Baseline Scenario, 2/9/09

Baseline Scenario for 2/9/2009 (11pm edition, February 8): link to pdf version

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


1) The world is heading into a severe slump, with declining output in the near term and no clear turnaround in sight. We forecast a contraction of minus 1 percent in the world economy in 2009 (on a Q4-to-Q4 basis), making this by far the worst year for the global economy since the Great Depression. We further project no recovery on the horizon, so worldwide 2010 will be “flat” relative to 2009.

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 and spend less.

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 during the boom and now face balance sheet constraints. The U.S. will provide a moderate fiscal stimulus in 2009 and 2010, amounting to about 2 percent of GDP in each year.

4) The forthcoming (due this week) attempt to deal with banking system problems in the US will be insufficiently forceful. The structure of executive compensation caps introduced last week suggests the Obama Administration currently is unwilling to take on the large banks politically. The degree of recapitalization will be too small and the measures will help existing management stay in place. Large banks will remain “too big to fail” and shareholders will still be unable to constrain executive compensation. Lending will remain anemic.

5) Compounding these problems is a serious test for the Eurozone: financial market pressure on Greece, Ireland and Italy is mounting; Portugal and Spain are also likely to be affected. The global financial sector weakness has become a potential fiscal issue of the first order in these countries. 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.

6) At the same time, the situation in emerging markets is moving sharply towards near-crisis, particularly as global trade contracts and there are immediate effects on both corporates and the financial system. Currency collapse and debt default will be averted only by fiscal austerity. The current IMF strategy – most clearly evident in East-Central Europe – is to protect creditors fully with programs that do not allow for nominal exchange rate depreciation. This approach increases the degree of contraction and social costs faced by domestic residents, while also making economic recovery more difficult. These programs will likely prove more unpopular and less successful than were similar programs in Latin America in the 1980s and in Asia in the 1990s. As East-Central Europe slips into deeper recession, there are severe negative consequences for West European banks with a high exposure to the region (including Austria, Sweden and Greece).

7) The global situation is analogous to the problem of Japan in the 1990s, in which corporates attempted to repair their balance sheets while consumers continued to save as before and fiscal stimulus repeatedly proved insufficient. The difference, of course, is that exports were 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.

8) 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. The European Central Bank still fails to recognize the seriousness of the economic situation. The Bank of England is embarked on a full-fledged anti-deflation policy, but economic prospects in the UK still remain dire.

9) The push to re-regulate, which is the focus of the G20 intergovernmental 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. The Obama Administration will have a hard time bringing its G20 partners to a more pro-recovery policy stance.

10) 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. A “lost decade” for the world economy is quite possible. There will be some episodes of incipient recovery, as there were in Japan during the 1990s, but this will prove very hard to sustain.


The current official consensus view (e.g., as seen in the World Bank’s Global Economic Prospects, the OECD’s leading indicators, or the latest IMF World Economic Outlook) is that we are having a serious downturn, with annualized growth for the fourth quarter in the US at around minus 4%.  But the consensus is that a recovery will be underway by late 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 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, 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.

Understanding the Crisis

The precipitating cause of today’s global recession was a severe “credit crisis,” but one that is frequently misunderstood in several 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. In particular, while the US boom was at the epicenter of the crisis, regulated European financial institutions played a critical role in facilitating the boom and spreading the adverse consequences worldwide. And, like the US, some European governments ran relatively irresponsible fiscal policies during the boom, making them now unable to bail out their financial systems without creating concerns about sovereign solvency.

3. 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.

4. The initial problem, from mid-September 2008, was a fall in the supply of credit. But this does not mean that the current and likely pending 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.

5. 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.

6. As a result, while attempts to clean up and recapitalize the US and European financial systems make sense – and are needed to support any eventual recovery – this will not immediately stop the process of financial contraction and economic decline.

7. Fiscal stimulus, similarly, can soften the blow of the recession, but will not directly address the underlying problems. And many countries already face binding constraints on what their governments can do in this regard.

8. A dramatic shift in the stance of monetary policy is required in almost all industrialized countries and emerging markets. Unfortunately, the need for this shift is not currently recognized by official orthodoxy and it is not yet clear when this will change.

The Global Situation Today

United States

Perhaps the most fundamental barrier to economic recovery in the US is the weakness of balance sheets in the private sector. 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. This desire to save is causing major reductions in both consumption and private investment, creating the economic contraction we see all around us.

There are three major categories of potential policy responses: fiscal, financial, and monetary. However, each of them faces real constraints.

First, a substantial fiscal stimulus is already in train. The constraints on this dimension are, first, the ability of the Republican opposition to block legislation in the Senate and, second, the US balance sheet. The US balance sheet is strong relative to most other industrialized countries – private sector holdings of government debt are around 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.

One view is that US government debt remains the ultimate safe haven, and this is surely true in general terms – particularly in moments of high stress.  But this excellent recent presentation by John Campbell should give us pause (technical paper here).  His point is that while US long bonds go through episodes when they are good hedges against prevalent risks (e.g., now and in the recent past), this is not always true. In particular, if inflation becomes an issue – think 1970s – then long bonds are really quite risky, in both popular and technical meanings of risk.  You may think your bond holdings are a great hedge, but in fact they are a fairly substantial gamble that inflation will not jump upwards.  Campbell’s worries fit with the recent creeping upwards of the yield on 10-year US government bonds, from near 2% towards 3% over the past 2 months.

We’re supportive of the fiscal stimulus, at the currently proposed level, and we also strongly support the view that cleaning up the banking system properly will add further to our national debt – probably in the region of 10-20% of GDP, when all is said and done. (While this seems like a lot, Linda Bilmes and Nobel Laureate Joseph Stiglitz have estimated the long-term cost of the Iraq War at $3 trillion which, although this may be on the high end, is over 20% of GDP.) And we further agree that some form of housing refinance program will help slow foreclosures, and this should further increase the chances that the financial system stabilizes.

But all of this adds up. US government debt held by the private sector will probably rise, as a percentage of GDP, from around 41% to somewhere above 70%.  This is still manageable, but it should concentrate our minds – we do not agree that the impact of the fiscal stimulus will be adverse, but we agree the US government fiscal position could become more precarious down the road.  The net effect of our financial fiasco is to push us towards European-style government debt levels, and this obviously presses us further to reform (i.e., spend less on) Social Security and Medicare.  And we really need to make sure we don’t have another fiasco of similar magnitude any time in the near future.

Second, financial sector policy has not been encouraging. Despite a series of efforts that were both heroic and chaotic, the banking sector today is roughly in the same state it was in after the collapse of Lehman in September: investors do not trust bank balance sheets, further writedowns are expected, and stock prices are above zero mainly because of the option value of a successful government rescue.

Looking at the banks more directly, there are no easy answers.  Dramatic bank recapitalization remains controversial because this would imply effective nationalization, which is not appealing to Wall Street (and to many on Main Street).  The original TARP terms from mid-October are no longer available, as they were very generous to banks and there is widespread backlash against bailouts.  Also, the latest Citigroup bailout (from mid-November), recently repeated for Bank of America, is not appealing as an approach for the entire financial system as this was an even worse deal for the taxpayer. A clever financial engineering-type approach of ring-fencing bad assets, with some sort of government guarantee, is unlikely to provide a decisive breakthrough.

