/10/24/eurozone-default-risk/

More on current US and global topics

Strategies for bank recapitalization

• Economic ideas: http://baselinescenario.com/2009/01/27/to-save-the-banks-we-must-stand-up-to-the-bankers/
• Guide to evaluating official announcements: http://baselinescenario.com/2009/02/07/ten-questions-for-secretary-geithner/

Global fiscal stimulus: http://baselinescenario.com/2009/01/21/global-fiscal-stimulus-should-it-be-an-obama-priority/

Citigroup bailout (the second round): http://baselinescenario.com/2008/11/27/international-implications-of-the-citigroup-bailout/ and http://baselinescenario.com/2008/11/24/citigroup-bailout-weak-arbitrary-incomprehensible/

Policy recommendations from October/November 2008

“The Next World War?  It Could Be Financial” (October 11, 2008): http://baselinescenario.com/2008/10/12/next-up-emerging-markets/

Pressure on emerging markets (October 12, 2008): http://baselinescenario.com/2008/10/12/next-up-emerging-markets/

Pressure on the Eurozone (October 24, 2008): http://baselinescenario.com/2008/10/24/Eurozone-default-risk/

Testimony to Joint Economic Committee (October 30, 2008): http://baselinescenario.com/2008/10/30/testimony-before-joint-economic-committee-today/

Bank recapitalization options (November 25, 2008): http://baselinescenario.com/2008/11/25/bank-recapitalization-options-and-recommendation-after-citigroup-bailout/

Peter Boone, Simon Johnson, and James Kwak, copyright of the authors

Summary

1) The world is heading into a severe slump, with declining output in the near term and no clear turnaround in sight.

2) Consumers in the US and the nonfinancial corporate sector everywhere are trying to “rebuild their balance sheets,” which means they want to save more.

3) Governments have only a limited ability to offset this increase in desired private sector savings through dissaving (i.e., increased budget deficits that result from fiscal stimulus). Even the most prudent governments in industrialized countries did not run sufficiently countercyclical fiscal policy in the boom time and now face balance sheet constraints.

4) Compounding these problems is a serious test of the eurozone: financial market pressure on Greece, Ireland and Italy is mounting; Portugal and Spain are also likely to be affected. This will lead to another round of bailouts in Europe, this time for weaker sovereigns in the eurozone. As a result, fiscal policy will be even less countercyclical, i.e., governments will feel the need to attempt precautionary austerity, which amounts to a further increase in savings.

5) At the same time, the situation in emerging markets moves towards near-crisis, in which currency collapse and debt default is averted by fiscal austerity. The current IMF strategy is designed to limit the needed degree of contraction, but the IMF cannot raise enough resources to make a difference in global terms – largely because potential creditors do not believe that large borrowers from an augmented Fund would implement responsible policies.

6) The global situation is analogous to the problem of Japan in the 1990s, in which corporates tried to repair their balance sheets while consumers continued to save as before. The difference, of course, is that the external sector was able to grow and Japan could run a current account surplus; this does not work at a global level. Global growth prospects are therefore no better than for Japan in the 1990s.

7) A rapid return to growth requires more expansionary monetary policy, and in all likelihood this needs to be led by the United States. But the Federal Reserve is still some distance from fully recognizing deflation and, by the time it takes that view and can implement appropriate actions, declining wages and prices will be built into expectations, thus making it much harder to stabilize the housing market and restart growth.

8) The push to re-regulate, which is the focus of the G20 intergovernmental process process (with the next summit set for April 2), could lead to a potentially dangerous procyclical set of policies that can exacerbate the downturn and prolong the recovery. There is currently nothing on the G20 agenda that will help slow the global decline and start a recovery.

9) The most likely outcome is not a V-shaped recovery (which is the current official consensus) or a U-shaped recovery (which is closer to the private sector consensus), but rather an L, in which there is a steep fall and then a struggle to recover.

[Details after the jump]:

Introduction: Our Baseline vs. the Current Consensus

The current consensus view (e.g., as seen in the World Bank’s Global Economic Prospects) is that we are having a serious downturn, with annualized growth for the fourth quarter in the US at minus 4% or worse.  But the consensus is that a recovery will be underway by mid-2009 in the US and shortly thereafter in the eurozone.  This will help bring up growth in emerging markets and developing countries, so by 2010 global growth will be moving back towards its 2006-2007 rates.

Our baseline view is considerably more negative.  While we agree that a rapid fall is underway and the speed of this is unusual, we do not yet see the mechanisms through which a turnaround occurs.  In fact, in our baseline view, there is considerably more decline in global output already in the works and, once the situation stabilizes, it is hard to see how a recovery can easily be sustained.

The consensus view focuses on disruptions to the supply of credit and recognizes official attempts to support this supply.  In contrast, we emphasize that the crisis of confidence from mid-September has now had profound effects on the demand for credit and its counterpart, desired savings, everywhere in the world.

To explain our position, we first briefly review the background to today’s situation.  Readers who would like more detail on what happened in and since mid-September should refer to the previous (November 10) edition of our Baseline Scenario. We then review both the current situation and the likely prognosis for policy in major economies and for key categories of countries.  While a great deal remains uncertain about economic outcomes, after the US presidential election much of the likely policy mix around the world has become clearer. We conclude by reviewing the prospects for sustained growth and linking the likely vulnerabilities to structural weaknesses in the global system, including both the role played by the financial sector almost everywhere and the way in which countries’ financial sectors interact.  In the end we come full circle – tomorrow’s dangers can be linked directly back to the underlying causes of today’s crisis.

Background

We are in a severe “credit crisis,” but one that is frequently misunderstood in four ways.

1. While the US housing bubble played a role in the formation of the crisis and continued housing problems remain an issue, the boom was and the bust is much broader. This was a synchronized debt-financed global boom, facilitated by flows of capital around the world.

2. The boom exacerbated financial system vulnerability everywhere. But the crisis in the current form was not inevitable. The severity of today’s crisis is a direct result of the failure to bail out Lehman and the way in which AIG was “saved” – so that senior creditors took large losses and confidence in the credit system was shaken much more broadly.

3. The initial problem, from mid-September 2008, was a fall in the supply of credit. But this does not mean that official support for credit supply will turn the situation around. Now the crisis has affected the demand side – people and firms want to pay down their debts and increase their precautionary savings.

4. There is no “right” level of debt, so we don’t know where “deleveraging” (i.e., the fall in demand for and supply of credit) will end. Debt could stabilize where we are now or it could be much lower. Leverage levels are very hard for policy to affect directly, as they result from millions of decentralized decisions about how much people borrow. Anyone with high levels of debt in any market economy is now re-evaluating how much debt is reasonable for the medium-term.

The Situation Today

United States

Households did not save much since the mid-1990s and reduced their savings further this decade, in part because of the increase in house prices; this was the counterpart of the large increase in the US current account deficit.  Desired household saving is now increasing.  The main dynamic is a fall in credit demand rather than constraints on credit supply in the US.

The US corporate sector is in better shape but, faced with the disruptions of the last three months, is also seeking to pay down debt and conserve cash.  Even entities with deep pockets, strong balance sheets and long investment horizons (e.g., universities, private equity) are cutting back on spending and trying to strengthen their balance sheets.

There are constraints on all three main potential policy responses: fiscal, financial, and monetary.

First, a substantial fiscal stimulus has already been pre-announced by the incoming Obama administration, and this will have broad support in the next Congress.  If the stimulus comes in (over 2 years) closer to $500bn than $1 trillion, this may be seen as a disappointment relative to current expectations. The constraint, of course, is the US balance sheet. The US balance sheet is strong relative to most other industrialized countries – private sector holdings of government debt are close to 40% of GDP.  But the US authorities also have to worry about increasing Social Security and Medicare payments in the medium term, and so are reluctant to accumulate too much debt.  The underlying problem is that fiscal policy was not sufficiently counter-cyclical during the boom. The federal fiscal stimulus will be helpful, but it will not be enough to prevent a substantial decline or quickly turn around the economy.

Second, financial sector policy has not been encouraging.  Dramatic bank recapitalization is off the table, at least for the time being, because this would imply effective nationalization, which is not appealing to Wall Street.  The original TARP terms from mid-October are no longer available, as they were very generous to banks and there is some backlash against bailouts.  Also, the latest Citigroup bailout (from mid-November) is not scalable to the entire financial system as this was an even worse deal for the taxpayer. Policies that would directly address the financing of housing are appealing and could help at the margin.  But this approach seems unlikely to scale up politically in such a way as to make a macroeconomic difference.  This route will take a long time and many modified mortgages will also become delinquent.

Third, monetary policy can still make a difference, particularly as we risk entering a deflationary spiral with falling prices and downward pressure on nominal wages.  On December 12, 2008, the inflation swap market implied minus 0.5% average annual inflation for the next five years.  Deflation is not yet completely entrenched – over a 30 year horizon, the implied average annual inflation rate is 1.75% – so it is still possible to turn the situation around.  However, the dominant view at the Fed remains that deflation is not yet the main issue, and there is no internal consensus in favor of printing money (or focusing on increasing the monetary base).

Generating positive inflation in this environment is not easy.  One way would be to talk down the dollar.  The fact that this would feed into inflation is not a danger but a help in this context.  Unfortunately, this would be seen as too much of a break from the tradition of a “strong dollar” and it would likely upset both Wall Street and US allies.  Ultimately, probably later in 2009 (and definitely by early 2010), the US will move to a more expansionary monetary policy and manage to generate inflation.  This will weaken the dollar and put pressure on other countries to follow suit – expansionary monetary policy is infectious in a way that expansionary fiscal policy is not.

Eurozone

There is growing pressure on some of the weaker sovereigns that belong to the euro currency union.  Greece faces the most immediate problems, as demonstrated both by widening credit default swap spreads and increasing spreads of Greek bonds over German government bonds.  The cost of servicing Greek government debt is thus rising at the same time as Greece has to roll over debt worth around 20 percent of GDP in the coming year.Greece has a debt-to-GDP ratio that is close to 100 percent, so there is real risk of default.

In our baseline view, Greece receives a fairly generous bailout from other eurozone countries (and probably from the EU).  This, however, does not come early enough to prevent problems from spreading to Ireland and other smaller countries (which then also need to implement fiscal austerity or to receive support).  Italy is also likely to come under pressure, due to its high debt levels, and here there will be no way other than austerity.  With or without a bailout, Greece and other weaker euro sovereigns will need to implement fiscal austerity.The net result is less fiscal stimulus than would otherwise be possible, and in fact there is a move to austerity among stronger euro sovereigns as a signal.  Governments will therefore struggle to dissave enough to offset the increase in private sector savings.

