Is The Crisis Over Yet? The CBO Weighs In

Confidence is returning to most credit markets, consumer spending is likely to rebound for some items (autos and housing repair are leading contenders), and firms in the US are starting to sound more optimistic.  On’s Economix yesterday, Peter Boone and I suggested that we are out of the panic phase of the crisis – in large part because the US fiscal stimulus has reassured people worldwide, but also because President Obama has had a broader calming effect.

Today, the Congressional Budget Office is pointing out that it would be premature to congratulate ourselves too much (disclosure: I’ve joined the CBO’s Panel of Economic Advisers, but none of the information here comes from them).  As you likely know, the administration is proposing to lend $100bn to the IMF, as part of that organization’s increase in resources following the G20 summit.  Peter Orszag, head of OMB, argued that there was zero probability of this money being lost, so $100bn should be “scored” for budget purposes as $0bn – which is how this kind of transaction has been handled in the past.  As the IMF likes to say, it is “the lender of last resort, but the first to be repaid.”

After considerable back and forth, the scoring issue was refered to the CBO.  The CBO has reportedly decided there is a 5 percent probability of default by the IMF.  This is an extraordinarily important statement.  Most informed people just assume that the risk of IMF default is zero, because that would essentially constitute a complete breakdown of the global economy and payments system.  But nothing is zero probability, particularly in a world of massive financial panics, incipient protectionism, and improvised global governance.

We can discuss if 5 percent is too high or too low; the CBO details are not out yet, so it’s hard to know exactly the time scale they are thinking about – my guess is 5 years.  In any case, this estimate tells you that – even with the increase in IMF resources to close to $1trn, which will go through if the US approves this $100bn loan – the CBO thinks (a) the crisis is not over, and (b) there is a nonzero probability that the entire global system breaks down.  Take this seriously.

Our point yesterday was: don’t throw another fiscal stimulus into the mix at this point, even the IMF – which has become a strong advocate of discretionary fiscal policy under some circumstances – is saying that it will not speed the recovery much.  Save the fiscal space for further stimulus for when you might really need it, i.e., the unlikely, but possible, confluence of circumstances that would constitute another serious panic phase.

By Simon Johnson

43 thoughts on “Is The Crisis Over Yet? The CBO Weighs In

  1. I’m curious about the statement that another serious panic phase is unlikely. What time frame are you envisioning here? I’m terrified that the combination of dangerous incentives for banks (explicit statements they won’t fail, instructions to “earn their way out of the hole” or subject themselves to more oversight, no real change in the risk culture) and the need to keep monetary policy lax for the foreseeable future to let them earn their way out of the hole is setting us up for another serious panic phase in the next few years.

    The core strategy of the administration seems to be to inflate another bubble as quickly as possible rather than bother with jumpstarting the real economy. I don’t have any idea what type of bubble it will be, but given the rickety foundations they’re building on, catastrophic collapse when it bursts and the proposition that it will do so relatively soon seem somewhere closer to the likely side of the scale.

  2. “…and (b) there is a nonzero probability that the entire global system breaks down.”

    Well that’s the whole point isn’t it. We’ve learnt from this crisis that if you underestimate the tail risk, you actually increase their likelihood of occurance because of the “implicit leverage” in selling off those tails. Take a AAA rated mortgage CDO, whom S&P determined would have a 0.5% chance of facing impairment. By underestimating that tail risk, an institution could lever it up to 99.5% of its value, do this across all of our institutions, and you get an explosion in leverage.

    I don’t know if 5% is the right answer, but I would argue that it is definitely ALWAYS non-zero. The probability that we enter a depression is non-zero. The probability that this crisis sparks WW3 is non-zero. The probability that the S&P 500 trades below 300 is non-zero. And while these things are all obvious now, they’re not so obvious when times are good. But they need to be, because if everyone sells off the tail, and leverages against it, then those probabilities skyrocket.

  3. I do not know about this argument. There appears to be some confusion between exiting the panic phase of the crisis and actually recovering.

    The administration has received a lot of criticism for 1) not making the stimulus large enough, and 2) structuring a large part of the stimulus as tax cuts. This criticism is based on the fact that the actual effect of the stimulus on the economy is delayed and is coupled with further criticism that the administration is underestimating our financial institutions’ problems. So far, fiscal stimulus has been successful at managing market participants’ expectations. But there has to be a money-goodness to the fiscal stimulus as an investment for it to contribute a recovery and not just disperse the attitude of panic. This means it actually has to work as expected and cancel out a large part of the collapse in demand. If the stimulus does not actually deliver, then any future stimulus will also have a delayed effect and would be greeted with very different expectations.