And a long laundry list of measures (“try everything”), each of which is insufficient, does not add up to a comprehensive approach unless and until it fully recapitalizes the banking system.  In fact, a relatively complex and opaque approach to what is really a simple problem – the chronic lack of capital in the banking system – could well generate the (accurate) impression that the bankers are availing themselves of a nontransparent approach and in effect stealing resources from the state.  This is the kind of behavior more commonly seen at such scale in a troubled developing economy, and while it does not preclude episodes of growth, it is usually associated with repeated crises, widening inequality and – eventually – social/political instability.

Our baseline view is that the government launches a medium-scale bank recapitalization and balance sheet clean-up scheme.  This will not be enough to really turn around the situation in US banking.  But it could temporarily bolster confidence in the US banking system, causing a rise in equity prices for banks (as the market expects more government subsidies) and – most important – a strengthening of debt, both for banks and perhaps for leading nonbank corporates.  Three international consequences seem likely.

1) This move forces the rest of the G7/G10 and the Eurozone to do the same, or something very similar. If we have government-backed banks in the US and somewhat more dubious banks anywhere in other industrialized countries, money will flow into the stronger US banks. Think back to the consequences of the original infectious blanket guarantees in Ireland in October; the effects now would be similar. You can think of the UK’s upcoming moves either as a smart way to get ahead of this, or as something that will further a destabilizing wave of competitive recapitalizations – the policy is good, but doing it without coordination across countries cantrigger Iceland-type situations.

2) If all major economies need to back the balance sheets of their banks, then we have converted our myriad banking sector problems into a single (per country) fiscal issue. Who has sufficient resources to fully back their banks? This obviously depends on (a) initial government debt, (b) size of banks (and their problem loans, global and local), and (c) underlying budget deficit. Ireland and Greece will be in the line of fire, but other weaker Eurozone countries will also face renewed pressure. Officials are currently trying to work through this predictive analysis, and there is some thinking about preemptive preparations, but events are moving too fast- and the international policy community again can’t keep up.

3) In some countries – particularly emerging markets but also perhaps some richer countries – the foreign exchange exposure of banks will matter. Here the issue will be whether the government has enough reserves to back (or buy out) these liabilities; the problems of Russia since September foreshadow thisfor awide range of countries.The absolute scale of reserves does not matter as much as whether they fully cover bank debt in foreign currency. Most emerging markets face significant difficulties and need some form of external support in this scenario, particularly as both commodity and manufactured exports from these countries will continue to fall.

If, by good fortune, the US and global recession is already at its deepest – as some in the private sector now hold – then we face a tough situation but the difficulties are manageable. However, our baseline view remains that the real economy is not yet stabilized, and hence we will see worse outcomes in Q1 and Q2 of 2009 than currently expected by the consensus.  Such outcomes are not yet reflected in asset prices, and the problems for banks – and the implications for fiscal sustainability – around the world will mount.  We will need to readdress the need to fully recapitalize the banks, but really making progress with this depends on a political willingness to take on the powerful banking lobby.

Third, monetary policy can still make a difference. In particular, we risk entering a deflationary spiral with falling prices and downward pressure on nominal wages. The inflation swap market currently implies minus 0.3% average annual inflation for the next two years (although the five-year expectation is for inflation at 1.5% per year). Deflation is not yet completely entrenched, so it is still possible to turn the situation around. However, the Fed has not yet settled on the view that deflation is 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; a more explicit form of inflation targeting is also likely to be introduced.  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.  The net effect on the dollar, of course, depends on how bad the situation is in other regions, particularly the Eurozone.

Western Europe

Major Western European countries, beginning with the UK, have been severely affected by the global recession. The composite of forecasts tracked by Bloomberg predicts a contraction of 3% in GDP not only for the UK, whose housing bubble and degree of dependence on the financial sector were arguably greater than in the US, but even in Germany, whose exports are under severe pressure; their cars, machinery, and similar durables have a great reputation, but how many of them do customers really need to buy this quarter? The Eurozone as a whole is expected to contract by over 2%.

In the UK, the prospect of further bank nationalization now looms.  The UK is an AAA-rated sovereign with its housing market in a nose dive, overextended (and apparently mismanaged) major banks, and a government on its way to guaranteeing all financial liabilities and directing the flow of credit moving forward. The emerging strategy is based more on depreciating the pound – which is contributing to tensions with other European countries – and surprising people with inflation than on fully-funded bank recapitalization. Additional fiscal stimulus increasingly looks irrelevant and perhaps even destabilizing.  The yield on 10-year government bonds is, of course rising – now over 3.5%.

Pressures on individual governments are even greater in some parts of the Eurozone, where individual countries do not have control over monetary policy. 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. Recognizing that credit ratings are a lagging but not meaningless indicator, Greece’s downgrade was not unexpected, but Spain’s downgrade from AAA is a significant milestone.  Further European downgrades are in the air.

What do all these situations have in common?  Markets are repricing the risk of lending to a wide range of governments.  And this is not just about emerging markets (East-Central Europe) or industrialized countries that sustained a boom based on euro convergence (Portugal, Ireland, Italy, Greece and Spain are now known collectively in the financial markets as the PIIGS). The markets are potentially rethinking the risk of any government’s obligations.

The reaction that one hears from senior European officials and richer Eurozone countries is that Greece (and Spain and Italy and others) should deal with their fiscal problems themselves. There is very little sympathy. However, we expect that in the end Greece will receive a 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.

What are the implications for German debt? There is no question that Germany will do whatever it takes to maintain a reputation for fiscal prudence. Despite the severe downturn, the German government recently struggled to pass a stimulus package of only 2.5% of GDP over two years, and the pressure now is to balance the budget.  But problems in the Eurozone are putting pressure on the European Central Bank (ECB) to loosen its policies (and there are murmurs already about easing repo-rules as credit ratings fall – basically, supporting euro sovereigns during their downward spiral), and this has implications for currency risk. Despite the pressure to relax monetary policy, the ECB will continue to be slow to respond.  The ECB’s decision-making process seeks consensus and some key members are still more worried about inflation down the road than deflation today. The ECB’s benchmark rate is still at 2%. Eventually the ECB will catch up, but not before there has been considerable further slowing in the Eurozone.

The current consensus forecast 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.


The yen has appreciated as carry trades have unwound, so people no longer borrow in yen to invest elsewhere. This, in addition to the global recession, has had a crippling effect on exports, which fell by 35% from December 2007 to December 2008. Corporates are likely to want to strengthen their balance sheets further and households with already-high savings rates are unlikely to go on a spending spree. As a result of these factors, the Bank of Japan recently predicted that the country will suffer two years of economic contraction and deflation.

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 recently over five years is around minus 2.4%, and an astonishing minus 1.0% over 30 years. This difficulty in creating positive inflation expectations will make it harder for any fiscal stimulus to be successful in restarting the economy. Overall, it is difficult to see Japan being a major contributor to global growth.


The current crisis has shown that China’s economy is far from invulnerable. The 6.8% year-over-year growth rate in Q4 may have implied that the quarter-over-quarter growth rate was around zero, and forecasts for 2009 are in the 6-8% range – below the level commonly understood as the minimum to avoid growth in unemployment.

