What happened to the global economy and what we can do about it
Month: October 2008
Simon will be a guest on the Diane Rehm Show (WAMU, syndicated on NPR) from 10 am to 11 am (U.S. Eastern time). This is a call-in show, so you’ll be able to ask questions of the panel at 1-800-433-8850 or drshow@wamu.org.
Update: You can now listen to the show here.
Events of the past several days have convinced us that the state of the global economy is getting worse and we have revised our analysis and proposals accordingly. In short, coordinated, large-scale actions by the U.S. and Europe, including bank recapitalization plans and guarantees of banks’ obligations, are necessary to limit the spread of a crisis that threatens to trigger national defaults in vulnerable countries around the globe.
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.
Global rate cuts: attacking the symptom?
After yesterday’s move by the Fed into the commercial paper market, today’s big news is a global interest rate cut, including the Fed, the European Central Bank, and the Bank of England, among others. The effect of an interest rate cut should be to reduce borrowing costs across the board, which is a good thing for the real economy. However, the rate cut may not have a direct impact on the crisis at the heart of the financial system, which is that banks are not lending to each other. To put this in perspective, the spread between 3-month inter-bank lending rates and 3-month Treasury bill rates – a measure of how willing banks are to lend money to each other, as opposed to socking it away in risk-free Treasury bills – is running at about 4 percentage points. Ordinarily, it should be about 0.5 percentage points. As a matter of simple arithmetic, a 0.5 percentage point cut in central bank interest rates is small compared to a 3.5 percentage point increase in risk premia. As long as lenders are afraid their borrowers could go bankrupt, lowering the cost the lenders pay for money will only slightly lower the price that they charge for money.
Still, though, today’s move is a valuable signal that the world’s central bankers are on the same page and that they will do whatever they can to fight the crisis. And the good news may have come from the United Kingdom, where the government announced a straight-up bank recapitalization plan, in which 25 billion pounds will be used to buy preferred shares in eight banks, and another 25 billion pounds will be allocated to buy shares in those or other banks. Banks that have more capital are less likely to go bankrupt, making other players more willing to lend to them. As we’ve pointed out before, the Paulson Plan may have the indirect effect of increasing bank capital (because we expect Treasury to overpay for the securities it buys under the plan), but uncertainty over how that will work has diluted its impact on the markets. Explicit bank recapitalization is a more direct way to attack the problem.
Simon Johnson will be on NPR’s Planet Money podcast today. Planet Money is a new, daily podcast focusing on the financial crisis, and is one of the best places for friendly, accessible reporting on daily events. You can find the podcast feed on the NPR web site, or you can look for Top Podcasts in iTunes. (Planet Money is currently #1, which means it has displaced my favorite radio show, This American Life.) Today’s episode will be available after 5 pm U.S. Eastern time. Once it’s up, I’ll put a direct link on this post.
Update: The podcast is up, and you can listen to it here. Simon is about 12 minutes in, but he is preceded by Amir Sufi, who does a good job describing the relationship between the credit crunch and the ongoing slowdown in the real economy.
Just a couple weeks ago, European finance ministers were insisting that the credit crisis was an American invasion that they were adequately prepared to repel, with German Finance Minister Peer Steinbrueck insisting that an American-style rescue plan was not required in Europe because the financial crisis was an “American problem.” As we’ve learned over the past few weeks, things change very fast. Although European leaders now appreciate the seriousness of a crisis that threatens their economies every bit as much as the American one – perhaps more, judging by the number of bank bailouts over the last few days – they have not been able to implement solutions even on the scale of the Paulson plan. The on-line Economists’ Forum of the Financial Times published (Tuesday morning in the US) a new op-ed by Peter Boone and Simon Johnson describing the challenges facing European policymakers and presenting some concrete solutions – including interest rate cuts and bank recapitalization, for starters.
Update: Martin Wolf’s latest column for Wednesday’s paper, just out (Tuesday evening in the US), takes similar positions. In the column, Martin discusses how the deepening crisis over the last week has led him to change his position. Many in European leadership positions follow Martin’s views closely, so hopefully his forceful arguments will have an immediate effect.
As has been widely reported, the Federal Reserve announced today that it will start buying commercial paper directly from issuing companies. (Commercial paper, as expertly explained in last weekend’s episode of This American Life, is a short-term IOU that companies issue when they need to smooth out the short-term fluctuations in their bank balances; the issuer promises to pay $1 million in 7 days’ time and, for example, gets $999,000 from the lender immediately.) Highly experienced journalists have described this action as using the Fed’s “emergency powers,” although the Fed was itself careful not to use the word “emergency” in its press release. Rather, the terms and conditions released this morning cite the authorization of Section 13(3) of the Federal Reserve Act. That section reads as follows (bold emphasis added; you don’t need to read it carefully, there won’t be a quiz):
3. Discounts for Individuals, Partnerships, and Corporations
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
(“Discounting” just means that the Fed can loan the holder or issuer of the commercial paper a little less than the face value of the paper.)