    I do not think it is debatable that there is a market limit to how much we can borrow, but we can debate where that point is. So the question should probably be not about whether there needs to be additional stimulus, but what our relative priorities are with respect to government spending.

  4. Is this probability of default figure helped or harmed (or not affected) by the (so far small but symbolically significant) increased emphasis on SDRs?

  5. “There appears to be some confusion between exiting the panic phase of the crisis and actually recovering.”

    Yes; a nice phrase by a poster on Calculated Risk ther other day was: “in the Pre-Recovery phase”.

  6. This is entirely true, assuming the panic phase has passed.

    If we are still at risk of deflation, however, then the bar for govt. spending remains lower (provided that the spending is financed by some degree of monetary expansion/QE).

    Critically, we still have a huge amount of outstanding debt in the system, and debt-repayment has suddenly become popular – which will remain a long term drag on end-consumer spending power and money velocity (and thus asset values, wealth, feeding back into spending). This would imply a long period of deleveraging, which would need to be carefully matched by govt. spending and QE to prevent the money supply from shrinking by injecting non-debt currency into the system.

    And since the _real_ economy is not spending on consumption, and expectations of depressed consumption are deterring private investment (muddling the savings/investment equillibrium), this implies an opportunity for public investment to put slack capacity to use.

    Or, in real-economy terms, let’s have those unemployed people do something useful.

    All-in-all, it’s better to use the slack capacity than let it sit and rot, but it’s even better (as you note) to use it effectively.

  7. If this whole thing comes off without a hitch, tell you what. Im sure going to feel alot safer about the fact I have no idea how the financial apparatus operates outside the realm of my credit/payments systems.

  8. Somebody – CBO, IMF, a bunch of graduate assistants, needs to lay out a timeline of events from about 1970 to the present.
    GDP, prime rate, credit outstanding, trade balance and other statistics, along with effective dates of regulatory changes would provide a good starting point for analysing causes of the meltdown.

  9. “Confidence is returning to most credit markets, consumer spending is likely to rebound for some items (autos and housing repair are leading contenders)…”

    fact that the market for titanium dioxide can serve as a useful barometer of overall economic activity. In “Paint Chemical Price Drop Signals Broader Weakness,” the Associated Press notes that the current price trend of this important commodity — which I’ve not really heard of before now — reveals what might be described as the unvarnished truth about how our economy is really doing.

    When price of ingredient in white paint falls, economists see weakness in housing, economy

    The price of a key ingredient in white paint fell in April, signaling another drop-off in home construction and renovation activity, and hinting at more economic weakness ahead.

    Titanium dioxide prices fell 0.8 percent from March, the Labor Department reported Thursday, bringing the decline over the last 12 months to 5.7 percent.

    Economists track titanium dioxide as a barometer of the country’s overall financial health. When people are building homes, remodeling, redecorating or even getting a house ready to sell, they buy paint. About 419 million gallons of paint were sold last year, and more than a third of it was white.

    “It is basically telling us construction, remodeling, homes for sale and manufacturing were down,” said John Silvia, chief economist at Wachovia

  10. Obama has had a calming effect? Huh?

    What has happened is that the media that was forever talking down the economy during the Bush Administration is now talking up the economy. Most people only understand the tone of business reporting not the substance.

    Business owners I know are petrified of Obama, his creeping socialism and his attack on the rule of law. They are not going to be employing new people any time soon. There likely will be a short term bit of optimism followed by another slump, when people realize underlying market conditions are still eroding.

  11. How about a good currency / bad currency model?

    For a time we will have two currencies.

    One is backed by legacy bank assets, the other by the rest of the US economy.

    For now, the government will stimulate the economy by paying unemployed people with the “bad” currency. This currency will be negotiable because it will be exchanged for real currency later:

    In five years, the government will buy back the bad currency with real currency at a rate determined by the value of the legacy assets.

  12. of course i am kidding here, i was just trying to think of a way to create money without creating debt or inflation.