Monetary policy will be slow to respond.  The European Central Bank decision-making process seeks consensus and some key members are still more worried about inflation down the road than deflation today.  Eventually the ECB will catch up, but not before there has been considerable further slowing in the eurozone.

The current official consensus is that the eurozone will start to recover in mid-2009 and be well on its way to achieving potential growth rates again by early 2010.  This seems quite implausible as a baseline view.

United Kingdom

Over the last month, the Bank of England has moved to a pro-inflation policy, with big interest rate cuts and statements that are tending to depreciate the pound.  The inflation swap market implies annual average inflation in the UK of 0.8% per year over the next five years.  This fits with the fiscal stimulus of the British government, and presumably amounts to effectively inflating away debts.

Still, the UK faces a major problem with falling house prices and a decline in the financial sector.  We could think of the UK as a place with one primary export: financial services.  This sector has just suffered a major terms of trade shock and will contract globally, so first-order macroeconomic adjustment in the UK is essential.  Inflation will be used to cushion the necessary real adjustment.

Japan

The yen has appreciated as carry trades have unwound, so people no longer borrow in yen to invest elsewhere.  Corporates are likely to want to strengthen their balance sheets further.  Households are unlikely to go on a spending spree.

The government’s balance sheet is weak, but it is funded domestically (in yen, willingly bought by households), so there is room for further fiscal expansion.  However, this is unlikely to come quickly.

The ability of the Japanese central bank to create inflation has proved limited.  Once deflationary expectations are established, these are hard to break.  In the inflation swap market, the average annual rate of inflation expected over five years is minus 2.4%, and an astonishing minus 1.0% over 30 years.

Emerging markets

The major increase in savings by China over the past 10 years was primarily due to high profits in the corporate sector.  This was the counterpart to the current account.  Chinese growth now seems likely to slow sharply.

Pressure on other emerging markets will intensify after Ecuador’s default.  Some countries will be willing to go early to the IMF, but for others the fear of a potential stigma will lead them to prefer fiscal austerity (and perhaps even contractionary monetary policy) without IMF involvement.The IMF will be helpful in smaller emerging markets, such as in East-Central Europe.  But it doesn’t have (and won’t receive) enough funding to make a difference for large emerging markets, whose problems are due to their own policy mix, particularly allowing the private sector to take on large debts in dollars.  Emerging markets will also have no appetite for massive bailout loans.

Larger emerging markets will not suffer collapse, but will have increased (attempted) savings and, as a result, will experience slowdowns.  The temptation for competitive devaluation will grow over time; adjusting the exchange rate is easier if there is no IMF program.

But emerging markets cannot grow out of the recession through exports unless there is a strong recovery in the US or the eurozone or both, which is unlikely. Many emerging markets are particularly hard hit by the fall in commodity prices, which could be exacerbated by expected US policies to reduce oil consumption.  Commodity prices are likely to fall further.

Political risks in China and other emerging markets create further downside risks.  In our baseline, we assume no serious domestic or international disruptions in this regard.

Looking Forward: Structure of the System

Potential for Revising Expectations Upwards

The last few months have shown the importance of confidence. The severity of the current downturn was largely caused by the climate of fear that was triggered by the Lehman bankruptcy and that has yet to dissipate. In a downturn, poor policy choices have the procyclical effect of decreasing confidence further.

Conversely, increased optimism could itself have a significant stimulative effect on the world economy, as the announcement of President-Elect Obama’s economic team – which contained no surprises – boosted spirits in the US stock market. While attitudes today are resoundingly negative, in virtually every sector and every country, there is a strong human tendency to want to believe in positive stories and to think that things have improved with a “structural break.” Arguably, the US recovered from the collapse of the technology bubble in 2000-2001 by convincing itself that housing prices would rise forever.

There is always the potential for another boom. This is especially true because it is politically difficult to impose regulation to dampen growth; central banks have shown little appetite to take away the famous punch bowl (see Alan Greenspan in particular); and boom environments create rational incentives for the private sector to play along in inflating the bubble of the moment (see Andrew Lo’s testimony to Congress, excerpted here).

However, the answer to a recession should not be to seek out the next bubble. The only real way to protect a national economy in the face of systemic financial problems is with a sufficiently strong government balance sheet (i.e., low debt relative to the government’s ability to raise taxes).  This requires counter-cyclical fiscal policy during a boom, which is always politically difficult.  However, this implies less room for fiscal stimulus now, or a need to put in place measures now that will compensate for the stimulus once the economy has recovered.

What’s the real structural problem?

In order to create the conditions for long-term economic health, we need to identify the real structural problem that created the current situation. It wasn’t a particular set of payments imbalances (read: US-China), as these can and will change (which does not excuse policymakers who refused to address this issue). It wasn’t the failure of a particular set of domestic regulators, as regulatory challenges and responses change over time (which doesn’t excuse the specific regulators).

The underlying problem was that, after the 1980s, the “Great Moderation” of volatility in industrialized countries created the conditions under which finance became larger relative to GDP and credit could grow rapidly in any boom.  In addition, globalization allowed banks to become big relative to the countries in which they are based (with Iceland as an extreme example).  Financial development, while often beneficial, brings risks as well.

The global economic growth of the last several years was in reality a global, debt-financed boom, with self-fulfilling characteristics – i.e., it could have gone on for many years or it could have collapsed earlier. The US housing bubble was inflated by global capital flows, but bubbles can occur in a closed economy (as shown by experiments). The European financial bubble, including massive lending to Eastern Europe and Latin America, occurred with zero net capital flows (the eurozone had a current account roughly in balance). China’s export-driven manufacturing sector had a bubble of its own, in its case with net capital outflow (a current account surplus).

But these regional bubbles were amplified and connected by a global financial system that allowed capital to flow easily around the world. We are not saying that global capital flows are a bad thing; ordinarily, by delivering capital to the places where it is most useful, they promote economic growth, in particular in the developing world. But the global system also allows bubbles to feed on money raised from anywhere in the world, exacerbating global systemic risks. When billions of dollars are flowing from the richest countries in the world to Iceland, a country of 320,000 people, chasing high rates of interest, the risks of a downturn are magnified, for the people of Iceland in particular .

The prevalence of debt in the global boom was also a major contributing factor to today’s recession (although major disruptions could also arise from the busting of pure equity-financed booms). Debt introduces discontinuities on the downside: instead of simply becoming losing money, companies with high debt levels go bankrupt in hard times.  Lehman, AIG, and now GM all created systemic risks to the US and global economies because one default can trigger a series of defaults among other companies – and simply the fear of those dominos falling can have systemic effects. Similarly, emerging market defaults can have systemic effects by spreading fear and causing investors to pull out of unrelated by similarly situated countries (and causing speculators to bet against their currencies and stock markets).

Ideally, global economic growth requires a rebalancing away from the financial sector and toward non-financial industries such as manufacturing, retail, and health care (for an expansion of this argument, see our earlier op-ed). Especially in advanced economies such as the US and the UK, the financial sector has accounted for an unsustainable share of corporate profits and profit growth. However, the financial sector, despite the experiences of the last year, is still powerful enough to resist significant structural reform. While this will not prevent a return to economic growth, it will maintain all of the risks that led to the current situation – in particular, the risk of synchronized booms and busts around the world.

Further reading

Background material

Previous edition of Baseline Scenario: http://baselinescenario.com/2008/11/10/baseline-scenario-111008/

Beginners section: http://baselinescenario.com/financial-crisis-for-beginners/

Causes of the crisis: http://baselinescenario.com/category/causes/

MIT classes on the global crisis, including webcasts: http://baselinescenario.com/category/classroom/

More details on current topics

Auto bailouts: http://baselinescenario.com/tag/auto-industry/

Global fiscal stimulus: http://baselinescenario.com/2008/12/08/global-fiscal-stimulus-will-this-save-weaker-eurozone-countries/

Latest on official forecasts: http://baselinescenario.com/2008/12/11/forecasting-the-official-forecasts/

Citigroup bailout (the second round): http://baselinescenario.com/2008/11/27/international-implications-of-the-citigroup-bailout/ and http://baselinescenario.com/2008/11/24/citigroup-bailout-weak-arbitrary-incomprehensible/

As it happened

First edition of Baseline Scenario (September 29, 2008): http://baselinescenario.com/2008/09/29/the-baseline-scenario-first-edition/

Testimony to Joint Economic Committee (October 30, 2008): http://baselinescenario.com/2008/10/30/testimony-before-joint-economic-committee-today/

“The Next World War?  It Could Be Financial” (October 11, 2008): http://baselinescenario.com/2008/10/12/next-up-emerging-markets/

Pressure on emerging markets (October 12, 2008): http://baselinescenario.com/2008/10/12/next-up-emerging-markets/

Pressure on the eurozone (October 24, 2008): http://baselinescenario.com/2008/10/24/eurozone-default-risk/

Bank recapitalization options (November 25, 2008): http://baselinescenario.com/2008/11/25/bank-recapitalization-options-and-recommendation-after-citigroup-bailout/

The Baseline Scenario is our periodic overview of the current state of the global economy and our policy proposals. It includes two sections:

1. Analysis of the current situation and how we got here
2. Policy proposals

Please note that we do not currently publish our upside and downside risk scenarios in detail.

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ANALYSIS

The roots of the crisis

For at least the last year and a half, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we are now in.

The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion.  A 25% decline in the value of housing would generate a paper loss of $5.75 trillion. With an estimated 1-3% of housing wealth gains going into consumption, this could generate a $60-180 billion reduction in total consumption – a modest amount compared to US GDP of $15 trillion. We should have seen a serious impact on consumption, but, there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but did not by itself turn a housing downturn into a global financial crisis. There is no basis on which to say banks were too leveraged in one year but were safe the year before; how leveraged a bank can be depends on many factors, most notably the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, today’s crisis was not a foregone conclusion.

There are two possible paths to resolution for an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending, and raise underlying capital. This can occur without much harm to the economy over many years. The second path is more dangerous.  If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices.  These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to falls in their value.

A crisis of confidence

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998.  For countries then, read banks (or markets) today.  In both cases, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

The crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession.  Investors almost instantly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves.  Their currencies fell sharply and their creditors suffered major losses.

From there, the contagion spread for no apparent reason to South Korea – which had little exposure to Southeast Asian currencies – and then to Russia. Russia also had little exposure to Asia. However, Russia was funding deficits through short-term ruble bonds, many of which were held by foreign investors. When short-term creditors panicked, the government and the IMF could not prevent a devaluation (and a default on those ruble bonds). GDP fell 10% the following year. After Russia, the story repeated itself in Brazil. In January 1999 Brazil let the currency float, leading to a sharp depreciation within one month.

