Let’s say you face a pervasive loss of confidence in your financial institutions, the stock market just fell 7 percent, depositors are (needlessly) rattled and a certain small country is talking about something that sounds ominously like a significant default (it’s Iceland on line 2). What do you do?
Your instinct might be to go for a broad bold package of measures, throwing a great deal resources in to strike at the root causes of the problems at the same time as addressing some of the more painful symptoms. But that is because (and part of why) you are not a leading economic policy official in a G7-type industrial country.
These officials are outstanding individuals, who take their jobs seriously, work hard, have the highest standards on all dimensions, and are very smart. But they have been trained, just as their mentors were, and their mentors before them, to make macroeconomic policy in small steps. The best way to unsettle the markets, they have learned, is to be overly bold. Macro management, the mantra holds, needs a steady hand and an unblinking eye. And policy changes should be incremental: 25 basis points (that’s 0.25%) is a much favored step in interest rates, up or down.
All of this is completely reasonable and makes a lot of sense in ordinary times. And the times have been ordinary on almost every day over the past 60 or so years. In fact, if you spend time with long-time practitioners, they are hard pressed to find a close parallel to the circumstances of the past 3 weeks.
And this is the point. Someone who has had every kind of experience in the US market over the past 35 years, up and down, boom and bust, is in all likelihood not at all prepared for the situation we now face. What we are seeing now in the United States and, just as amazing, in Western Europe is the kind of situation that, in our lifetimes, has only been seen in middle-income “Emerging Markets” open to capital flows.
It is, of course, the capital flows that make the difference. If you build an economy in which financial services are large relative to other economic activity and have a high ratio of debt-to-equity (check that box for the US and Western Europe), you are vulnerable to “jumps” downward in confidence. Of course, you can also get confidence to jump upwards, but this is not so easy. (This is the fish soup problem.)
Now, I do think that officials in the G7 and other rich countries will eventually figure out what they need to do. They will take their time, organize big packages (along the lines we are suggesting, at least roughly), and they will show up eventually with overwhelming financial force. But the odds on this happening soon are slim. They need more discussion among themselves (which they do a lot), more analysis (they read everything), more reports (very important for shifting the consensus) and – above all – much more by way of downward movement in markets. We will get there, but not tomorrow and, I’m afraid, not this week.
Days to the election: 29