  13. Seriously. I’m surprised Prof Johnson has fallen into the media trap of attributing a change in the market/economy to who’s the sitting president. Clinton wasn’t responsible for the roaring 90s…the internet had much more to do with that. Bush wasn’t responsible for the current crash…CDOs are. And Obama isn’t responsible for the current rally…the market is moving because its moving.

  14. Paul – what did the business owners think of Paulson’s plan for addressing the collapse of the economy? I was utterly terrified when he announced the need to inject nearly a trillion into Wall Street to prevent the collapse of the global economy.

    And in most insider explanations about the crash – they point to the “rumors” that took down the big firms. Frankly, I have been shocked at the continued references from Wall Street insiders about the illusion of confidence and success being all important to the health of a company.

    The Bush administration, as I saw it, was the one that set the tone at PANIC. Would love to know how your colleagues responded to the initial announcements surrounding the crisis last fall.

  15. I live, as I do, in that alternate universe known as the “fly-over zone.” And in my universe, the green shoots of recovery appear to have withered on the vine. The panic may be over, and the people on Wall Street may be happy and making money once again, but in my neck of the woods, the crisis appears quite strong.

    And in today’s economy, the appearance of things is as important as the facts. Here’s what I see:

    Gas prices have jumped up a half-dollar in the last two weeks (forcing flashbacks to last summer – and we all remember what gas prices did for consumer spending last summer.)

    People are not buying new houses because they don’t know if they’ll have a job after they sign the mortgage.

    They’re not signing the kids up for sports, summer school or other activities that suck up money because they want to hang on to their pennies… just in case. So all those programs and employers are having a bad summer too.

    I’m seeing an unusual surplus of college kids looking for babysitting jobs this summer – because they simply cannot find any other jobs anywhere else.

    Car dealers are seeing their businesses dry up and go away.

    Credit is more, not less expensive, for most consumers these days.

    Retail spending has been down in March and April.

    And though everyone heralds it as “good news” – the last jobs report showed more than half a million people lost their jobs last month. Though an improvement over the previous months, very large numbers of people are still losing jobs – and those who’ve lost their jobs are having problems finding new ones.

    There is a very large surplus of unemployed people looking for work these days.

    If our economy is based on consumer spending (I read a stat that 70 percent of our economy is based on consumer spending), the investment the feds have made in Wall Street hasn’t seemed to have trickled down to the people who prop up the economy by buying houses, cars, clothes, etc.

  16. anne —

    i don’t think anyone thinks that things are good now, or even that they are on their way up yet.

    it’s more that people think that they are getting a better handle on how bad it could get, and that the answer is more “really bad” than “great depression bad”.

    not particularly comforting, but that is how i look at the talk about the end of the crisis.

    the “investment” that the feds made in wall street (more generally the banks, many of which aren’t headquartered anywhere near new york) and all the quantitative easing machinations alluded to above are meant really to cushion what could otherwise be a really nasty collapse. it’s more a propping up than an investment. when you hear people say “it’s working” it’s a combination of “we’re still here” and “we see some promising signs”. nobody would say things are particularly bright now.

  17. Some people live paycheck to paycheck; modern economies live bubble to bubble. Remember The Onion headline: “Recession-Plagued Nation Demands New Bubble To Invest In.”

  18. The action of “propping up” banks has required astronomical sums of capital, sucking out the lifeblood from other areas of the economy. Essential, I guess. But extraordinarily costly in so many ways.

    Here’s to hoping there’s better ways to manage an economy in the future….

    What do you think the economy would have looked like had the government taken a different approach to the crisis? I have no way to visualize how much nastier the collapse would have been – the crisis we’re seeing now is pretty bad.

  19. anne —

    i don’t have time to write a long reply right now, but i suggest that you read this by the economist Irving Fisher where he writes about debt deflationary depressions. i am not sure of the exact date but i believe he wrote this piece in 1933. i think this is what the fed / treasury have been fighting against.

    Click to access fisdeb33.pdf

  20. There is actual surprise that this calculation (or any calculation, for that matter) leads to a non-zero probability?

    ALL probabilities are non-zero. And, somehow, we’re surprised by that. Sum-over-histories, people!

    Or are we just surprised to see the CBO ADMIT that?

    Mathematics is not THE answer, it’s only AN answer.