In each case, creditors lost confidence that they could get their principal back and rushed to get out at the same time. In such an environment, any institution that borrows short and lends long is vulnerable to such an attack. The victims had one common trait: if credit were cut off they would be unable to find funding. The decision of credit markets became self-fulfilling, and policy makers around the world seemed incapable of stopping these waves.

The current crisis

The evolution of the current financial crisis seems remarkably similar to the emerging markets crisis of a decade ago.

America’s crisis started with creditors fleeing from sub-prime debt in summer 2007.  As default rates rose, investment-grade debt – often collateralized debt obligations (CDOs) built out of sub-prime debt – faced large losses. The exodus of creditors caused mortgage finance and home building to collapse.

The second stage began with the Bear Stearns crisis in March 2008 and extended through the bailout of Fannie Mae and Freddie Mac. As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on the ability to roll over their short-term loans, regardless of the quality of their assets. Given sufficient panic, it can become impossible to roll over those loans. And in a matter of days, despite no major news, Bear Stearns was dead. However, while the Federal Reserve and Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole – a pattern they would follow with Fannie and Freddie. As a result, creditors learned that they could safely continue lending large financial institutions.

This changed on September 15 and 16 with the failure of Lehman and the “rescue” of AIG, which saw a dramatic and damaging reversal of policy. Once Bear Stearns had fallen, investors focused on Lehman; again, as confidence faded away, Lehman’s ability to borrow money evaporated. This time, however, the Fed let Lehman go bankrupt, largely wiping out creditors. AIG was a less obvious candidate target. Despite large exposure to mortgage-backed securities through credit default swaps, no analysts seemed to think its solvency was truly in question. Overnight, however, without any fundamental changes, the markets decided that AIG might be at risk, and the fear became self-fulfilling. As with Lehman, the Fed chose not to protect creditors; because the $85 billion loan was senior to existing creditors, senior debt was left trading at a 40% loss.

This decisive change in policy reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear:  RUN from all entities that might fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needed access to the credit markets to survive might lose access at any time.

As a result, creditors and uninsured depositors at all risky institutions pulled their funds – shifting deposits to Treasuries, moving prime brokerage accounts to the safest institutions (read JPMorgan), and cashing out of securities arranged with any risky institutions. The previously invincible Morgan Stanley and Goldman Sachs saw large jumps in their credit default swap rates. Washington Mutual and Wachovia vanished. LIBOR shot up and short-term US Treasury yields fell as banks stopped lending to each other and lent to the US government instead. The collapse of one money market fund (largely because of exposure to Lehman debt), and the pending collapse of more, sent the US Treasury into crisis mode.

At the same time, the credit market shock waves spread quickly throughout the world. In Europe, interbank loan rates and EURIBOR rates shot up, and banks from Bradford & Bingley to Fortis were nationalized. Further afield, Russia and Brazil each saw major disruptions in their interbank markets and Hong Kong experienced a (small) bank run. From late September, credit markets around the world were paralyzed by the fear that any leveraged financial institution might fail due to a lack of short-term credit. Self-fulfilling collapses can dominate credit markets during these periods of extreme lack of confidence.

The response

There are two ways to end a crisis in confidence in credit markets. The first is to let events unfold until so much deleveraging and so many defaults have occurred that entities no longer rely on external finance. The economy then effectively operates in a “financially autonomous” manner in which non-financial firms do not need credit.  This is the path most emerging markets took in 1997-1998. Shunned by the world investment community, it took many years for credit markets to regenerate confidence in their worthiness as counterparties.

The second is to put a large balance sheet behind each entity that appears to be at risk, making it clear to creditors that they can once again safely lend to those counterparties without risk.  This should restore confidence and soften the coming economic recession.

Governmental responses to the crisis were fitful, poorly planned, and abysmally presented to the public. The US government, to its credit, was the first to act, while European countries boasted they would be little affected. Still, though, Paulson and Bernanke had made the mistake of insisting right through the Lehman bankruptcy that the system was fundamentally sound. As a result, their rapid reversal and insistence that they needed $700 billion for Paulson to spend however he wished was greeted coldly on Capitol Hill and in the media.

The initial Paulson Plan was designed to increase confidence in financial institutions by transferring their problematic mortgage-backed securities to the federal government’s balance sheet. The plan had many problems, ranging from uncertainty over what price the government would pay for the assets to questions about whether it would be sufficient to stop the crisis of confidence. Our initial Baseline Scenario, on September 29, recommended passing the plan and supplementing it with four additional measures: the first two were unlimited deposit insurance and an equity injection program for financial institutions.

After the Paulson Plan was passed on October 3, it was quickly overtaken by events. First the UK announced a bank recapitalization program; then, on October 13, it was joined by every major European country, most of which also announced loan guarantees for their banks. On October 14, the US followed suit with a bank recapitalization program, unlimited deposit insurance (for non-interest-bearing accounts), and guarantees of new senior debt. Only then was enough financial force applied for the crisis in the credit markets to begin to ease, with LIBOR finally falling and Treasury yields rising. Continued interest rate cuts and liquidity measures by the Federal Reserve and its counterparts have been just enough to ensure a slight easing in interbank credit markets. However, the supply of credit to the real economy remains constrained.

Dangers for emerging markets

Although the US and Europe have grabbed most of the headlines, the most vulnerable countries in the current crisis are in emerging markets. Just like highly leveraged banks, highly leveraged countries – such as Iceland – are vulnerable to the flight of capital. Countries that got rich during the commodities boom are also highly vulnerable to a global recession.

The flight to safety is already destabilizing banks around the world. For companies that can get credit, the cost has skyrocketed. These financial sector tremors are sending shockwaves through emerging market economies. While wealthy nations can use their balance sheets to shore up banks, many other countries will find this impossible. Like Latin America in the 1980s, or emerging markets after 1997-98, the withdrawal of credit after a boom can lead to steep recessions and major internal disruptions.

Four sets of countries stand to lose.

1. The over-leveraged. With bank assets more than ten times its GDP, Iceland cannot protect its banks from a run. Other countries that borrowed heavily during the boom face a similar situation.
2. The commodity-dependent. Oil has already fallen below $80 per barrel, and demand continues to fall. All other major commodities will fall for the same reasons. Commodity exporters facing sharply reduced revenues will need to cut spending and let their currencies depreciate.
3. The extremely poor. Sub-Saharan Africa, which was a beneficiary of the commodity boom, will be hit hard by the fall in commodity prices. At the same time, wealthy nations are likely to slash their foreign aid budgets. The net effect will be prolonged isolation from the global economy and increased inequality.
4. China. The global slowdown has already had a major impact on several sectors of China’s manufacturing economy. The collapse in the Baltic Dry Index shows that demand for commodities and manufactured goods is plummeting. While China’s economic influence will only grow in the long term, a global recession could cause a severe crimp in its growth.

The world’s attention is currently focused on the G7. But crises in the rest of the world will inflict damage on G7 economies, increase global inequality, and create geo-political instability.

The current situation

Today, although it is by no means assured, it seems relatively likely that the financial panic will gradually ease and the successive collapse of many large banks in the US and Europe will not occur. However, the resumption of interbank lending alone will not be enough to reverse the downward trajectory of the real economy. Banks still need to deleverage in a major way and there are doubts about how much lending to the real economy will pick up. For example, mortgage rates in the US actually increased since the recapitalization plan was announced. In a worst case scenario, even some wealthy countries may not be able to absorb the losses sustained by their banks. The US will have to worry not just about its banks, but also about some insurance companies and quasi-financial companies such as GMAC, Ford, and GE.

Before the severe phase of the crisis began on September 15, the world was already facing an economic slowdown. The credit crisis of the past month and the lingering uncertainty have ensured that we are now in a global recession. In the face of uncertainty and higher credit costs, many spending and investment decisions will be put on hold. US and European consumption are declining along with housing prices, with a major fall in US personal consumption in Q3. With interest rates rising around the world, companies will pay down debt and reduce spending and investment plans. State and municipal governments will see lower tax revenues and cut spending. No country can rely on exports to provide much cushion, as growth and spending around the world have been affected by the flight from credit.

Recent economic indicators in the US show significant deterioration in the real economy. Because many of these indicators are from the entire month of September, they probably understate the effect of the acute credit crunch of the second half of the month, which we will not fully appreciate until October data appear in the middle of November. Consumer confidence is already at record lows. The recent unemployment report showing a net loss of 240,000 jobs in October will probably only get worse in the next few months.

The damage will be particularly acute in emerging market economies. As the wealthiest nations protect their banking sectors, investors and lenders will be less likely to put their money in countries perceived as risky. So far, Iceland, Hungary, and Ukraine have required bailouts from the IMF, sometimes joined by other entities such as the European Central Bank, and Pakistan is in negotiations with the IMF. Argentina has taken the extreme step of nationalizing its private pension system, most likely in an attempt to avert a national default. The psychology of fear is likely to take over as creditors try to guess which country will be next, just as in 1997-98. Unless a country has a sufficient balance sheet and a very large amount of reserves, there will be selective defaults and large devaluations. It is hard to see how the IMF or anyone else can provide resources on a sufficient scale to make a difference. Credit default swaps show that several countries in Eastern Europe and Latin America are at risk of default.

Falling commodity prices due to the coming recession will also hurt many exporting countries. Even Russia, with its large foreign currency reserves (and vast oil and gas reserves) may have a significant mismatch problem between short term liabilities and longer term assets. This is complicated further by large private sector debt in foreign currency. The government may be moving toward deciding which companies they will save. Hopefully, for the companies they do not support, it will be possible to have an orderly workout.

Even China is showing the negative effects of the global recession. With a risk that growth could fall below 6% this quarter (from 11-12% over the past few years), the Chinese government recently announced a $600 billion stimulus plan, spread over two years, in an effort to keep the economy growing fast enough to absorb a growing labor force.

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POLICY PROPOSALS

The G7

So far, the US response has included major increases in liquidity, the $700 billion TARP program, the dedication of $250 billion of that money to bank recapitalization, unlimited deposit insurance, guarantees of new senior bank debt, a program for the Fed to buy commercial paper directly, an interest rate cut, and the usage of Fannie and Freddie to buy $40 billion per month of mortgage-related securities. Put together, this seems to have stopped the panic from worsening, although it certainly has not yet dissipated.