The major increase in savings by China over the past 10 years was primarily due to high profits in the corporate sector. Chinese growth now seems likely to slow sharply, and this will likely reduce savings and the current account. China still does have long-standing scope for a fiscal stimulus. But the Chinese economy is only about 6% of world GDP and their effective additional stimulus per year is likely to be around 3% of GDP. 3% of 6% is essentially a rounding error in the world’s economy, and will have little noticeable effect globally – although it might just keep oil prices higher than they would be otherwise.


There are striking similarities between the current policy debate in India and in the Eurozone.  In both places, there is little or no concern that inflation will rebound any time soon.  At least for people based in Delhi, there is as a result confidence that aggressive monetary policy can cushion the blows coming from the global economy.  As in the Eurozone, all eyes are on monetary policy because of fears that fiscal policy cannot do much more than it is already doing, given that government debt levels are already on the high side.

The discordant note comes from the business community.  They feel that Delhi does not fully understand that the real economy is already in bad shape.  Sectors such as real estate and autos are hurting badly.  Small businesses, in particular, are bearing the brunt of the blow.  The banking picture seems more murky, but is surely not good.  And of course the Satyam accounting scandal could not come at a worse time.

Overall, official growth forecasts need to be marked down for India, although the monsoon was good and the agricultural sector is not highly leveraged.  India will likely cut interest rates further quite soon (and has space for additional cuts), but we should not expect much more from the fiscal side.

Other emerging markets

Pressure on other emerging markets continues to intensify.  East-Central Europe (including Turkey), which spent the last several years borrowing heavily from Western European banks, has been especially hard hit by the contraction of credit as those banks turn to hoarding cash. The IMF is projecting contraction for both East-Central Europe and Russia; in the latter case, this is a severe turnaround from estimated growth of 6.2% in 2008.

The European Union’s strategy for East-Central Europe is coming apart at the seams.  Supporting exchange rates at overvalued levels does not make sense and actually adds to adjustment costs.  Consequently, social tension is mounting in Latvia and elsewhere.  The Latvian government is struggling to reduce nominal wages; this is an almost impossible task anywhere. The government in Iceland has fallen.  Fresh waves of financial market pressure are likely to move throughout the region, probably triggered by the timing of external debt rollover needs.

Worldwide, many emerging market countries will need to borrow from the IMF. Some countries will be willing to go early to the IMF, but for most the fear of a potential stigma (and desire to do well in upcoming elections) will lead them to prefer fiscal austerity (and perhaps even contractionary monetary policy) without IMF involvement. The IMF will be more engaged in smaller emerging markets, such as in East-Central Europe.  But even if the IMF doubles its loanable resources to $500bn (as recently announced), it doesn’t have 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. We should expect the IMF to lend another $100bn over the next six months (worldwide), and the G20 needs to keep talking about providing the Fund with more resources.

Larger emerging markets will not suffer collapse, but will increase (attempted) savings and, as a result, will experience slowdowns. The temptation for competitive devaluation will grow over time. 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. While some commodity prices may have reached their floors, a return to the levels of early 2008 will not happen until significant global growth has resumed, which could take years.

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.

Global Policy Implications

One leading anti-recession idea for the moment is a global fiscal stimulus amounting to 2% of the planet’s GDP.  The precise math behind this calculation is still forthcoming, but it obviously assumes a big stimulus in the US and also needs to include a pretty big fiscal expansion in Europe.  (Emerging markets will barely be able to make a contribution that registers on the global scale.)

This global policy strategy is already running out of steam.

  • Very few countries now find room for a fiscal stimulus; debt levels are too high and fiscal capacity is hard pressed by contingent liabilities in the banking system – particularly with an increasing probability of quasi-nationalization. As a result, the idea of a 2% of GDP global fiscal stimulus seems quite far-fetched at this point.
  • Further monetary easing is therefore in the cards, especially as fears of deflation take hold, both for developed countries and emerging markets. There may now be some catching up by central banks – in that regard, see the latest Turkish move as a foreshadowing.
  • Commodity prices will likely decline further as the global economic situation turns out to be worst than current consensus forecasts.  As a result, official growth forecasts for most low income countries seem far too high.
  • The worldwide reduction in credit continues, largely driven by lower demand for credit as households and firms try to strengthen their balance sheets by saving rather than spending.

The crisis and associated slowdown started in the US, but the recession is now global.  The US economy is no more than 1/4 of the world economy, so even the largest US fiscal stimulus – say 3% of U.S. GDP per annum – cannot be not large enough to significantly raise the world’s growth rate at this stage.  If we stabilize our financial system fully and restore consumer credit, this will help.  But remember that we are subject to shocks from outside and the outlook there is worse than in the US in many ways. Outside the US the tasks look much harder.

One key principle, stated repeatedly by both the G20 and the IMF, is that policy responses need to be coordinated. This is a basic lesson of the Great Depression, when protectionist trade policies reduced exports across the board without benefiting any nation. The current crisis has not seen a widespread outbreak of higher trade barriers – although some of the bailout programs national governments have offered to domestic industries could amount to protectionist subsidies. Instead, however, we are seeing friction over currency valuations, as countries (who can afford to) try to boost their exports.  In terms of recent developments, Switzerland threatened to intervene on foreign exchange markets to suppress the value of the Swiss franc. And the French finance minister criticized the U.K. for letting the pound depreciate.

In addition, fiscal constraints give national governments an incentive to reduce the size of their stimulus packages and attempt to free-ride off of other countries instead. Many countries are probably looking to the United States and hoping that our reasonably large stimulus – 6% of GDP, spread roughly over two years – will help turn around the global economy as a whole.

Looking Forward

The first order of business is clearly to revive the US and global economies. However, it is also imperative that we understand the nature of the global economic order that we live in, with the goal of minimizing the chances of a similar economic crisis in the future and reducing the severity of such a crisis should it occur. As mentioned above, while the government balance sheet can absorb the cost of restoring the economy this time, it is not clear how many times we can add 20% of GDP to the national debt.

We also need to recognize that financial crises, just like bubbles, will recur. Government regulators, no matter how motivated and skilled, are no match for the collective ingenuity of billions of human beings doing things that no regulator envisioned. 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 alternatively the need to put in place measures that will compensate for the stimulus once the economy has recovered.

In order to create the conditions for long-term economic health, we need to identify the real structural problem that created the current situation. 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. 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. Ordinarily, by delivering capital to the places where it is most useful, global capital flows 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 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.

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 this 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. The only solution is to invest in the basic ingredients of productivity growth – education, infrastructure, research and development, sound regulatory policy, and so on – so that our economy can develop new engines of growth.

But this change in the allocation of resources is greatly complicated by the increased political power of the financial lobby.  During the boom years, large banks and their fellow travelers accumulated ever greater political power.  This power is now being used to channel government subsidies into the now outmoded (and actually dangerous) financial structure, and in essence to prevent resources from moving out of finance into technology and manufacturing across the industrialized world.

We have done considerable damage to our economies through a debt-fueled bubble.  But it could get worse.  If the financial sector can use its political power to generate a higher level of subsidies from the government, we will convert even more of our banking industry into pure rent-seeking activities (i.e., all the bankers will do is lobby, successfully, for more support in various forms).  If public policy is captured by banks in the US, Europe and elsewhere, then we face much slower productivity and overall growth rates for the next 20 years.