  21. I second Richard Feynman’s statement. All possibilities exist, by definition. What is the probability that we are witnessing the prelude to a run on the dollar in the foreseeable future. I’m not an economist, and I’ll be honest: I don’t even really know what “a run on the dollar” means in technical terms. So in one sense I’m blowing hot air. BUT I do know enough about natural systems and the mathematics of probability in the natural sciences to know that yes, all probabilities exist in a non-zero state. What scares me is that it’s the highly-improbably event that always catches us by surprise…

  22. I both agree and disagree with SJ’s observations. I agree that the “panic phase” is (substantially over). This is because (well stated by Simon) that the Obama persona has had a calming influence, and the patient, while still in ICU is stabilized and the doctors are cautiously optimistic about recovery, although none of them is willing to speculate on just how soon the patient will get better, or how it will respond in the long term (i.e. with such a crippling encounter with death, it is likely that the patient may be perminently disabled, considering the quality of the future global circumstances to engender “full” recovery).

    My concern is that GM isn’t going to make it, and that this will further exacerbate the likelyhood of any kind of near term recovery. This will cause much larger employment displacement, both domestically and in the larger world. It will also cause many more of the toxic assets to deteriorate much further, with GMAC leading the way and the consumber gropes to meet their obligations and decide how to respond to a failing major manufacturing sector. All things considered, this could result in the revelation that the “stress tests” were not nearly strict enough.

    I am sorry to be so cynical, and truly hope I am wrong, but listening to the testamony of the second and third tier auto supplier representatives in Congressional committee yeaterday, gave me great pause. What they had to say about the problem and potential solutions struck me as more than panic, if analysed by a little between-the-lines reading and sensitivity to the committee’s response (or lack thereof) in any kind of positive way (they seemed to be at a real loss and most wanted to be anywhere but there.

    So, the “Green Shoots” may be nearing their expiration, but “panic” will not be a descriptor to be used in the future, because most of us now assume what has proven so far to be true, and that is that when it comes to other shoes to drop, we are dealing with a millipede which has only lost a couple so far, and that the rest will continue to drop as small bomb shells. But our hearing has been so damaged by the bomb shells thus far exploded that those which continue to drop are heard less and less, and theirfore panic is an unlikely response. The next stage is called civil revolution, not just here, but worldwide. Just look at the evidence and the real fact that there is yet to emerge anyone or any group which has a real grasp on a solution. Every solution (suggestion) has come with a major caveat.

    We will be truly discovering the role of psychology in economic activity over the coming months. Hopefully Obama can continue to control the discussion because he is the most calming and pragmatic leader available, and he may be able to pull off the continued belief in positive outcomes that he has so far engendered. He needs to avoid becoming overly mired in the side issues that seem to have occupied him over the past ten days.

  23. Really? Default? Realistically, wouldn’t use inflation to devalue the debt as much as necessary rather than default on it? In some sense, inflation basically is default but by degrees — is there a reasonable read in which the “5%” figure reflects a more flexible measure such as the interest rate assessed by creditors (which would take into account inflationary risk) instead of a ham-handed binary assessment of the probability of outright default?

  24. When you talk about the panic phase being over, I assume you mean panic in the financial markets, as that is the usual basis for the term. But even here, there are two interpretations possible, one is that the great unwind continues and further depresses asset prices (which is likely if the fed printing presses slow – and this in turn is likely if the ECB doesn’t join in.), and the other is that uncertainty causes an avalanche of selling. What triggers the first leg of selling may be over, but secondary effects can drag main street. In other words there could still be a factory, and labor market panic.

    I think this is like saying “1932 was post panic”

  25. Is there any difference between what you wrote in NYT’s Economix and your comment on whether Larry Summers was another Gordon Brown? In four days, have you become less pessimistic or more optimistic?

  26. Just curious about comments here stating Obama has been a calming influence, does anyone remember him and his administration claiming ‘crises’ for 4-5 months in order to get his stimulus package passed. In one speech he used the word 26 times.

    If one believes his actions now are calming the market, then one would also have to believe that his previous comments were creating instability in the market. Then I have to ask why would the President want to influence a market downward if it wasn’t warranted?

    As for Paulson’s plan, wasn’t it originally 3 pages? After the Senate got ahold of it, it was over 1000 pages. My point here is that the Administration, Congress, and Obama who voted for the measure and publically supported it are all responsble for it.

  27. “we are out of the panic phase of the crisis-in large part because the US fiscal stimulus has reassured people worldwide, but also because President Obama has had a broader calming effect.”