The US and other leading economic powers will have to continue to fight on several fronts for months if not years to come. We recommend the following program of steps:

1. Ensure sufficient capital. While the credit markets have reacted with cautious optimism to recent initiatives, they must still be implemented successfully to have their desired impact. In the US, we recommend dedicating all $700 billion of the TARP money for bank recapitalization, because $250 billion may not be enough as a percentage of the assets involved. Purchasing mortgage-backed securities, if necessary, can be done by Fannie and Freddie. Treasury and the Fed will also need to find a meaningful way to encourage recipients of government capital to use the money to increase lending to the real economy while maintaining healthy capital levels.
2. Lower interest rates. The monetary authorities of these countries need to lower interest rates dramatically. While the United States has little room to lower rates, the UK and the Eurozone still have room for additional reductions. The recent 0.5 percentage point reduction by the ECB, in particular, is particularly worring, as it indicates that the ECB is having a hard time shedding its inflation-fighting instincts to fight the global recession. With a global recession, falling commodity prices, and weak demand, inflation will be low and deflation is a risk.
3. Maintain liquidity. Monetary authorities need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year.
4. Fiscal stimulus. A major fiscal stimulus package is needed to help restore confidence back to the economy, and to encourage businesses not to postpone investment plans. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion (at least 1 percent of GDP), structured so as to work within the local political environment, to offset the coming large decline in global demand. In the US, we recommend a stimulus of $450 billion (3% of GDP), including extended unemployment benefits, expanded food stamp aid, direct aid to state and local governments, and short- and long-term infrastructure spending, at least.
5. Contain the damage in housing. In a credit cycle-driven recession, housing prices can fall below their fundamental value just as they rose above it during the boom. Direct measures need to be taken to break the cycle of foreclosures and fire sales that is driving down prices and causing collateral damage to communities. The goal should not be to prop up housing prices at artificially high levels, but to find outcomes that are better for both homeowners and lenders than foreclosures, large write-offs, and blighted neighborhoods that harm all homeowners.

In addition, these nations also need to determine how their financial sectors should be regulated in the future. Most economists and policy makers agree that the crisis was aggravated by some failure of the regulatory system. While there are disagreements over what that failure was, it is certain that a new regulatory system will be built.

The international arena

The risk for the global financial system is the prospect of financial war. With his appeals for assistance turned down by European countries, Iceland’s prime minister, Geir Haarde, said it is now “every country for itself.” This smacks of the financial autarchy that characterized defaulters in the 1998 financial crisis in Asia, when countries changed the rule of law to benefit domestic constituents over foreigners.

Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and even global peace. Unless the leading industrial countries take concerted action, there’s a very real danger that we will all suffer more.

Highly leveraged countries are at risk of substantial private or public defaults. They need to assess their ability to cover their debts and decide which entities to protect and which to let fail. If necessary, they should commit to early Paris Club and London Club negotiations to restructure external national debts, and encourage private sector entities to begin negotiations with creditors.

Commodity exporters should let their currencies depreciate instead of spending reserves to slow down the adjustment process. Devaluation will be necessary to bring imports and exports back into balance.

The IMF can work with countries needing fiscal and balance of payments support.  It is already signaling that it will reduce the detailed conditions for which it is so well known, and increase its flexibility.  The G7 should support this, and make additional resources available.  We recommend a significant expansion in the IMF’s lending capacity, perhaps up to $1 trillion.

Finally, despite their domestic challenges, wealthy nations also need to do their part. We are going to recapitalize our banks and exercise greater control over them.  We need to make sure they continue to deal with emerging market banks.  We should also avoid cutting our aid to the world’s extremely poor. The upcoming G20 meeting is an opportunity for concerted action by both developed and emerging market countries to combat the global recession.

Conclusion: The need for coordination

We believe the US economy, along with many other parts of the world, is in a major recession precipitated by housing markets but deepened by an extreme loss of confidence in global credit markets. The withdrawal of credit undermines previously solvent institutions, causes unnecessary economic damage and constricts consumption and investment plans. Once confidence is gone, it is extremely difficult to restore. Even after the credit panic subsides, it will leave in its wake the worst global recession in decades.

The outlook for the global economy continues to worsen. While the US and several European countries are already in recession, we are also likely to see substantially more defaults and credit panics in smaller countries and emerging markets. These developments point out the urgent need for international coordination to limit the depth of the recession and avoid international financial warfare.

The last two months have shown that partial and piecemeal actions will no longer work. Small steps announced frequently, especially by a single country acting alone, are neither credible nor powerful enough to make much of a difference. It’s worth bringing a sufficient mass of economic power to bear, in a comprehensive program, to make an impact on the markets.

There is also a need to let prices move to a level supported by the market, which unfortunately means that wealth is likely to decline further. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it may take a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it’s important to be clear that the success of the program should not be measured by rising asset prices.

Finally, we are well past the days where even dramatic steps could have prevented a major recession. Under any scenario, we will see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare.

The Baseline Scenario is our periodic overview of the current state of the global economy and our policy proposals. It includes three sections:

1. Updates that have caused us to modify the baseline since the last version
2. Analysis of the current situation and how we got here
3. Policy proposals

Please note that we do not currently publish our upside and downside risk scenarios in detail.

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UPDATES

This edition of the Baseline Scenario has been extensively updated to reflect recent events, in particular the adoption by the world’s leading economic powers of the first two of our proposals in our original Baseline Scenario.

Europe and the US recapitalize

Last week was a momentous week in the financial crisis, with Europe and the US taking their largest steps yet to stem the credit crunch. On Monday, the UK implemented its bank recapitalization plan, and several European countries announced plans for recapitalization and loan guarantees. As we found out that night, Henry Paulson spent the day twisting the arms of nine US bank CEOs, and the next morning the US announced that $250 billion of TARP money was going into recapitalization.

Is the credit crisis easing?

There are real signs that the credit crisis is easing, at least as far as interbank lending is concerned. LIBOR is coming down, Treasury bill yields are going up, and the market for high-quality commercial paper has started to come back to life. To track this on a daily basis, try Calculated Risk or Planet Money. (However, although banks are finding it slightly easier to raise money, mortgage rates have actually gone up.)

The real economy continues slowing

A barrage of economic indicators shows the economy slipping further into recession, at least in the US.

Emerging market problems deepen

The other major development of the week has been the increasing problems faced by emerging markets, even potentially China.

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ANALYSIS (largely rewritten this week)

The roots of the crisis

For at least the last year and a half, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we are now in.
The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion.  A 25% decline in the value of housing would generate a paper loss of $5.75 trillion. With an estimated 1-3% of housing wealth gains going into consumption, this could generate a $60-180 billion reduction in total consumption – a modest amount compared to US GDP of $15 trillion. We should have seen a serious impact on consumption, but, there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but did not by itself turn a housing downturn into a global financial crisis. There is no basis on which to say banks were too leveraged in one year but were safe the year before; how leveraged a bank can be depends on many factors, most notably the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, today’s crisis was not a foregone conclusion.

There are two possible paths to resolution for an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending, and raise underlying capital. This can occur without much harm to the economy over many years. The second path is more dangerous.  If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices.  These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to falls in their value.

A crisis of confidence

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998.  For countries then, read banks (or markets) today.  In both cases, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

The crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession.  Investors almost instantly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves.  Their currencies fell sharply and their creditors suffered major losses.

From there, the contagion spread for no apparent reason to South Korea – which had little exposure to Southeast Asian currencies – and then to Russia. Russia also had little exposure to Asia. However, Russia was funding deficits through short-term ruble bonds, many of which were held by foreign investors. When short-term creditors panicked, the government and the IMF could not prevent a devaluation (and a default on those ruble bonds). GDP fell 10% the following year. After Russia, the story repeated itself in Brazil. In December 1998 Brazil let the currency float, leading to a sharp depreciation within one month.

In each case, creditors lost confidence that they could get their principal back and rushed to get out at the same time. In such an environment, any institution that borrows short and lends long is vulnerable to such an attack. The victims had one common trait: if credit were cut off they would be unable to find funding. The decision of credit markets became self-fulfilling, and policy makers around the world seemed incapable of stopping these waves.

The current crisis

The evolution of the current financial crisis seems remarkably similar to the emerging markets crisis of a decade ago.

America’s crisis started with creditors fleeing from sub-prime debt in summer 2007.  As default rates rose, investment-grade debt – often collateralized debt obligations (CDOs) built out of sub-prime debt – faced large losses. The exodus of creditors caused mortgage finance and home building to collapse.

The second stage began with the Bear Stearns crisis in March 2008 and extended through the bailout of Fannie Mae and Freddie Mac. As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on the ability to roll over their short-term loans, regardless of the quality of their assets. Given sufficient panic, it can become impossible to roll over those loans. And in a matter of days, despite no major news, Bear Stearns was dead. However, while the Federal Reserve and Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole – a pattern they would follow with Fannie and Freddie. As a result, creditors learned that they could safely continue lending large financial institutions.

This changed on September 15 and 16 with the failure of Lehman and the “rescue” of AIG, which saw a dramatic and damaging reversal of policy. Once Bear Stearns had fallen, investors focused on Lehman; again, as confidence faded away, Lehman’s ability to borrow money evaporated. This time, however, the Fed let Lehman go bankrupt, largely wiping out creditors. AIG was a less obvious candidate target. Despite large exposure to mortgage-backed securities through credit default swaps, no analysts seemed to think its solvency was truly in question. Overnight, however, without any fundamental changes, the markets decided that AIG might be at risk, and the fear became self-fulfilling. As with Lehman, the Fed chose not to protect creditors; because the $85 billion loan was senior to existing creditors, senior debt was left trading at a 40% loss.

This decisive change in policy reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear:  RUN from all entities that might fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needed access to the credit markets to survive might lose access at any time.

As a result, creditors and uninsured depositors at all risky institutions pulled their funds – shifting deposits to Treasuries, moving prime brokerage accounts to the safest institutions (read JPMorgan), and cashing out of securities arranged with any risky institutions. The previously invincible Morgan Stanley and Goldman Sachs saw large jumps in their credit default swap rates. Washington Mutual and Wachovia vanished. LIBOR shot up and short-term US Treasury yields fell as banks stopped lending to each other and lent to the US government instead. The collapse of one money market fund (largely because of exposure to Lehman debt), and the pending collapse of more, sent the US Treasury into crisis mode.

At the same time, the credit market shock waves spread quickly throughout the world. In Europe, interbank loan rates and EURIBOR rates shot up, and banks from Bradford & Bingley to Fortis were nationalized. Further afield, Russia and Brazil each saw major disruptions in their interbank markets and Hong Kong experienced a (small) bank run. From late September, credit markets around the world were paralyzed by the fear that any leveraged financial institution might fail due to a lack of short-term credit. Self-fulfilling collapses can dominate credit markets during these periods of extreme lack of confidence.