Further coverage of the crisis and policy proposals

Background material

Previous editions of Baseline Scenario:

Financial Crisis for Beginners primer, includes recent material on “bad banks” and the Swedish approach to cleaning up the banking system:

Deeper causes of the crisis, an ongoing series:

More details on current topics

Strategies for bank recapitalization

Global fiscal stimulus:

Citigroup bailout (the second round): and

As it happened

First edition of Baseline Scenario (September 29, 2008):

“The Next World War?  It Could Be Financial” (October 11, 2008):

Pressure on emerging markets (October 12, 2008):

Pressure on the Eurozone (October 24, 2008):

Testimony to Joint Economic Committee (October 30, 2008):

Bank recapitalization options (November 25, 2008):

80 thoughts on “Baseline Scenario, 2/9/09

  1. We can’t begin to set this right until we are honest with ourselves about the scale and extent of the crisis. It ought to be unecessary to say this, but all about us are people in denial: from politicians to people on the street. So thank you for describing the situation as you see it. It is not pleasant or confortable but nevertheless absolutely vital that you continue to be so straightforward in characterizing this mess.

  2. “The main dynamic is a fall in credit demand rather than constraints on credit supply in the US.” This statement about the current US situation is contrary to what I hear from the retail sector. That said, I have no direct statistics on credit applications/rejections.
    As with you, none of the trial balloons from Mr. Geithner give me any reason to believe his proposals will bring certainty or stability to our credit markets.

  3. As I read the the last part of this piece, a few questions come to mind. How can it be that the financial lobby still possesses so much power? Why isn’t there more blame attached to the repeal of Glass-Steagall? and why isn’t there any talk of re-implementing the act?

  4. Regarding the longer term:

    1. As you note, we were in a bubble. We don’t want to restore the economy to the same bubble state yet if we don’t, then growth, etc. will be significantly below what they were during the bubble. Thus it would seem that no one (except, perhaps, some economists) will be happy with the result of “restoration” efforts.

    2. Furthermore, the developed economies are all based on cheap energy as are most technologies, and the energy demands of the rapidly growing economies will quickly cause us to hit the short-term energy production limit (even if we don’t hit the long-term production limit). That too can be expected to impose a major drag on growth, increasing dissatisfaction.

    3. This may well have all sorts of implications, including vulnerability to populist politicians promising the impossible and demands for economic actions that can not be effective.

    4. And I am not hearing much about fundamental changes to the economic system (with the possible exception of alternative energy sources – all of which would be significantly more expensive than traditional energy sources have been) either in the short term (next few years) or in the longer term.

    Please tell me I’m wrong. What am I missing?

  5. Simplicitus:

    Probably worth adding:
    3b. Populist frustration finding few other available options gets harnessed by demagogues in the Hitler/Milosevic mold who can only offer persecution of whomever they find it popular to blame.

  6. So it seems that my comment on a better solution isn’t getting posted for some reason. A proposed alternative to the problematic, costly and uncertain TARP/Bad Bank approaches gathering steam is to be found at my site.

  7. What is lacking is a radical departure from the lies of fare market liquidity. Since 911, blinders have turned to slots, as a nation, a world population, as humans we’ve excepted the manipulation of our keepers. Wake up all your tomb stone will read dupped!

  8. I am always impressed by the number of Ph.D. level economists who have not learned to count. Current plans for bank recapitalization only happen dollar-for-dollar at taxpayer expense. The benefit to the economy of freeing up $1 on a bank’s asset column is no greater than that of adding $1 to a company’s balance sheet through a tax cut. i.e. if companies are the eventual borrowers of a bank’s assets, how is giving money to banks any better than the more direct approach of giving money to the eventual benefitiaries of a loan ?

    Banks are merely intermediaries, and as we have seen not very good ones in terms of their stated capitalist task of evaluating risk or allocating capital to highest ROI investments. Stop kidding yourselves.

  9. “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” – this statement alone destroys any semblance of credibility this site might possibly lay claim to.

    The crisis in the current form was and is completely inevitable as a result of a boom built on debt.

  10. I was hoping to see a ray of hope in the updated version of your baseline analysis. With no clear end in sight, we’re trying to hammer our way to an opening – the baseline analysis is realistic, but the not so distant global sociopolitical implications make my stomach churn. Some one please say something positive !
    We’re out of monetary ammunition, hence the ambiguous lessons drawn from the teachings of John Maynard Keynes will do for now. The zombie banks are a whole different animal, we haven’t found an elixir that either resurrect them or put them to rest. On a related note, some of the theoretical concepts that I learned in intermediate-macro are back with a bang — ranging from the almost obscure Philips curve to the infamous paradox of thrift, they are back to life and in the near term the “crowding out effect” will be back to haunt us as well.
    In a world where the central problem of restoring trust in corporate America remains relevant.Capitalism is on its knees, hate to bring Karl Marx here, but Marx had predicted that capitalism would fall in a spirited, pro-active, fashion: The workers, fed up with immiseration, would revolt, seize the “means of production,” and insist on running the show themselves. We’ll hope to believe that Marx’s prophecy will remain unfulfilled, but we know we can be wrong !

  11. Having the power to create money out of thin air via the fractional reserve system is something that the rest of us need to get in on. The world has changed and I see the only solution is to make banks a public utility.

  12. It takes a long time to get to the punch-line of this piece, but at least you get there. And the punch line is that economies are supposed to be about making things–manufacturing, farming, mining, fishing–rather than about finance per se. This is the economy that needs to be rescued. Or rather, re-structured. The current world system is not sustainable, and needs to be rebuilt from the bottom up. If you get the real economy going, banking will be a trivial problem. If you don’t, there is no possible “rescue” plan for the banks. Who cares how much capital they have if there are no businesses to borrow the money?

  13. I am amazed that such a document could be written without once mentioning *military budget* or just *military*. You seem to have overlooked a great deal.

  14. J. Robert Oppenheimer, father of the atomic bomb, conjectured in 1946 that
    “. . . wars might be avoided by: universal disarmament; limited national sovereignties; provision for all people of the world: of a rising standard of living, better education, more contact with and better understanding of others; and equal access to the technical and raw materials which are needed for improving life. . . . ”

    Think that would solve some problems?
    Thank you. I will read more.

  15. Raymond- While you and I probably can agree that the endless war on terror is a waste of resources, war is inevitable. As one researcher once posited, “all nations maintain their sovereignty exclusively by force”. Therein lies the dilemma, as top dog we need to use our heads more than our gut level to restrain the urge to police the World. This use to be one of the Republican platform positions.

  16. Hal–

    War as an inevitable solution to human problems may yet be eclipsed by “meta-organization” of our species which is–and perhaps always has been–occurring. We are all like a colony of ants crawling across a painting: we can sense a succession of colors and changes, but it takes the poet, prophet or mystic to recognize the whole picture.

    And it is the poet who puts his/her “head” aside to explore the mystery of the human “gut.”

    We seem to be in the process of recognizing ourselves and each other as passengers on the same ship, but as time goes on there are less and less passengers: everybody’s crew. As the world shrinks, tribalism and exceptionalism become less useful for problem-solving, mediation, collaboration and cooperation.