    How has President Obama had a broader calming effect? When Obama fired the CEO of GM, I did not feel calm. When the GM preferred shareholders were snubbed and frauded by our new “car czar” many felt a degree of panic. But when Obama threatens to fire all the staff at 5000 public schools in the US, I felt definate alarm.

    Might you please reassure we dear readers as to how Obama is calming with some exact evidence or antidotes?

  28. The first panic is over. There is no reason why we cannot have a second panic. To think otherwise is hubris (defined as “overweening pride, superciliousness, or arrogance, often resulting in fatal retribution or nemesis,” according to Wikipedia, and my favourite word these days). Anyone who does not prepare for another crisis is asking for trouble.

  29. Anne: Paul is a wingnut. Don’t dance with crazy people. “Creeping socialism, blah blah blah, rule of law” is the Neocon talkingpoint technique of blaming the victim for what the accuser is doing: Bush’s juggernaut of Corporate Socialism & full-frontal assault on the rule of law.

    Arguments with rabid wingnuts leads to tiny attempts to appease them with small “narrative concessions”: “Yes, well, both sides share some blame” you will eventually tell them. Then they will build these crumbs into a threshhold narrative that will reverse their political fortunes.

    The resurgence of the rabid is inevitable. Because too many sane people try to compromise with clearly deranged belligerents.

  30. Anne-

    One could make a good argument that the “panic” started in September when Paulsen and Bernacke alarmed with market with their demands for a immediate bailout. Their alarm was akin to screaming “fire” in a crowded theatre, and in this case investors rushed to the exits. To add insult to injury that bailout did not achieve it’s stated goal avoiding a crash in commercial and residential lending.

    Bush had a ‘hands off” managerial style where he let his department heads often run amok. Which Bernacke and Paulsen surely did in the case of the bailout. So Bush must take responsibility in part for the collapse. He also let the SEC relax capital reserve standards for investment banks, an incredibly dumb move. Plus while he did try to reform Fannie and Freddie, he never really invested much political capital in doing so and never informed the public of the magnitude of the potential risk that quasi public agencies egregious practices could have on this country’s economic future.

    Jude- talk about a wingnut. What do you call it when a President disregards completely bankruptcy law and strong arms investment banks that he now controls into relinquishing their fiduciary responsibility to their bondholder clients? You’re right, maybe “creeping socialism” isn’t the right term, perhaps “fascism’ would be better.

    The underlying reason why all of Geithner’s public/private partnership schemes won’t work is that any level headed CEO is not going to get in bed with the government headed by a guy who abandons the rule of law on whim for purely short term political advantage.

  31. Your arguments are precise and cogent to say the least. I would generally say something like: Let’s hope for their actions to create some sort of miracle for all of us. But as you well know, even miracles must ultimately make sense – at least the real ones anyway.

    Getting back to your point, I concur that the administration seems to only want to put humpty-dumpty back together again w/o addressing the root causes of this crisis.

  32. Everything hinges on the reality that the panic drove investors into cash. This resulted in yields on cash “investments” dropping to zero. This resulted in the holders of cash taking renewed risk in their search for yield. This resulted in equity markets rallying despite the fact that ALL the global economic fundamentals are still profoundly sick. The next step …..investors wake up to the reality that their capital is still very much at risk and that yield is of secondary importance. The next step will be new market lows

  33. The only name calling deranged belligerent I see here is you. Bush is gone. Now it is Obama that has overstepped his Constitutional authority and deserves criticism. Your blind acceptance and support of his actions make you the partisan foot soldier you purport to detest. There is widespread corruption in out government and the current point man is Barack Obama. I think you would be better served checking our current “ruler” (as some of his supporters refer to him) and the current group in power. They have shown contempt for the law especially to those parts governing private property.

  34. I guess that both of us have observed from the inside the farce of the HIPC (Highly indebted poor countries) efforts by the Fund and the Bank, with its PRGFs and PSRPs, Trust Funds, etc. In the process, defaulting countries would be passed, if possible, from Bank loan terms to IDA terms. There has been a total lack of transparency in the accompanying resource transfer process and the conflicts of interest governing the actions of the Fund and the Bank. It is indeed disappointing that you appear to be endorsing the pap about the “Senior Creditor” status of the Fund and the Bank. I hope that your participation in the CBO advisory panel demonstrates more intellectual honesty.

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