The response

There are two ways to end a crisis in confidence in credit markets. The first is to let events unfold until so much deleveraging and so many defaults have occurred that entities no longer rely on external finance. The economy then effectively operates in a “financially autonomous” manner in which non-financial firms do not need credit.  This is the path most emerging markets took in 1997-1998. Shunned by the world investment community, it took many years for credit markets to regenerate confidence in their worthiness as counterparties.

The second is to put a large balance sheet behind each entity that appears to be at risk, making it clear to creditors that they can once again safely lend to those counterparties without risk.  This should restore confidence and soften the coming economic recession.

Governmental responses to the crisis were fitful, poorly planned, and abysmally presented to the public. The US government, to its credit, was the first to act, while European countries boasted they would be little affected. Still, though, Paulson and Bernanke had made the mistake of insisting right through the Lehman bankruptcy that the system was fundamentally sound. As a result, their rapid reversal and insistence that they needed $700 billion for Paulson to spend however he wished was greeted coldly on Capitol Hill and in the media.

The initial Paulson Plan was designed to increase confidence in financial institutions by transferring their problematic mortgage-backed securities to the federal government’s balance sheet. The plan had many problems, ranging from uncertainty over what price the government would pay for the assets to questions about whether it would be sufficient to stop the crisis of confidence. Our initial Baseline Scenario, on September 29, recommended passing the plan and supplementing it with four additional measures: the first two were unlimited deposit insurance and an equity injection program for financial institutions.

After the Paulson Plan was passed on October 3, it was quickly overtaken by events. First the UK announced a bank recapitalization program; then, on October 13, it was joined by every major European country, most of which also announced loan guarantees for their banks. On October 14, the US followed suit with a bank recapitalization program, unlimited deposit insurance (for non-interest-bearing accounts), and guarantees of new senior debt. Only then was enough financial force applied for the crisis in the credit markets to begin to ease, with LIBOR finally falling and Treasury yields rising, although they are still a long way from historical levels.

Dangers for emerging markets

Although the US and Europe have grabbed most of the headlines, the most vulnerable countries in the current crisis are in emerging markets. Just like highly leveraged banks, highly leveraged countries – such as Iceland – are vulnerable to the flight of capital. Countries that got rich during the commodities boom are also highly vulnerable to a global recession.

The flight to safety is already destabilizing banks around the world. For companies that can get credit, the cost has skyrocketed. These financial sector tremors are sending shockwaves through emerging market economies. While wealthy nations can use their balance sheets to shore up banks, many other countries will find this impossible. Like Latin America in the 1980s, or emerging markets after 1997-98, the withdrawal of credit after a boom can lead to steep recessions and major internal disruptions.

Four sets of countries stand to lose.

1. The over-leveraged. With bank assets more than ten times its GDP, Iceland cannot protect its banks from a run. Other countries that borrowed heavily during the boom face a similar situation.
2. The commodity-dependent. Oil has already fallen below $80 per barrel, and demand continues to fall. All other major commodities will fall for the same reasons. Commodity exporters facing sharply reduced revenues will need to cut spending and let their currencies depreciate.
3. The extremely poor. Sub-Saharan Africa, which was a beneficiary of the commodity boom, will be hit hard by the fall in commodity prices. At the same time, wealthy nations are likely to slash their foreign aid budgets. The net effect will be prolonged isolation from the global economy and increased inequality.
4. China. The global slowdown has already had a major impact on several sectors of China’s manufacturing economy. The collapse in the Baltic Dry Index shows that demand for commodities and manufactured goods is plummeting. While China’s economic influence will only grow in the long term, a global recession could cause a severe crimp in its growth.

The world’s attention is currently focused on the G7. But crises in the rest of the world will inflict damage on G7 economies, increase global inequality, and create geo-political instability.

The current situation

Today, although it is by no means assured, it seems relatively likely that the financial panic will gradually ease and the successive collapse of many large banks in the US and Europe will not occur. However, the resumption of interbank lending alone will not be enough to reverse the downward trajectory of the real economy. Banks still need to deleverage in a major way and there are doubts about how much lending to the real economy will pick up. For example, mortgage rates in the US actually increased since the recapitalization plan was announced. In a worst case scenario, even some wealthy countries may not be able to absorb the losses sustained by their banks. The US will have to worry not just about its banks, but also about some insurance companies and quasi-financial companies such as GMAC, Ford, and GE.

Before the severe phase of the crisis began on September 15, the world was already facing an economic slowdown. The credit crisis of the past month and the lingering uncertainty seem certain to produce a global recession. In the face of uncertainty and higher credit costs, many spending and investment decisions will be put on hold. US and European consumption decline along with housing prices. With interest rates rising around the world, companies will pay down debt and reduce spending and investment plans. State and municipal governments will see lower tax revenues and cut spending.  No country can rely on exports to provide much cushion, as growth and spending around the world have been affected by the flight from credit.

Recent economic indicators in the US show significant deterioration in the real economy. Because these indicators are from the entire month of September, they probably understate the effect of the acute credit crunch of the second half of the month, which we will not fully appreciate October data appear in the middle of November.

The damage will be particularly acute in emerging market economies. As the wealthiest nations protect their banking sectors, investors and lenders will be less likely to put their money in countries perceived as risky. Iceland is already facing default, either by its banking sector or by its government. After Iceland, the psychology of fear is likely to take over as creditors try to guess which country will be next, just as in 1997-98. Unless a country has a sufficient balance sheet and a very large amount of reserves, there will be selective defaults and large devaluations.  It is hard to see how the IMF or anyone else can provide resources on a sufficient scale to make a difference. Some countries in Eastern Europe and Latin America are clearly showing signs of risk.

Falling commodity prices due to the coming recession will also hurt many exporting countries. Even Russia, with its large foreign currency reserves (and vast oil and gas reserves) may have a significant mismatch problem between short term liabilities and longer term assets. This is complicated further by large private sector debt in foreign currency. The government may be moving toward deciding which companies they will save. Hopefully, for the companies they do not support, it will be possible to have an orderly workout.

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POLICY PROPOSALS

The G7

So far, the US response has included major increases in liquidity, the $700 billion TARP program, the dedication of $250 billion of that money to bank recapitalization, unlimited deposit insurance, guarantees of new senior bank debt, a program for the Fed to buy commercial paper directly, an interest rate cut, and the usage of Fannie and Freddie to buy $40 billion per month of mortgage-related securities. Put together, this seems to have stopped the panic from worsening, although it certainly has not yet dissipated.

The US and other leading economic powers will have to continue to fight on several fronts for months if not years to come. We recommend the following program of steps:

1. Ensure sufficient capital. While the credit markets have reacted with cautious optimism to the initiatives announced last week, they must still be implemented successfully to have their desired impact. In the US, we recommend dedicating all $700 billion of the TARP money for bank recapitalization, because $250 billion may not be enough as a percentage of the assets involved. Purchasing mortgage-backed securities, if necessary, can be done by Fannie and Freddie. Treasury and the Fed will also need to find a meaningful way to encourage recipients of government capital to use the money to increase lending to the real economy while maintaining healthy capital levels.
2. Lower interest rates. The monetary authorities of these countries need to lower interest rates dramatically. Europe, Canada and the United States recently announced a coordinated 0.5 percent reduction in rates. This is a good start, but only a start. More will be needed, especially in Europe, where a historical focus on inflation fighting risks having the wrong effect. We are on course for a global recession, in which commodity prices will continue to fall and demand will remain weak. Inflation will be low and deflation is a risk.
3. Maintain liquidity. Monetary authorities need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year.
4. Fiscal stimulus. A major fiscal stimulus package is needed to help restore confidence back to the economy, and to encourage businesses not to postpone investment plans. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion (at least 1 percent of GDP), structured so as to work within the local political environment, to offset the coming large decline in global demand. We would recommend cash payments and rebates to households and short term investment tax credits to businesses. This is a major way to help both homeowners and renters.
5. Contain the damage in housing. In a credit cycle-driven recession, housing prices can fall below their fundamental value just as they rose above it during the boom. Direct measures need to be taken to break the cycle of foreclosures and fire sales that is driving down prices and causing collateral damage to communities. The goal should not be to prop up housing prices at artificially high levels, but to find outcomes that are better for both homeowners and lenders than foreclosures, large write-offs, and blighted neighborhoods that harm all homeowners.

In addition, these nations also need to determine how their financial sectors should be regulated in the future. Most economists and policy makers agree that the crisis was aggravated by some failure of the regulatory system. While there are disagreements over what that failure was, it is certain that a new regulatory system will be built.

The international arena

The risk for the global financial system is the prospect of financial war. With his appeals for assistance turned down by European countries, Iceland’s prime minister, Geir Haarde, said it is now “every country for itself.” This smacks of the financial autarchy that characterized defaulters in the 1998 financial crisis in Asia, when countries changed the rule of law to benefit domestic constituents over foreigners.

Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and even global peace. Unless the leading industrial countries take concerted action, there’s a very real danger that we will all suffer more.

Highly leveraged countries are at risk of substantial private or public defaults. They need to assess their ability to cover their debts and decide which entities to protect and which to let fail. If necessary, they should commit to early Paris Club and London Club negotiations to restructure external national debts, and encourage private sector entities to begin negotiations with creditors.

Commodity exporters should let their currencies depreciate instead of spending reserves to slow down the adjustment process. Devaluation will be necessary to bring imports and exports back into balance.

The IMF can work with countries needing fiscal and balance of payments support.  It is already signaling that it will reduce the detailed conditions for which it is so well known, and increase its flexibility.  The G7 should support this, and make additional resources available.  One widely expressed view is that currently the IMF could save only 2-1/2 Icelands.

Finally, despite their domestic challenges, wealthy nations also need to do their part. We are going to recapitalize our banks and exercise greater control over them.  We need to make sure they continue to deal with emerging market banks.  We should also avoid cutting our aid to the world’s extremely poor.

Conclusion: The need for coordination

We believe the US economy, along with many other parts of the world, is entering a recession precipitated by housing markets but primarily caused by an extreme loss of confidence in global credit markets. The withdrawal of credit undermines previously solvent institutions, causes unnecessary economic damage and constricts consumption and investment plans. Once confidence is gone, it is extremely difficult to restore. This is not a case of efficient markets, but a self-fulfilling series of credit panics causing significant economic damage.

The outlook for the global economy continues to worsen. While the US and several European countries are likely to go into recession, we are also likely to see substantially more defaults and credit panics in smaller countries and emerging markets. These developments point out the urgent need for international coordination to limit the depth of the recession and avoid international financial warfare.