    Maybe we have been hard-wired to reach a new standard of global living. The Dutch researcher Charles Fort once wrote that “a social growth cannot find out the use of steam engines, until comes steam-engine-time.”

    To paraphrase that Beatle, you may say that I’m an idiot, but I’m not the only one….

  17. I was so relieved to find this website. I have been scouring every news outlet available trying to get a clear global picture. Historically, we have experienced rule by monarchy, rule by theocracy, and lately rule by financiality, and as Nature tells us, monocultures, even if they thrive for a moment, usually do not survive. The rise of this global financial monoculture lacks the diversity that is so critical to survival. I hope Mr. Obama has the strength and political will to take on the monoculture and destroy it, in favor of a diverse financial underpinning. I’m afraid I do not see a bright future. I am in agreement with a stimulus package etc… but what I believe is needed most is a global consciousness shift on how the game is played.
    If the global financiers aren’t willing to experience that shift on their own, I hope the various governments come to their senses and impose that shift upon them.

  18. One potentially positive psychological factor for consumer spending may be overlooked. Americans tend to have a short attention span. Many are oblivious to financial markets and the financial news in general. If unemployment rates, 401(k) balances, and credit availability can be stabilized perhaps the combination of 5th Avenue and boredom with the crisis will lead to consumerism as usual. We can only hope the tendency to reign in spending is as short lived as the new year’s diet resolution. The president could help by switching from realist to cheer-leader once his legislation has been passed.

  19. On the Jon Stewart Show last week, someone was selling a book named “Two Billion Cars”. Right now there are one billion cars on the planet. We will reach the two billion car mark in about 15 years. So how could it be that the human race builds and sells 1 billion new vehicles over the next 15 years but still the world economies would remain flat? hmmmm

  20. I have a data question.

    Where can one find debt/sovereign liability statistics for G-10 economies, using consistent methodology, which also captures off-balance-sheet liabilities that are generally accepted to be sovereign? (For example, Fannie and Freddie liabilities should be included for the US, even though the US prevents this.) Is there a time series, too?

    In emerging economies, I’ve been able to find this, probably because they’ve endured many debt crises recently and off-balance-sheet became on-balance-sheet.

    Given that there is no “appropriate” level of debt, some consistent measure of relative debt would seem to be important to policy makers and market participants.

  21. All the options mentioned seem to take too long to show results. I imagine we all will have to lower our sights and accept less as an acceptable result.

    What is the little guy to do? How can one protect his savings in these troubling times?

  22. I’ve certainly found this extensive examination of the global financial outlook to be helpful and informative. After reading this exposition, I’ve been left with a seeming contradiction. This sounds dire until you reach the last paragraph concerning the United States There, in the bottom lines, it seems to me to repudiate its cautionary tale. There the authors write, “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…” I interpret this to mean that by the end of this year, the U. S. will have escaped from its liquidity trap, and will have begun a slow recovery. We’ll have experienced the longest, if not the deepest recession since the Great Depression, but at least (as I interpret what the authors have written), the deflationary period will end late this year or early next year.

    Muneeb, might this be the ray of hope you’re seeking?

  23. Left out of this very good summary is the effect of unemployment on the costs of labor, and how a reduction in these key costs may fuel the recovery quicker than the political class is willing to admit.

    Just as companies experience a de facto tax-cut when energy prices fall, so, too, do their balance sheets improve when they can shuffle their employee costs downwards.

    The way I see it, the huge lay-offs that are resulting from this world-wide recession are paving the way for the coming recovery of corporate balance-sheets. The recovery could very well be fueled by enormous reductions in the cost of labor, and not by more conventional consumer or government spending increases.

    I think it is unpopular in both Europe and America to discuss lay-offs in a positive light. But, it could be said that, with the American economy having experienced “full-employment” over the last two decades, we have been stuck in a labor-bubble, and that, while politicians pose as populists for the hoi poloi, Adam Smith’s invisible hand is hard at work remedying it.

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  25. Another thought on how to get out of this mess.We know banks need to freely lend to banks. We know banks need to get the balences of “toxic assets” down.One way to support this need is to allow all U.S. citizens to take about 20% of their retirement funds and pay down their mortgage debt tax free! This will give those with the highest propensity to save the opportunity to buy back the mortgages at PAR! This will allow the banks then to focus on the most toxic of assets on a smaller scale. Freeing up captial for the banks without the Government issuing even more checks right now.Yes, this will put further pressures on the equity markets but if the equity market knows we are making real progress this will be somewhat offset as it will be fact and not fiction.President Obama had a brief thought in this direction yet the amount can not be capped at 10K.Even those mortgages that are secure in these pools are being looked at with the same glasses as those that are not. That is why AAA/AA rated tranches are marked to market at 30-50 cents on the dollar. Until this changes we will continue down this slippery slope. Once the banks can live with a smaller “toxic waste dump” they can start the road to free movment of captial with reasonable lending standards.This idea might have worked better in September when I e-mailed the NY FED but it will work better now than in 6 months. Your thoughts?

  26. Debt-based growth is poisonous. Until the IMF and Federal Reserve pirates stop poisoning the world economy we’ll all continue to suffer, or until people refuse to take the poison they’re offered, wrapped nicely in the form of “credit” and “Low interest loans”


  27. While somewhat useful, the article only brushes the surface and, unfortunately, contains too much ideological and partisan baggage:

    1. “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.” That’s really not true. A journey through the historical charts of personal debt, financial institution balance sheets, the amount of securitized debt and derivatives on balance sheet, government spending, debt and unfunded liabilities show decisively that we have never been anywhere close to where we are today. The “regression to the mean” process is underway. Back of the envelop calculations would show that we have a long, long way to go to correct our balance sheets. Incurring more debt to generate artificial spending, and thus trying to counter this correction, will at best postpone the reckoning. More likely, it will make it worse. A little more work by the authors could show the worst-likely-best case timing and destination for this deleveraging.

    2. These guys are kinda, sorta supporting the “stimulus,” aka “porkulus” bill. The contents of the bill, which they diligently try to skate around, serve to make it worthless. It turns to be a federalization of Chicago style machine politics: pay off your campaign financing/voting bloc constituencies with patronage. Rather than a reasoned non-partisan description of this spending bill, containing a critique of its timing and recipients, we get a standard issue ad hominem attack on “the ability of the Republican opposition to block legislation in the Senate.” In case these fellows want to take their partisan blinkers off the Republican Party offered an alternative “stimulus” bill, which in contrast to that of P-O-R actually had timely and targeted spending and tax cuts.

  28. I am a fiscal conservative. I found the party of the last decade extremely distressing, every single day it was going on. But I have heard nothing from the Republican party to date except for their mantra of “tax cuts” and “cut capital gains taxes.” How either of those ideas would help the economic math of the moment escapes me.