So while the phrase “emergency powers” can be frightening, this doesn’t mean that martial law has been declared, or its financial equivalent; just that the Fed identified an “unusual and exigent circumstance” in the market. By this action, the Fed is intervening in the short-term credit market for ordinary companies directly; previously, its actions had been devoted to encouraging banks to provide short-term credit to those companies. We can infer from this that the Fed has decided that the previous strategy wasn’t working, at least not well enough. Because it bypasses the banking sector altogether to provide credit to the real economy, this should reduce borrowing costs for companies, which is a good thing. (The downside is that theoretically it creates exposure for the government, and hence the taxpayer, if any issuers default on their commercial paper.)
Still, though, this latest Fed action points out two concerns. First, the Fed still appears to be reacting to events as they arise rather than plotting a strategy to get ahead of the crisis and stop it in its tracks. (A set of steps that might stop a crisis of confidence, if announced in one fell swoop, could fail to have that effect if spread out over several weeks or months.) Second, there is no Congress in session, and there won’t be until after the election at the earliest. The election is only four weeks away, but as we have seen markets can shift significantly from one day to the next. Today’s action can be seen as a signal that the Fed will do whatever it takes to keep credit flowing until Congress can reconvene and develop a more fundamental set of solutions. Which is a good thing, assuming that Bernanke doesn’t run out of tools in his magic toolbox.
My co-author, Simon Johnson, will be on C-SPAN’s Washington Journal show tomorrow (Tuesday) morning from 7:30 to 8:30 in the morning, U.S. Eastern time. He’ll be discussing – what else? – the global credit crisis. It’s a call-in show, so you’ll be able to submit questions live.
Update: You can see now watch the show online here.
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
One week ago, the House rejected the bailout bill and the Dow fell more than 700 points. That fall was a major reason why public opinion shifted from heavily against the bailout to confused, and why the bill passed on Friday. On Friday, though, the Dow fell another 150 points, and today at 1 pm Eastern it’s down another 500 or so.
Before panicking, though, we have to consider what this means. Broadly speaking, we are faced with two related crises, each of which is approximately represented by a different market. The first is a global economic slowdown that people have been talking about for months. The second is the acute credit crunch that hit after Lehman went bankrupt on September 15.
Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.
Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people’s investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don’t cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll. (See the posts tagged “real economy” for a couple examples of this.)
Now the credit and stock markets are related, because when the credit market freezes up, people’s expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. (As Simon advised me, if you write a post entitled “your money is not going to go poof,” as I did, 20% of your readers won’t see the “not.”)
So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble – given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.
As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy.
Since launching a week and a half ago, we’ve gotten far more attention and input than we expected. Thank you for your attention, your participation, and your comments. In addition to some of the comments I answered directly on the post in question, I answered some more below. I’ll try to do this periodically. I apologize if I didn’t get to your question; there are just too many to respond to all of them.
Update: I’m restructuring some of the blog to use fewer pages, so I copied the contents of the old page below. To do this I had to copy-and-paste the comments, but they are all still there.
For reasons of space, I’ll have to paraphrase some of the questions.
1. Why not use the bailout money to buy houses outright, which will also prop up the mortgage-backed securities everyone is worried about?
Continue reading “Financial Crisis – Reader Questions, 10/6/08”
Our weekly baseline scenario is divided into three parts: updates since last week; our analysis of the current situation; and our policy proposals. First-time readers should begin with the analysis and continue with the proposals; returning readers may want to just read the updates and the proposals. (Or download the complete baseline in PDF.)
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.
Lech Walesa, electrician turned President of Poland, famously quipped that, “it is easier to make fish soup from fish than vice versa.” He was talking about moving from quasi-socialism to a more market-based economy, but the same thought struck me when I read today’s announcement that the British Chancellor of the Exchequer will soon put in place a bank recapitalization scheme.
My first reaction was positive, particularly as this is something we have been arguing for. But then I began to wonder if the scale would be sufficient, if it would be combined with measures to restructure mortgages for people with negative equity (an important upcoming issue for the UK), and if it would be supported with a sufficient fiscal stimulus.