The last month has shown that partial and piecemeal actions will no longer work. Small steps announced frequently, especially by a single country acting alone, are neither credible nor powerful enough to make much of a difference. It’s worth bringing a sufficient mass of economic power to bear, in a comprehensive program, to make an impact on the markets.

There is also a need to let prices move to a level supported by the market, which unfortunately means that wealth is likely to decline further. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it may take a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it’s important to be clear that the success of the program should not be measured by rising asset prices.

Finally, we are well past the days where even dramatic steps could have prevented a major recession. Under any scenario, we will see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare.

Published weekly, The Baseline Scenario is divided into two parts: analysis (this post) and policy (a separate post).  In the analysis section, we first explain how we have updated (or not) our views, based on the major developments of last week.  Then, we state our overall view of how the global economy got into its current situation and where this is likely heading. Readers who remember what we said last week can just look at the updates and then go to policy).  The policy section reports our current view on policies in the US and elsewhere.

Please note that we do not currently publish our upside and downside risk scenarios in detail.

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Updates

Europe recapitalizes

The most important recent development is the – at least partial – shift in European government attitudes during the past few days.  Over the weekend Europe announced a bank recapitalization program, along national lines.  As we prepare to publish, key details remain vague, but it appears they are trying to provide guarantees only at the margin (for new debt, etc).  Presumably this is because the total balance sheets involved are too large for the governments to take on blanket guarantees.

Each country will have a different plan and how these will mesh together remains unclear.  It is also unclear why these plans were not announced with and coordinated within the G7 on Friday, the communiqué of which was vague.  Exactly what the European Central Bank will do also remains unclear.  And surely there are unaddressed gaps between these country-based approaches.

There will also be an end of mark-to-market accounting in Europe, which seems unfortunate.  Reducing transparency is not obvious as an exit strategy in this environment.

The continental European moves follow steps by the British last week towards recapitalization.  These resulted in lower credit default swap spreads for British and European banks (i.e., lower probability of default, in the market view), but LIBOR actually increased (i.e., interbank lending problems did not get better).  There were some signs that international trade credit was drying up on Friday, notwithstanding these policy moves.

The main result of these measures is that we can be somewhat more confident that a major financial panic causing the downfall of many European banks will not occur soon.  However, although these moves mark a substantial change, it is not clear how this changes the (downward) trajectory of the real economy or turns around equity valuations in a sustained manner. Banks still need to deleverage in a major way and government equity injections will dilute existing shareholders.  It is true that there should be more confidence in being a creditor to a European bank, but markets already thought they would get bailed out by European governments, so the gain in this regard is limited.

The grim reality is that most European nations cannot truly afford to bail out their banks if a serious recession occurs.  For example, the assets of Royal Bank of Scotland are similar to the UK’s entire GDP.  If the UK’s recession proves deep, markets will start to question whether the UK government can afford to finance these banks.  It will be tempting to either default, or let inflation rise to erode the value of liabilities.  The probability of default for sovereigns in Europe has risen significantly (although it still remains low) over the past 10 days.

America follows Europe

The US is also moving towards bank recapitalization, but more slowly, and it is unclear if a comprehensive program is the top priority.  It is true that the number of financial institutions in the US adds a level of complexity, and that there are various ways to treat nonbank financial institutions, each with its own drawbacks.  The treatment of insurance companies remains a particularly important unclear part of the overall puzzle.

However, the US strategy also seems hung up on the original mission of the Troubled Assets Relief Program, which was to buy mortgage-backed securities (MBS).  As this program is due to start in about a month, it now seems neither here nor there.

The US already has Fannie Mae and Freddie Mac buying up distressed mortgage-backed securities, to the tune of about $40bn total per month.  It is not clear why this has not been scaled up faster, particularly as it is much easier to run that the not-yet-designed TARP auctions.  Fannie and Freddie are capable of restructuring quite a large volume of MBS, if this were to become their top priority.

The US strategy for Morgan Stanley and Goldman Sachs remains unclear.  For Morgan Stanley, a sale to foreigners (Mitsubishi UFG) with backstop from the Fed seems to be signaled, although it is not clear how this will play politically.  Something similar might happen with Goldman Sachs.  If those don’t work, conservatorship is still possible.  This is an important event to watch: if creditors are made whole, it will provide some badly needed additional confidence in bond markets.  As of Friday, Morgan Stanley’s long-dated bonds were trading at 50-60 cents on the dollar.

Once Morgan Stanley and Goldman Sachs are put to bed, there will be plenty more finance-related firms to come.  The market knows that GMAC, Ford, GE and several other quasi-financial companies are at risk.  Very recently, there has been a concerning rise in credit default swaps of large insurance companies:  Prudential Financial now prices in a nearly 60% chance of default within five years, and other major insurance companies are at risk.

The US government was early to provide fiscal stimulus to the economy.  There is now talk of additional assistance: Congressional leadership seems interested in a lame duck session, in part to put through a modest fiscal package ($100-150bn).

Outside the US and Europe

The situation around Iceland and the default of its banks seems to point the way for emerging markets that previously relied heavily on capital inflows or commodity exports.  Unless a country has a sufficient balance sheet and a very large amount of reserves, there will be selective defaults and large devaluations.  It is hard to see how the IMF or anyone else can provide resources on a sufficient scale to make a difference. Some countries in Eastern Europe and Latin America are clearly showing signs of risk.

The Russian situation may indicate the future path for other emerging markets.  The government’s assumption is that everything will be fine because oil will be at least $60 per barrel oil as planned in their 2009 budget. Up to now, there was widespread agreement that this was a conservative assumption.  But it now looks like oil could fall a lot more, and the equity prices of global oil companies are already indicating this.

Russia is perceived as having a significant potential mismatch problem between very short term liabilities and longer term assets. This is complicated further by large private sector debt in foreign currency.  The government may be moving toward deciding which companies they will save. Hopefully, for the companies they do not support, it will be possible to have an orderly workout. There is a real danger that the substantial reserves will be used now, to defend the exchange rate, rather than being saved for later, when they could be more use.

It is quite evident that foreign and domestic banks are changing their strategy in Russia, going for “quality rather than growth.”  This will likely be the pattern much more generally, and points clearly to a major slowdown in growth across almost all markets.

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Overview (includes material from previous editions, edited partly in the light of reader comments).  Readers familiar with this material should skip to the latest policy implications.

In order to figure out how to combat the current economic crisis, it is important to understand what kind of crisis we are dealing with. The conventional wisdom is that we are dealing with a housing crisis (falling housing prices) magnified by excessive leverage. But this puts the emphasis in the wrong place, and fails to grasp the key dynamics of the crisis.

More than a housing crisis …

Problems in the U.S. housing market triggered a global crisis of confidence in global financial institutions, but the housing problems themselves were not big enough to generate the current financial collapse.

America’s housing stock, at its peak, was estimated to be worth $23 trillion.  A 25% decline in the value of housing would generate a paper loss of $5.75 trillion – similar to the losses observed in the 2000-2002 decline in stock prices, and not far off the losses as a share of GDP due to the 1987 stock market crash. With an estimated 1-3% of housing wealth gains going into consumption, this could generate a $60-180 billion long-term reduction in total consumption – a modest amount compared to US GDP of $15 trillion. The resulting decline in the US dollar, which boosts exports, and the offsetting fiscal stimulus, would probably have reduced the overall shock by at least half.  We should have seen a serious impact on consumption, but, there was no reason to a priori believe we were embarking on a crisis of the current scale or entering a deep recession.

… not just too much leverage

But, conventional wisdom continues, this fall in housing prices was magnified by leverage, causing financial institutions to collapse. But this is also not a compelling argument.  There is no magical point at which an institution becomes too leveraged. The range of leverage at institutions varies enormously: typical commercial banks have assets which are 10-12 times their equity, while some investment banks recently had assets that were 30 times their equity.  However, to the extent investment banks offer loans secured against underlying, liquid securities, those loans are more “secure” than typical commercial bank loans.

Credit in the economy, relative to the size of incomes, has been growing over the last 50 years, and it is hard to know when exactly the US had “too much” credit.  Even if we assume that credit was overextended, today’s crisis was not a foregone conclusion. There are two possible paths to resolution for an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending, and raise underlying capital. This can occur without much harm to the economy over many years.

The second path is more dangerous.  If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices.  These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to falls in their value.

Although leverage itself did not cause the current crisis, now we can see how leverage can be calamitous: all leveraged financial systems, regardless of the level of leverage, have the ability to collapse far more sharply than prior fundamentals would deem plausible.

How a crisis of confidence spreads

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets from Thailand to Korea to Russia to Brazil in 1997 and 1998.  For countries then, read banks (or markets) today.  In both sets of cases, a crisis of confidence among short-term creditors causes them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

The crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession.  Investors almost instantly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves.  Their currencies fell sharply and their creditors suffered major losses.

From there, the contagion spread for no apparent reason to South Korea – which had little exposure to Southeast Asian currencies, and even participated in the IMF bailout of Thailand – and then to Russia. At the time, Russia was emerging from recession and had little exposure to Asia. However, Russia was funding deficits through short-term rouble bonds, many of which were held by foreign investors.  When short-term creditors panicked, the best efforts of the government and the IMF could not prevent a devaluation (and a default on those rouble bonds). GDP fell 10% the following year, and creditors suffered in one of the largest single national defaults in history. After Russia, the story repeated itself in Brazil. In December 1998 Brazil let the currency float, leading to a sharp depreciation within one month.

In each case, creditors lost confidence that they could get their principal back and rushed to get out at the same time. In such an environment, leverage is not a necessary ingredient for a financial collapse; any institution that borrows short and lends long is vulnerable to such an attack. However, the contagion often spread despite little real economic links. The victims had one common trait:  if credit were cut off they would be unable to find funding. The decision of credit markets became self-fulfilling, and policy makers around the world seemed incapable of stopping these waves.

How did we get here?

In this context, the evolution of America’s crisis seems remarkably similar to the emerging markets crisis of a decade ago.

America’s crisis started with creditors fleeing from sub-prime debt in summer 2007.  Rapidly rising default rates made clear these were poor investments. Investment-grade debt – often collateralized debt obligations (CDOs) built out of sub-prime debt – faced large losses. The exodus of creditors caused mortgage finance and home building to collapse.

The second stage began with the Bear Stearns crisis in March 2008 and extended through the bailout of Fannie Mae and Freddie Mac. As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on the ability to roll over their short-term loans, regardless of the quality of their assets. In other words, they became like emerging market economies in 1997. And in a matter of days, despite no major news, Bear Stearns was dead.