  29. The US problem is a simple one: corporate and household debt exploded to the point that lenders stopped believing it can be serviced. Asset prices must now fall and debt must be liquidated; the government Ponzi finance schemes now being engineered are too small and too late to do anything but delay the inevitable. The longer the liquidation process takes the more output will suffer. Everyone wants production to expand but every producer wants to cut back his own commitments; those with capital refuse to buy assets at today’s still exaggerated values. Government is not a solution; its interference will create winners but only extend the pain for many many more losers. The idea that Treasury can borrow forever at low interest rates is idiotic. Sooner or later the fantasy of globalization will be replaced by national strategies of protected markets. Globalization always was a fantasy and economists are like the crowd admiring the new clothes of the naked emperor. Finance ought to provide lubrication of a real economy. Instead charlatans have made finance the tail wagging the dog for so long that economists do not see the dog at all.

  30. I hear blame for the population taking on too much debt but this was an engineered event by the central bankers who used their powerful marketing machine to create it, nothing less than a financial coup, which is where the blame should be directed in no uncertain terms. This is part and parcel to their effort to establish a global central bank and they don’t care who gets hurt. The D&P parties are enablers for the bankers who own them. The criminals are at the top. Now lets look at the solutions.

  31. I don’t know if they wanted to establish a global central bank but I do know that they could not have had any intention of anyone benefitting from their actions but themselves, and that’s a very small group. The whole country is waiting to see if this economy has had a heart attack and will revive or if it’s been given a diagnosis of terminal cancer and we’re at the beginning of a long, slow, painful death. The longer they wait in either case, the more certain is death.
    I see the past decade as psychological delusion…from Cheney on down, the pervasive attitude was that debt didn’t matter. Ratios of 1/35, assets/liabilities were INSANE, but they deluded themselves because the delusion was more fun than real life.

  32. Very interesting and insightful, except for the ending.

    Financial Innovation and debt are not inexorably bad forces of nature beyond our control. We do not need a return to industrial or agrarian output to balance financial innovation.

    What we need is a 21st century information-driven regulatory capacity that can measure and monitor the wealth and value financial innovation can create.

  33. True enough. We do not need a “return to industrial or agrarian output to balance financial innovation,” but to say that “debt doesn’t matter” is a harmful and erroneous message. “Financial innovation and debt are not inexorably bad forces of nature beyond our control,” but we seemed to have abdicated our need and ability to control ourselves on nearly every level of financial management, from the kithen table to board rooms, in inverse proportion to how pleasant it was to leave reality for a time. But enough complaining from me. These days my focus is economic rehabiliation, and I confess that as an individual, I am at a loss.

  34. I think we do need a return to industrial and agricultural output. Wealth in the first instance is created on the farms, fields, forests, fisheries, factories, and mines of a nation. Everything else depends on these. All other occupations are secondary; they must eat the bread of the farmer. Financial innovation is only useful to the extent that it contributes to the primary wealth producers; without that it has no point, and produces no real wealth.

  35. I would recommend reading Peter Senge’s Fifth Discipline. All current government proposals only treat the symptoms. The root cause of our current woes is NAFTA and the associated manufacturing job loss. Combined with Gen X population decelleration and its negative impact on demand, our situation will continue to sprial in a vicious cycle. This will occur until we stabilize at a new, lower demand level and enough Baby Boomers retire or die-off, creating job openings. I would not expect improvement for at least 10 years. In the meanwhile, one side-effect is that U.S. “Border Control” becomes a non-issue. Americans will soon be sneaking across the border to find a job in Mexico!!!

  36. Point 8: inflation versus deflation.

    To summarise, point 8 says “by the time it [Fed] takes that [deflationary] view and can implement appropriate actions, declining wages and prices will be built into expectations”.

    It is perfectly reasonable to argue that a fall in global income level will (eventually) lead to decline in prices of all goods.

    Has anyone around the world -from emerging to developed country – seen prices of core goods (such as milk or bread) fall drastically? Is anyone out there ‘building up expectations’ of price of food falling?

    After Japan’s ‘lost decade’ with low inflation (at times suffering from mild deflation), I don’t think people have priced in significantly lower housing costs (rental or buying), or cost of food.

  37. “5. There is no “right” level of debt”

    I disagree; it is just that this has not been well-studied and is poorly understood. At the extremes it is obvious: some debt (ie: money) is a clear necessity. On the other extreme, if you promise ten full years of your future work you are likely to be disbelieved.

  38. I work with clients every day who have managed to acquire a stupifying amount of unsecured debt. One example is a young man, 26 yrs old, who has not held a full time job yet in his life, but had managed to acquire 60k in unsecured credit card debt. It’s easy to think he’s irresponsible, but the list of banks who issued those credit cards is long. We could debate who should have known better but it will do little to solve the country’s economic problem or the problems of this 26 yr old. As soon as Mr. Obama began talk of the stimulus package, the political cartoons pictured him as a “drunken sailor” spending cash. I think we just lived through 8 yrs of drunken sailors spending cash and they were unfortunately running banks, governments, and households.

  39. An alternate theory?

    The baseline assessment and analysis is plausible and illuminating from a high level view. However more emphasis should be placed on the tightening and contraction of credit card interest rates in Q4 2007 and Q1 2008 which continues today.

    In the section “The Global Situation Today, United States” the baseline states, “The main dynamic is a fall in credit demand rather than constraints on credit supply in the U.S.” Your choice of words is unfortunate, since it gives a static picture while alluding to it as a dynamic. The fourth bullet under “Global Policy Implications” restates the same claim: “The worldwide reduction in credit continues, largely driven by lower demand for credit as households and firms try to strengthen their balance sheets by saving rather than spending.” These statements, as well as “Summary” item 2), do not take into account that consumers are spending, albeit on non-productive products in the form of credit card interest.

    Here’s more of the dynamic.

    From the consuming public’s point of view, — where the high-level view meets the road — additional light needs to be shined on Bank of America, Capital One, and (the then) Providian, among others, which began raising credit card interest rates to such usurious levels (29.99%) that consumers began to realize that about 25% of their monthly net income was consumed soley by credit card interest, before considering credit card principle.

    This move by the credit industry began in 2007, following the Congressional hearings about the abusive practices of credit card companies. This move was directed against, or at least included, consumers who were paying, on time, more than monthly minimum payments. At the same time, this consumer was being solicited weekly with “convenience checks” and other incentives to push credit card debt to its limit, and to push the debt to the highest-interest debt components (cash advances). Very frequent solicitations to obtain additional credit cards occurred as well.

    Written requests for justification from Credit card companies for the increase in rates went un-answered.

    Practices described above continued through 2008 and into 2009 as credit limits declined and interest rates went up. Additionally, since consumer credit scoring depends in part on the ratio of outstanding-balance-to-credit-ceiling, as credit ceilings are being ratcheted down by the banks, credit reporting agencies continue to lower credit ratings for consumers who are actually significantly paying down their balances in a timely manner.

    From the consuming public’s point of view, eliminating such onerous credit card debt is the prime motivator on a day to day basis. Achieving that end works against other, even prudent, consumer spending.

    Not addressed in your baseline view is the conspicuous double-whammy that the taxpayer is bailing out various banks and financial institutions with present and future tax dollars, at the same time that these institutions are squeezing the same taxpayers through their interest rates. The irony is, therefore, that consumers who were trying to get themselves out from under chronic and medium term debt to credit card companies, are incurring as taxpayers equal or greater debt for themselves and their children and children’s children.

