Baseline Scenario, 10/13/08 – Policy

Baseline Scenario: Policy, October 13, 2008
By Peter Boone and Simon Johnson, copyright

(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.


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.

3 thoughts on “Baseline Scenario, 10/13/08 – Policy

  1. Hi Simon, James –

    Very interesting reading. I absorb as much as I can on this topic…

    I’d be interested to know your thoughts on regulation/standardization of the Credit Default Swaps market. Even with confidence building measures, bank re-capitalization, and interest rate cuts, I personally think we’re still highly vulnerable to a confidence crisis.

    I keep asking myself “why aren’t banks lending to each other?” and the media keeps talking about a lack of balance sheet transparency. Which leads to the quesiton, “what can be so bad that it would keep banks from lending?” It surely isn’t just Mortgage Backed Securities. It’s obviously related to CDS and, in light of the Lehman bankruptcy, the realization that a lot of financial companies and hedge funds are vulnerable to a huge CDS hit. And since the CDS market is a collection of unregulated, non-standardized, bilateral contracts between buyer/seller, nobody knows what’s out there. ($50-$60 trillion is a lot not to know about.)

    So, confidence could be restored temporarily via government guarantees of interbank lending etc… but that seems like a poor overall solution. Basically confidence can be restored by guaranteeing “no more bankruptcies”. (That is essentially how the AIG deal was structured at the behest of large AIG CDS writers such as PIMCO.) I don’t even know how much CDS exposure out there is written by hedge funds and other entities that have no ability to pay in the event of default.

    Seems all the solutions I see ignore the hard work that needs to be done which is to unravel this CDS mess and put them on an exchange or clearinghouse where participants are required to register their positions and that CDS contract payments can be guaranteed – similar to the CME/CBOE.

    This is the core of the moral hazard argument. Financial companies/hedge funds were reckless in writing CDS contracts that they were not prepared to honor. If the government is going to step in and provide guarantees on interbank lending and provide low cost capital to the financial institutions, it needs to require companies to do the hard work to fix the CDS problem now.

    (I am starting work at Guidewire in a couple weeks and met James via phone interview a couple weeks ago.)

  2. Three points.
    1) Much of the work by economists on resolving these crises understates the managerial difficulties governments confront as they try to implement the solutions. I wrote a book on the Resolution Trust Corporation, the agency charged with resolving the S&L crisis. The RTC’s task was relatively easy compared to what is currently being proposed yet the RTC struggled with a whole series of managerial, oversight, and organizational challenges. Economist need to pay more attention to how government should be set up to carryout this plan instead of “just assuming the can opener.”

    2) The Federal Home Loan Bank System not the Federal Reserve should be running this show. The FHLBanks have a much broader reach in terms of their members (they include small and large financial institutions throughout the country), and unlike the Fed or Treasury, the FHLBanks actually know something about housing. I find it surprising that the FHLBank System has gotten almost no attention. And finally,
    3) What if the problem is simply that families in the US have hit a wall in terms of how much more they can earn? Since the mid 1970s median family incomes have risen largely because families worked more and more hours. Wages were relatively flat. The housing boom allowed people to avoid the inevitable by borrowing against their equity. But at some point they have to hit a wall. If that’s the problem, it’s not obvious how injecting liquidity into the system will solve the problem.

  3. Thank you for points 1 and 2.

    On point 3, I agree that may be the problem. But even so I think policy should aim to prevent over-correction on the downside. There is a difference between a reduction in spending due to reduced buying power, and an additional reduction in spending due to unavailability of credit. Right now many lenders are not making loans to credit-worthy borrowers that would be economically rational. This is why I support government intervention to encourage lending. I also support intervention to prevent collateral damage from falling home prices. I think it would be a mistake to try to support home prices at artificially high levels, but, for example, we should try to prevent the damage to communities caused by foreclosures.

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