However, while the Federal Reserve and Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole – a pattern they would follow with Fannie and Freddie. In effect, the government sent the message that creditors could safely keep their counterparty risk with large financial institutions – implicitly encouraging banks to continue lending to each other.

The third stage, beginning two weeks ago with the failure of Lehman and the “rescue” of AIG, marked a dramatic and damaging reversal of policy.  Once Bear Stearns had fallen, it was natural that investors would focus on Lehman; and again, as confidence faded away, Lehman’s stock fell  and its ability to borrow money evaporated. This time, however, the Fed let Lehman go bankrupt, largely wiping out creditors.

AIG was a less obvious candidate for a liquidity run. Despite large exposure to mortgage-backed securities through credit default swaps, no analysts seemed to think its solvency was truly in question. This changed almost overnight, not because of any fundamental changes, but simply because the markets decided that AIG might be at risk. As with Lehman, Treasury and the Fed sent the message that creditors would not be protected. The $85 billion loan was not only granted at the usurious rate of LIBOR plus 850 basis points but secured by AIG’s most valuable assets, leaving senior debt trading at a 40% loss.

This decisive change in policy probably reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear:  RUN from all entities that might fail – even if they seem too big to fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needs access to the credit markets to survive might lose access at any time. The next targets were obvious: the previously invincible Morgan Stanley and Goldman Sachs, each with $1 trillion balance sheets and a assets-to-equity ratios of 24 and 30, respectively (in the second quarter), saw large jumps in their credit default swap rates.  Citibank, with its $2 trillion balance sheet, also experienced a major fall in its share price.

As a result, creditors and uninsured depositors at all risky institutions are finding means to pull their funds – shifting deposits to Treasuries, moving prime brokerage accounts to the safest institutions (read JPMorgan), and cashing out of securities arranged with any risky institutions.  The sudden rise of LIBOR (for interbank lending) matched by a fall in short-term US Treasury rates illustrates the shift of funds from banks to Treasuries. These sudden changes in liquidity invariably lead to stress:  the collapse of one money market fund (traditionally seen as safe and attracting retail customers), and the pending collapse of more, sent the U.S. Treasury into crisis mode.

Like a decade ago, the credit market shock waves spread quickly throughout the world. In Europe, interbank loan rates and EURIBOR rates shot up, and banks from Bradford & Bingley to Fortis were nationalized. Further afield, Russia and Brazil each saw major disruptions in their interbank markets and Hong Kong experienced a (small) bank run.

Creditor beware

There is general fear around the world that any leveraged institution might fail. Capital and solvency don’t matter, just whether the company can survive if short-term credit is cut off or borrowing rates sharply rise. JPMorgan obviously thought Bear Stearns was not insolvent when they paid $10 per share in the fire sale; Lehman fell when it still had a reported book value per share of $27.29; and the fall of AIG seems clearly due to a liquidity run.  The problem is simple: there are just too few entities with a large enough balance sheet to stop liquidity runs. Once a liquidity run succeeds, liquidation destroys a large portion of the value, and creditors lose out. Self-fulfilling collapses can dominate credit markets during these periods of extreme lack of confidence.

There is a second aspect of these collapses. When companies fall, the survivors benefit: JPMorgan obtained Bear Stearns and Washington Mutual at fire-sale prices; Bank of America hauled in Merrill Lynch; Barclays and Nomura divided Lehman’s assets; Warren Buffett negotiated a sharp deal with Goldman Sachs; Mitsubishi-UFG is doing the same with Morgan Stanley; and it looks like Wells Fargo will win the bulk of Wachovia. While the conventional wisdom views this as healthy, in reality this leads to predatory behavior by health companies. The acquirers have an incentive to wait, let a company fall, and then scoop up the assets, with the blessing of Treasury and the Fed.  This is standard market behavior, without any collusion or conspiracy.

In this context, there are two critical questions.  First, what happens next?  And second, what can we do about it?

What’s next?

The events of the last few months could be setting the stage for a major global recession.  In the face of uncertainty and higher credit costs, many spending and investment decisions will be put on hold. We will surely see US and European consumption decline along with housing prices. With credit default swap rates and interest rates rising around the world, companies will prefer to pay down debt and reduce spending and investment plans. State and municipal governments will see lower tax revenues and so cut spending.  In the United States, we can no longer rely on exports to provide much cushion, as growth and spending around the world have been affected by the flight from credit.

There are two ways to end a crisis in confidence in credit markets.  The first is to let events unfold until so much deleveraging and so many defaults have occurred that entities no longer rely on external finance. The economy then effectively operates in a “financially autonomous” manner in which non-financial firms do not need credit.  This is the path most emerging markets took in 1997-1998. Shunned by the world investment community, it took many years for credit markets to regenerate confidence in their worthiness as counterparties. Today, the U.S. is still far from such a scenario.

The second is to put a large balance sheet behind each entity that appears to be at risk, making it clear to creditors that they can once again safely lend to those counterparties without risk.  This should restore confidence and soften the coming economic recession.

The policy makers of the world’s financial powers have chosen the second route, as evidenced by the statements made at this weekend’s G7 and IMF meetings. However, so far they have failed to act swiftly and decisively enough to stem the panic. The original Paulson plan (to purchase mortgage-backed securities) was not enough. $700bn is a relatively small fraction of the amounts in question. More than a week after passage, many details remain unclear.

The consensus seems to be shifting toward more drastic steps, including explicit bank recapitalization (since discovered in the Paulson plan) and guarantees of bank obligations. The coming week will see the announcement of many specifics, and will reveal whether these are able to restore confidence in the credit markets.

As the wealthiest nations protect their banking sectors, damage will spread to emerging market economies. Iceland is already facing default, either by its banking sector or by its government. Capital flight to the safety of the G7 will trigger major deleveraging in overextended countries around the world. Falling commodity prices due to the coming recession will also hurt many exporting countries.

Additional decisive, well-timed measures will be needed to restore confidence, and these should be thought out and prepared in advance. See our policy proposals for details.

(For an explanation of the baseline scenario and our analysis, go here.)

The U.S.

The key weapon that the United States possesses is that the U.S. balance sheet is credible.  The U.S. is not going to lose its AAA rating.  The U.S. balance sheet cannot save everyone in the world, but if necessary it can be used to draw a line in the sand and restore confidence.

Today, according to the spreads on credit default swaps – which measure the expected probability of default – investors believe a handful of large and medium-sized banks are safe.  However, these safe names may appear at risk in the future. The government needs to have a plan to protect today’s safe banks from self-fulfilling credit panics if necessary.

The US plan should include at a minimum the following measures:

1. For a limited period, the FDIC should extend its deposit guarantee to all deposits at regulated financial institutions.  The full extent of this coverage and how smoothly it works for depositors can be better communicated. Depending on the circumstances, a temporary guarantee for all bank obligations may be desirable.

2. The US Treasury should establish a preferred equity injection program for core financial institutions (regulated entities including commercial banks, savings and loans, and credit unions), and present them with two options for meeting capital requirements.  First, they can go to private markets.  Second, they can access the Treasury window, which is available for only a limited period of time.  The Treasury will accept all applications that meet two provisions: after the new issue of preferred shares to the government, the institution would be well capitalized even in stress situations (e.g., a severe recession); and the pricing of this equity injection makes sense for taxpayers as an investment.  This would put banks under a great deal of pressure to raise more capital, but whether they do it through shares that are bought by the Treasury or through private markets is up to them.  We would use all the $700bn in the Troubled Asset Relief Program (TARP) for this purpose.

3. A major fiscal stimulus package is needed to help restore confidence back to the economy, and to encourage businesses not to postpone investment plans.  Counter cyclical programs to help consumers always make sense in this kind of situation.  We would recommend cash payments and rebates to households and short term investment tax credits to businesses. This is a major way to help both homeowners and renters.  Note that implementing a fiscal stimulus package without recapitalizing the financial system would have a much lower chance of success and reduce the fiscal space that may be needed down the road to support the financial system.

4. Housing is a critical component of rebuilding confidence in financial markets.  In a credit cycle driven recession, it is easy to imagine that house prices could fall below some longer term measure of fundamental value.  Therefore direct measures need to be taken that will break the cycle of foreclosures and fire sales that is now driving down prices.  Managing that process will be a major task for the next 2-3 years.  Starting this process now may also be essential to the political legitimacy of any decisive approach.

The main objection to this approach will come from people who worry a great deal about “moral hazard” in the banking system, meaning that if we bail out banks, this will encourage further risk taking.  Moral hazard is an important potential problem in any financial market.  Because people believe that something may be bailed out, the pattern of investment is distorted and the market becomes less efficient.  But at this point, we need to stop the credit crunch in order to begin moving back in the direction of a more efficient allocation of capital.  In a short-term crisis of this nature, moral hazard is not the preeminent concern.
In the long term, however, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.  And we should aim to design, down the road but quite soon, a system with less pervasive and less damaging moral hazard-related problems than the system that now needs to be saved.

Europe

European policy makers were initially being slow to respond. While Americans recognized the danger of a rapidly spreading crisis of confidence, Europeans seemed more preoccupied with avoiding the inflation of the 1970s. More recently, however, European policymakers have begun taking action. A decisive European policy response will be critical to limiting the scope of the recession.

Today, markets and events are predicting a major global recession. The Dow Jones Basic Materials Index has fallen 32% since end August. This index reflects the future profitability of basic materials producers, and so predicts a major decline in commodity prices. The price-earnings ratios of European and UK stocks, now near historic lows, are only reasonable if we believe a major earnings recession is upon us. The rise of credit default swap (CDS) spreads, especially for the financial sector, also indicates that major banks around the world are in danger.

Because of the global credit crisis, inflation is not a serious risk. Despite the perverse but short-lived increase in commodity prices this year, we will now see sharply falling prices. Across most countries in Europe we will see sharply falling housing prices.  Companies are now reducing investment and spending plans due to the high cost, or lack, of debt and desire to build cash balances.  Today’s weak unions will not have bargaining power in this environment; workers will not want to risk losing their jobs when faced with negative equity in their houses. There simply will not be room for workers to demand high wages nor companies to pay, and hence a wage price spiral as in the 1970s is most unlikely.

Emerging markets

The most vulnerable countries in the current crisis are in emerging markets. Just like highly leveraged banks, highly leveraged countries – such as Iceland – are vulnerable to the flight of capital. Countries that got rich during the commodities boom are also highly vulnerable to a global recession.