I don’t know if the market was having similar thoughts, but as I write (very early on Monday, Oct. 6) it seems like more people are thinking in terms of a global recession scenario (e.g., oil is approaching $90 per barrel). Once people see the need to deleverage (reduce the amount they borrow) and reduce their risks, it is hard to get them to go the other way. Measures that would have been preemptively brilliant 6 months ago, may now have very little or zero effect.
Increasingly, it seems like only a decisive package of measures will turn things around. And even then, such a package may not be easy to adopt until the situation is considerably worse than it is today.
Days to the US Presidential Election: 29.
Our goal is to provide analysis and commentary that are valuable not only to economists and policymakers, but also to a general audience. This is especially important today now that the workings of our financial system have become vitally important to, well, everyone. But I realize, as a couple of readers have noted, that our posts often assume familiarity with a specialized vocabulary. To some extent this is unavoidable, because we want our posts to be short, and we don’t want to explain what a credit default swap is every time we use the term. But it’s a problem.
So we’re introducing a page called Financial Crisis for Beginners that includes information and resources for people who want to get up to speed on mortgage-backed securities, collateralized debt obligations, bank balance sheets, and the other concepts that people toss around all the time these days. It doesn’t presume any prior knowledge, and it even includes links to episodes of This American Life. So if you’re at all confused, check it out.
All eyes turn to Washington this week for the annual meetings of the International Monetary Fund (and World Bank), which will include the finance ministers of the world (up to 185 of them, plus entourages).
Naturally, before these events there is another meeting that – arguably – is where the real decisions are taken. This is the meeting of the G7 finance ministers, which by tradition takes place in the US Treasury on Friday (with the broader meetings being Saturday through Monday). To remind you, the G7 is the club of the largest industrialized countries: the US, Canada, Japan, France, Germany, Italy, and the UK.
Some people regard the G7 as the group that is really in charge of the world. But as you probably noticed by now, no one is really in charge. Still, the G7’s voice carries considerable weight on many issues.
This is a particularly important week for the G7 for three reasons. First, the world economy is in worse shape and heading in a more dangerous direction than at any time in the recent past. Old hands cast their minds back to 1982 for anything comparable in terms of global circumstances. But 1982 was the beginning of an emerging market crisis, involving default and devaluation in Latin America, Eastern Europe and various other middle and low-income countries scattered around the world. Now we have a crisis in the core of the system, clearly in the US and Europe and quite possibly more widely.
The second reason to look to the G7 is that, this time, they really can do something. Their main policy tool is the communique, which is a joint statement that you should look for late on Friday. This will tell you what they think is going on, and what should be done and by whom. Of course, the language will be fairly indirect, but at least in this instance it should not be too hard to interpret. The statement is not binding on anyone, but it will give us an indication of whether they are on the same page.
The third point is that prominent members of the G7 seem already to be on different pages. The four European members had an unusual pre-meeting today in Paris, and their messages seem to be about the need for more regulation, looser accounting rules, and a change in the compensation system for executives so they take less risks. We’ll see what is the US position by the time we reach Friday; we guess there will be less than full convergence.
At least on one point, there is already a large gap in views opening up. The Europeans still want to rescue banks on a case-by-case basis, whereas the US has definitively switched to a systemic approach of some kind. Given the gravity of the situation, we prefer the US position at this point, and none of the current European proposals seem to bolster confidence: the problem in Europe was not lack of regulation, but rather failure to enforce existing regulation (fact: European banks bought a lot more collateralized debt obligations than anyone realized); looser accounting rules would open up a massive can of nontransparent worms (a lack of transparency helped get us into this mess, and it’s not clear how less transparency will get us out), and executives in all kinds of incentive systems took on, in retrospect, way too much risk recently.
The G7 could, speaking together, help to decisively break the crisis of confidence that still – at the end of last week – gripped financial markets. The indications at this moment, however, are that this unfortunately will not be the case.
If anyone is looking for a silver lining, Michael Fitzgerald has a post called “Bad Times Are Good Times for Entrepreneurs,” and I couldn’t agree more. On September 14, 2001 – at the trough of the technology meltdown, at the beginning of a recession, and on a day when the stock market was not even open because of the 9/11 attacks – I quit my job and co-founded Guidewire Software. It was a great time to start a company for a number of reasons:
Guidewire today is a leading provider of software to insurance companies with customers in Russia, Brazil, Japan, the United Kingdom, Australia, and New Zealand, in addition to the United States and Canada. Seven years from now there will undoubtedly be dozens or hundreds of successful companies that were started in the wake of the credit crisis.
The Baseline Scenario 