    As bleak as the baseline view is relative to the “consensus” orthodoxy, your baseline needs to be still more pessimistic. Once again, the consumer protections and assistance intended by Congress in 2006 – 2007 legislation, to take effect in 2010, has been outmaneuvered by the banks.

  40. My question is: if the banking industry has too much power and this is liable to lead to the failure of our economy, given the current scenario, what can the average person on the street do about this?

    Talk, economic analysis, etc is all very well, but actions are better than words. I’m not asking for financial advice here to protect my family, I want to know if there is some action I can take to try and change the course we are currently on. Should I write to my local paper, to some aspect of government, or what?

    Please translate this down to the level of the woman on the street!

  41. Could I make the observation that the root of the problem really goes back a step from the banks. I hear a lot of chatter about cleaning up and re-regulating banks, but I heard that in the eighties and before. I just read your Financial Crisis for Beginners page and saw a culprit in Developer Danny. Danny buys the land, appraises the land and sells the land. He builds the houses, appraises the houses and sells the houses. He runs neighborhoods down, appraises neighborhoods, buys neighborhoods, redevelops neighborhoods, re-appraises neighborhoods and sells neighborhoods. He loots the economy every 20 to 30 years and we allow him to operate with no oversight or regulation.

  42. Listening to you folks is like stepping through the ‘looking glass’.

    After the Terry Gross interview, looked up Baseline Scenario, 2/9/09, and started reading… after the a few pages I progressed to skimming.

    But, I skimmed with care ~ looking for one place where the basic physical reality of earth’s productivity, and/or health was mentioned as a critical factor in your equations let along examined. I didn’t spot anything.

    Nothing! What are you people thinking?
    allow for some thoughts beyond, what I see as, your blinders:

    The most troubling thing about listening to the politicians & media spun dialogue is their seeming oblivion to the physical living breathing world out here. One would think our economy was contained wholly within ledger sheets and credit capability.

    Maybe it’s denial? And maybe it’s not just them, maybe it’s most all of us? How many of us are guilty of ignoring what really keeps this economy afloat? For instance, do you turn on a water faucet totally disinterested in the water system & reservoirs & mountain wetlands & weather systems that made that stream of liquid life pour from your faucet? You should be interested, because there’s no guarantee that it will always be flowing.

    When have we heard a politician ~ be they Democrat, Republican, Obama or an ideological dinosaur ~ discuss the fact of America’s fantastic success these past couple centuries being attributable to the cornucopia of land and resources that lay before us immigrants. Sure our ingenuity helped, but without the resources at our disposal, all the ingenuity in the world would have come to naught.

    “We” had centuries of consuming as ravenously as possible, but the party couldn’t go on forever. Our fortune is to be part of the generation of reckoning. Our kids will have to learn to live in a brave new world. Within means and learning to become true stewards of the land, focused on sustaining and enhancing. What will they make of the our boast that: “too much is never enough?”

    The questions could go on. But, I think the bigger issue may be in recognizing how much ego we have invested in our views of the world. Both the left and the right have excellent ammunition against the other. It is too easy to ridicule the epic mistakes of each. Maybe one of the prerequisites for successfully dealing with the coming crisis is in recognizing our own mistakes, misunderstandings and blind spots. To gain a degree of humility. To appreciate that there is much to learn. To want to learn. To achieve a willingness to listen to others while suspending judgement for the moment and digesting the thoughts behind the words before returning to judgmental mode. Sounds easy, but so hard to do, yet oh so necessary.

  43. What a complete waste of taxpayer dollars. You don’t build on a rotten foundation. It seems to me we should take the near trillion dollars and divide it among the taxpayers, so they can pay the mortgages, car loans, student loans, doctor bills. We can ensure that the taxpayer would comply with the stipulations that all debt be paid before new spending, or savings. Because lets face it the average taxpayer has the largest oversite committee in the free world looking over his shoulder called the IRS. The large banks have not had effective regulation in years. They get the bail out and then get the real estate also, the only people suffering are the working class tax payer. Since the banks own the political machine we will never see effective oversite.

  44. The solution is the very “flattening” of the world that allowed me to just view your video seminar on Sloan’s SOM site. Notwithstanding all the babble on the US media, enough information is out there to make and monitor future economic decisions, both big and small. This is the transparency needed to keep both risk and growth reasonable in the future. I plan to buy some “penny” bank stock, just so that I can be a sharp-eyed stockholder looking for honest growth without undue risk….control from the bottom instead of the top!
    The second part of the solution is the safety net provided for those suffering from the crisis. Not, mind you, the unethical “suits,” but the little guys all over the world now with no job, no savings, and a hard road ahead. It doesn’t matter how much this safety net costs, or who pays for it…only that it is provided. If my taxes rise to do this, so be it!

  45. Steve, I think you are elegantly circling the genesis of a new understanding of economics which will increasingly begin to make more sense as we inevitably pass into it.

    As for as a safety net goes–I am certainly not a fundamentalist Christian, but the early Christian movement had the right idea: be your sister and brother’s keeper, protect the widown and the orphan and heal the sick. If we could set up more Christian conservatives up on a blind date with the historical Jesus a lot would improve.

    I wholeheartedly agree with you on taxes: so be it!

  46. There’s another component below the financial machinations – and it, human nature, gives me hope.

    1.Most people tend to content themselves with their personal, baseline standard of living, expecting it will increase gradually over time. [Why people are content with their baseline standards of living, when they can see other people that have significantly higher standards of living around them everyday is beyond me; just another aspect of human nature.] If their standard of living is reduced below their baseline standard of living, it provokes a strong, focused, enduring response – a struggle to return to the baseline standard of living. One result of the last 15+ years of general prosperity maybe that people have shifted, upwardly and permanently, their baseline standards of living. The economic collapse will provide these people either the ongoing misery of living below their baseline, or the success of strugging to return to that new baseline standard of living. This behavioral trait may elect populist politicians, or it may inspire hard work, creativity and the creation of value necessary to shift the recovery from an ‘L’ to a ‘U’ shaped recovery.

    2.If the financial crisis had not occurred, how much larger could the global economy have grown before reaching full capacity as limited by supply-side constraints like the availability of nature resources.

    2a.Is the use of natural resources to transport goods that could be produced locally a systemic inefficiency driven by inefficient global labor markets?
    2ai.Are we now in the process of mitigating, to some extent, the inefficiency in the global labor market by reducing wages in developed countries?
    2b.Will the capacity of the global economy expand if these markets – natural resources and labor – function more efficiently?

    3.Will there be an industrial renaissance in developed countries over the next ____ years?

  47. Time to Change up our system..
    Maybe time for Noam Chomsky’s advice for post industrial societs. Social Anarchy-hasn’t been tried and worth a shot!

  48. You conclude: “The only solution is to invest in the basic ingredients of productivity growth – education, infrastructure, research and development, sound regulatory policy, and so on – so that our economy can develop new engines of growth.” But it strikes me that the people charged with constructing such a solution remain primarily financially oriented and/or trained — and as diversified as you would need to revitalize other sectors (manufacturing, retail, healthcare, etc). Am I correct in thinking this bias remains in the new Administration?

  49. Before the housing bubble we were constantly reminded that about 70% of the US economy is based upon consumer spending. How is this sustainable in the long term? I propose that it is not … and the crisis we are experiencing is symptomatic of this problem.