The flight to safety is already destabilizing banks around the world. Despite India’s small external debt, its largest private-sector bank suffered a deposit run and lost half of its value. Liquidity contractions have affected banks in Russia, Brazil, and other emerging markets. And ror companies that can get credit, the cost has skyrocketed. Gazprom, despite reasonable debt levels and the world’s largest natural gas reserves, has seen financing costs rise from 7% to 11.5% over the past year. For Gazprom, debt servicing costs will restrict expansion; for many smaller companies, the result will be bankruptcy.

Financial sector tremors will send shockwaves through emerging market economies. While wealthy nations can use their balance sheets to shore up banks, many other countries will find this impossible. Like Latin America in the 1980s, or emerging markets after 1997-98, the withdrawal of credit after a boom can lead to steep recessions and major internal disruptions. This, in turn, will dampen economic activity in North America and Western Europe.  Four sets of countries stand to lose.

1.The over-leveraged. With bank assets more than ten times its GDP, Iceland cannot protect its banks from a run. Other countries that borrowed heavily during the boom face a similar situation. Some smaller East European nations have large current account deficits and central bank reserves that are low relative to (high) private sector gross debt levels.

2. The commodity-dependent. Oil has already fallen below $80 per barrel from its high above $140, and demand continues to fall. All other major commodities will fall for the same reasons. Commodity exporters facing sharply reduced revenues will need to cut spending and let their currencies depreciate. But managing this transition will be difficult.

During the boom, Russia’s government built up $550 billion in reserves and reduced public debt. At the same time, however, the non-public sector borrowed $450 billion, with many more loans probably going unreported. If the ruble depreciates, these foreign-denominated loans will drive many companies into bankruptcy. The government has transferred $200bn of reserves to the private sector to pay off foreign loans, while spending more to support the ruble instead of letting it depreciate. This is the challenge facing other commodity exporters.

3. The extremely poor. Sub-Saharan Africa, which was a beneficiary of the commodity boom, will be hit hard by the fall in commodity prices. At the same time, wealthy nations are likely to slash their foreign aid budgets. The net effect will be prolonged isolation from the global economy and increased inequality.

4. China? With its massive foreign reserves and rapidly rising domestic demand, China seems well positioned to weather the crisis. However, China alone is unlikely to meaningfully offset the global recession. Despite producing no more than 1/10th of the world’s GDP, China has a voracious appetite for commodities, consuming 37% of the world’s steel, largely due to infrastructure investment. The boom is likely over.

The world’s attention is currently focused on the G7. But crises in the rest of the world will inflict damage on G7 economies, increase global inequality, and create geo-political instability.

Highly leveraged countries are at risk of substantial private or public defaults. They need to assess their ability to cover their debts and decide which entities to protect and which to let fail. If necessary, they should commit to early Paris Club and London Club negotiations to restructure external national debts, and encourage private sector entities to begin negotiations with creditors.

Commodity exporters should let their currencies depreciate instead of spending reserves to slow down the adjustment process. Devaluation will be necessary to bring imports and exports back into balance.

The IMF can work with countries needing fiscal and balance of payments support.  It is already signaling that it will reduce the detailed conditions for which it is so well known, and increase its flexibility.  The G7 should support this, and make additional resources available.  One widely expressed view is that currently the IMF could save only 2 ½ Icelands.

Finally, despite their domestic challenges, wealthy nations also need to do their part. We are going to recapitalize our banks and exercise greater control over them.  We need to make sure they continue to deal with emerging market banks.  We should also avoid cutting our aid to the world’s extremely poor.

Conclusion: Time to prepare bigger programs

We believe the U.S. economy, along with many other parts of the world, is entering a recession precipitated by housing markets but primarily caused by an extreme loss of confidence in global credit markets. The withdrawal of credit undermines previously solvent leveraged institutions, causing unnecessary economic damage, and inhibits consumption and investment plans.  While the initial housing shock may have generated a moderate decline in growth, the credit shock will have a much larger impact.

Once confidence is gone, it is extremely difficult to restore.  Creditors need to be confident they can get their money back, but the list of entities where they feel secure is declining at a rapid rate.  This is not a case of efficient markets, but a self-fulfilling series of credit panics causing significant economic damage.
The global financial outlook continues to worsen. The United States has been forced to shore up Wall Street and European governments are bailing out numerous commercial banks. Even more alarmingly, the country of Iceland is presiding over a massive default by all its major banks. We’re now likely to see substantially more defaults and credit panics in smaller countries and emerging markets. This troubling development points not only to an even more painful recession than anticipated, but also to the urgent need for international coordination to avoid something worse: all-out financial warfare.

With his appeals for assistance turned down by European countries, Iceland’s prime minister, Geir Haarde, commented on Monday that it is now “every country for itself.” This smacks of the financial autarchy that characterized defaulters in the 1998 financial crisis in Asia, when countries changed the rule of law to benefit domestic constituents over foreigners.

This is a natural outcome of chaotic times. Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and global peace. Unless the leading industrial countries take concerted action, there’s a very real danger that we will all suffer more.

If governments don’t respond with sensible, coordinated policies, there’s a risk of financial war. Here are six steps toward avoiding “every country for itself,” building on our proposed approach for the US and on our earlier suggestions for Europe (some of which have now been adopted).

1. The world’s leading financial powers – at a minimum the United States, United Kingdom, France and Germany – should jointly announce national plans to require recapitalization of banks – i.e., restructuring their debt and equity mixture – so that they have sufficient capital to weather a major global recession. How this is done can be determined internally by each nation, but this should be a common goal, so that citizens and companies can again trust their banks.

2. If confidence continues to wane, countries should also announce a temporary blanket guarantee on all existing bank deposits and debts. This will in effect promise creditors that they can safely expect the institutions to function until the recapitalization takes place, and it will help prevent the large flows of funds that could occur as some banks or countries conduct recapitalizations earlier than others. This blanket guarantee should only be temporary (e.g., for six months).

3. The monetary authorities of these countries need to lower interest rates dramatically. Europe, Canada and the United States recently announced a coordinated 0.5 percent reduction in rates. This is a good start, but only a start. More will be needed, and it won’t stop the credit crunch within or across countries. The events of the last nine months have set us on course for a global recession, in which commodity prices will continue to fall and demand will remain weak. Inflation will be low and deflation (falling prices) is a risk. More interest rate cuts will be needed.

4. The monetary authorities also need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year.

5. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion (at least 1 percent of GDP), structured so as to work within the local political environment, to offset the coming large decline in global demand.

6. Many families worldwide are going to have negative equity (i.e., mortgages larger than the value of their homes) due to declining home prices. There are going to be large-scale recriminations against lenders and politicians. The most affected nations, including the United States, the UK, Ireland and Spain, urgently need to develop scaled-up programs to provide relief for homeowners both to offset real hardship and to prevent a vicious downward cycle in home prices.

It’s important to prepare properly: partial and piecemeal actions will no longer work. Actions by one country alone, and the current pattern of small steps announced frequently, are no longer credible enough to change the tide: Markets need to be jolted out of their panic. It’s worth bringing a sufficient mass of economic power to bear, in a very comprehensive program, to unfreeze the markets.

There is also a need to let prices move to a level supported by the market, which unfortunately means that wealth is likely to decline further. The events of the last six months will almost surely cause a recession, and large downward revisions in earnings estimates are a near certainty. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it take a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it’s important to be clear that the success of the program should not be measured by rising asset prices.

Finally, it’s important for everyone to recognize that we are well past the days where even dramatic steps could have stopped the panic and prevented a major recession. A successful program will not prevent recession, and we will still see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare.

Feel free to comment with criticisms or suggestions.

Editor’s Note: The content below was originally a separate page, linked to from the short blog post above. I have consolidated it into this single post, after the jump.

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.

[Comments from the original page have been copied below.]

1. With respect to the bank recapitalization component of your policy proposal, could you expand on safeguards, if any, you would recommend be attached to direct government involvement in the process?

   In particluar, at least in the US, there is a serious basis for concern about politicalization of the financial system unless government’s role is carefully circumscribed. As is all too painfully apparent now, one of the roots of the present crisis was political pressure to underwrite lending to uncreditworthy borrowers. How much moreso would the system be susceptible to political intermeddling with massive governmental capital now directly part of the picture.

   For example, would you recommend that any preferred rights to be acquired by government be nonconvertible to equity? That, under no circumstances, the governement stakeholders be given voting rights in the financial corporations? In addition, would you suggest mechanisms of insulating the government entities involved in recapitalization from the political branches?

   Given the gravity of the present crisis, the case for recapitalization is strong. But we don’t want to be sowing the seeds for the next crisis.

   AlexS

   October 8, 2008 at 11:19 am Edit

2. This website offers hope. Is there a way readers can help the cause?

   Thomas

   October 8, 2008 at 4:47 pm Edit

3. I feel that the financial situation can get better if we use the right approach and don’t spend anymore money that will put the country more in debt. I think the banks will eventually give confidence back to the consumers. In order to do that a diffrent policy must be formed.

   Andrea R.

   October 15, 2008 at 12:00 pm Edit

4. ….very much appreciate your help in understanding all this turmoil…I also feel that your proposals have great merit!!

   best wishes

   David Mark Lane, AIA

   October 6, 2008 at 4:27 pm Edit

In fact, the details of the Citi-Wachovia deal looked to be very much in line with our expectations (and, yes, we have a list of banks that we expect to run into trouble, but we’re not posting it here.)

The Baseline Scenario can also handle the Paulson Plan struggling in Congress, in two senses.  First, if it doesn’t pass, there are other measures that the Fed and Treasury can take to shore up markets in the short term.  None of these are attractive for the long haul, but we really need to get through November 4, so a new team can get in place (I know they don’t take office until January, and you can’t have more than one President, but there are workarounds.)

Second, even if it does pass, we’re quite skeptical that the Paulson Plan will fix the deeper underlying issues (see the long memo that is the First Edition of our Baseline Scenario).  So you’ve got to get cracking in any case on discussing, educating, and negotiating around a potential Plan B.

Also, market volatility and downward pressure on equity prices are very much in our Baseline.  The dollar, you will have noted, held up rather well today.  Where else are you going to put your money, particularly when there may be further nasty surprises lurking somewhere in the European banking system?

Still, I would mark the day overall as slightly below expectations.  I think it was the general tone and sense that order was lacking (and that expected votes in the House did not materialize).  Also, I wonder what will happen tomorrow, which is not a working day for Congress while the markets will be open.

Days until the election: 35

Update: to be clear, our plan for pulling the global financial system out of its nose dive is at the end of the document; feel free to skip straight to that and then work your way backwards to see our reasoning.

Update: the next edition will appear by 9am Monday morning, October 6.

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.