    A society that bases its economy on 70% consumer spending is essentially transferring its wealth to countries that produce more than they consume.

    Therefore, in coming out of this crises our goal should NOT be to return to the status priori. To thrive over the long run we MUST return to producing at least as much as we consume. How?

    Workers in developing countries are sure to work for lower wages than Americans, and politicians cannot be relied upon to level the playing field.

    There is only one way – in factories we must replace most human workers with machines – probably robots. Even the most industrious foreign workers can’t compete with the speed, accuracy, and shear 24 x 7 brute force of machines. No UAW, no pensions, no runaway medical costs.

    If the US fails to perform such an economic transformation then we are destined to become the Britain of the 21st century – a quaint tourist destination with a second rate services sector. Oh, and you should start learning to speak and write Mandarin as soon as possible!

  50. banks create money by lending many multiples of their deposits and fed credits. non-bank entities can only lend what they have. so how can banks be mere intermediaries since they are the ones who create credit?

  51. Lehman was a major conterparty to derivatives. the crisis is about the $700 trillion dollar in ‘notational’ derivatives most of which were ‘engineered’ in two years: 2005 and 2006 and that it is enough to swamp everything under the sun. Lehman couldn’t possibly be good on what it wrote. 7/10 quadrillion is 9 times bigger than global GDP. The Economist was screaming about it for many years.

  52. Citizenchallenge:

    You are earnest, you are concerned, you frame your concerns articulately, and you are refreshingly polite. I share your concerns. I like what I sense are your values and I would go out on a limb and guess that you are a responsible member of your community, a good neighbor and a reliable friend.

    I particularly like your last paragraph. Yes, we need humility, we need to want to learn, we need to be listen while maintaining open minds. Accordingly, I entreat you to spend just a little more time at The Baseline Scenario. Reread and engage, but this time, instead of skimming, please consider who the folks at The Baseline Scenario are and what the nature of their subject matter is.

    These are professional economists. They have spent decades studying the collective outcomes of everyday decisions made by individuals within large systems. You speak of “productivity” and “resources;” so do they. When they talk global inflation going from an annual rate of -1% to +.5% they are, in fact, describing a shift in “productivity” that would result in satisfying basic human needs for food and shelter for millions while providing surplus sufficient to fund sound regulatory policy for, amongst other things, the environment. Funding of wetlands enhancement projects, reforestation or watershed studies is seldom undertaken when the population is hungry or frightened. When they speak of a misallocation of “resources” into dangerous financial structures, they are talking about a disregard for what is really needed in the land. They seek the workable policy mechanisms for fulfilling real needs. Specifically, they mention health care, manufacturing, education, infrastructure, research and development and sound regulatory policy.

    Somehow I feel you would approve of a circumstance where your job and home are secure, as well as those of your neighbor, where the environment is subject to sound regulatory policy, where education and health care are available to all, and where you would earn tax credits for alternative fuel choices such as adding a panel to your solar power array or purchasing an electric vehicle.

    So, Citizenchallenge, you and the folks at The Baseline Scenario have a lot in common. You may not recognize buzz words with which you are familiar, but all your concerns are addressed. Read a little more, become accustomed to the significance behind the nomenklatura of economics, and you will see.

  53. “The main dynamic is a fall in credit demand rather than constraints on credit supply in the US.” That statement seems so questionable on its face that I wonder if there is some technical definition of “credit demand” intended, that I am not aware of. Can someone present a definition of “credit demand?”

  54. John, the 19th century Industrial Revolution did not cause markets to shrink. The farm laborers became factory workers, the wagon riders became truckers, and the craftsmen became engineers – since then output has expanded and it has been consumed, domestically and abroad.

    The crux of the matter is to learn from the mistakes of others like the Brits, who frittered away their competitive advantage in production to none other than the US. Now the US is in danger of repeating history – unless we do something differently.

    Currently, the developing nations have a huge advantage over the US, namely the masses of people who are willing to be more industrious than Americans, to work for far lower wages, and to risk dangerous working and living conditions. We must negate this advantage, or wither!

    Supply and demand will take care of what we will produce, and who will consume our output. It did so after the Industrial Revolution and I expect it will do so again.

    T. Boone Pickens gets it – do you?

  55. Dave, I am all for machinery, but you still haven’t answered the question about the problem of distribution. You pretend to cite the Industrial Revolution, but are you looking at the real history? Yes, they produced more stuff, but had a problem distributing it. There was a chronic failure of aggregate demand, that is constant recessions. In the period of 1853 to 1953, the economy was in recession 40% of the time. Since then, only 15% of the time. And the pre-war recessions were on average twice as deep and twice as long as the post-war ones. Is that what you want? Post war, they “solved” the problem by having the gov’t soak up excess supply, which is why we have a gov’t that is more than a third of the economy.

    You say S & D will take care of the problem, but history tells a different story. And T. Boone doesn’t get it, “it” being the gov’t subsidies he wants for his schemes. They may be good schemes or not, but one does wonder why, if the economy is so efficient, that our most “efficient” sectors require such large subsidies.

  56. “…. America’s fantastic success these past couple centuries being attributable to the cornucopia of land and resources that lay before us immigrants. Sure our ingenuity helped, but without the resources at our disposal, all the ingenuity in the world would have come to naught.”

    A point I have often returned to, and which my parents before me made: remember that the European hordes just flooded into this “new” land and simply took what they wanted, and dispossessed the peoples already here. It was a continuous war and nearly a genocide. The resources were abundant and relatively easy to acquire. Now, and more so in the future, what will we do when we can’t simply take what we want from relatively defenseless peoples? It strikes me that we have not yet paid the price for all that we took, especially in terms of the ease we became accustomed to, the corrosive effect that ease has had in inflating our sense of entitlement; the studied blind eye our country turned toward stewardship, and the decimation of the indigenous peoples who knew quite a bit about stewardship and could have taught us what we now need to know. Many loose threads of behavior will come home to roost — that is, will come around so that we’re on the receiving end of our own past behavior and its consequences. We must do better.

  57. My impression from following this in the papers, and being “a news junkie” to the extent it gets in the way of work, is that the economic crisis is somehwat analogous to a heart attack: as life-threatening as that event is, it’s also an expression of underlying much greater problems — greater because they are deeper, wider, and more pervasive than they appear. They’ve been gestating without our honest attention. As bad as this economic crisis is, I suspect that it is symptomatic of generally poor living habits on a dozen fronts. Dr. Obama is going to have to tell us patients some news we really are trying not to hear: change the way we live, er,… “our lifestyles,” because this way of operating in the world is not sustainable.

  58. What is wrong with citizenchallenge’s view? That it has no quick answer? Or is naive? Or unimportant? Why not respond with something like: “Yes, you are right. We the experts have always addressed the short-term. This must change. We have never been responsible servants of the common good. We must rethink our fundamental values and always include sustainability in our equations. Materialism is a doomed religion. We have seen greed on a global scale and it is bad.”

    But of course this is very hard. It must seem easier working to put Humpty Dumpty together again.

  59. Thank you for the clarity in describing the current situation and the possibilities for the future.

    I have to say, part of me is scared s**tless.

    As an aspiring economics student and teacher, continue the good work.

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