By Simon Johnson
In the wake of recent equity market declines, the clamor for bailouts of various kinds grows ever louder around the world. Influential voices call for “leadership” from the US and Western Europe, and for policymakers in those countries to “get ahead of the curve”. This is all code for a simple and familiar plea: Do something that will protect investors, particularly creditors who have lent a lot of money to banks and countries that now appear to be in serious difficulty.
But providing another round of unconditional creditor bailouts in this situation would be a mistake. What we need is a combination of transparent losses where bad loans were made, combined with a ring fencing approach that protects sound governments and firms. There is no sign yet that policymakers are willing to make that distinction clear.
The situation around the world is undeniably bad. As Peter Boone and I argued in a Peterson Institute policy paper released a couple of weeks ago, Europe is most definitely “On the Brink” of a serious economic crisis that could involve widespread defaults or significant inflation or both. At the same time, Bank of America shares this week fell to their lowest in 2 years; with other large banks under pressure, there is a legitimate fear of rerunning the parts of the financial crisis of 2008-09.
The Financial Stability Oversight Council’s recently released first annual report does not provide particularly up-to-date numbers, but most of the global warning lights that they discuss in Chapter 7 must now be flashing red. As recently as 2008-09, there were three kinds of government support available to the US and European economies when such systemic financial trouble hit. But all three traditional forms of bailout are now much harder to pull off.
First, over the past 30 years interest rate cuts and other forms of expansionary monetary policy became standard practice in the face of potential financial market disruption – this is the original meaning of the “Greenspan put”. But short-term interest rates are already very low in the United States. The European Central Bank (ECB) has room to cut rates – but both the ECB and the Federal Reserve fear that inflation may soon return. Unlike fall 2008, they are reluctant to respond to the latest round of stock market declines with a dramatic easing of monetary policy.
Second, after the initial monetary policy response in fall 2008, it was fiscal policy that took the lead in preventing global economic freefall – with significant attempts to provide countercyclical stimulus in the US, much of Western Europe, and China.
Now the eurozone faces a series of fiscal crises (see my paper with Peter Boone). Further stimulus is out of the question – the issue in Europe is who will do what kind of austerity and how fast.
The fiscal crisis in the US is more imagined than real. The S&P downgrade of long-term US government debt sparked a massive sell-off – but not in government debt. Investors around the world vote with their feet; they see US government assets as one of the safest available assets. Still, further fiscal stimulus is most definitely not on the political table in Washington.
And even Chinese fiscal policy shows signs of tightening – as the authorities try to prevent any overheating that could accelerate inflation.
Third, in 2008-09, monetary and fiscal policies were complemented by government capital injections directly into US and European banks. But these became harder to do under the Dodd-Frank financial reform legislation – unless there is a large-scale systemic approach, which would be very hard to get through this Congress.
The worst financial sector problems are in Europe. But the recent banking stress tests there were completely unrealistic as they did not include default events that now appear inevitable. To run one set of misleading stress tests (in 2010) might be considered excusable, to do this twice during the same crisis is unconscionable. There is no coherent financial sector policy within the eurozone.
What are the policy options now? The people in charge of European and US policy would clearly prefer to do nothing or postpone dealing with the underlying issues. This is a bad idea as it puts markets in charge – and these markets are panicked.
The core to any feasible strategy must be bank capital. As Anat Admati and her colleagues have been arguing, without sufficient capital large banks and other financial institutions are prone to failure – this is what spreads failure and panic far and wide (see this link for a recap). The Basel III framework, negotiated just last year, is crumbling before our eyes; the failure to ensure sufficient capital is at the heart of the European meltdown – and why the pressure on US banks is mounting.
The Europeans have to decide, once and for all, which sovereigns will restructure their debts and which will be protected – to an unlimited degree – by the European Central Bank (again, my paper with Peter Boone has more details and proposals). A full-scale bank recapitalization program is required, along with management changes at almost all major European financial institutions.
If the Europeans fail to get a grip on their economic situation, the FDIC will be pressed to use its Dodd-Frank resolution powers to take over and manage the unwinding of a major financial institution. In that scenario, creditors are supposed to face losses that are transparent and clearly understood; the theory is that this will stabilize market expectations. The FDIC has argued that it could have done this in the case of Lehman Brothers. I have my doubts.
The Dodd-Frank reform process decided not to break up global megabanks, but rather to handle them under the FDIC’s resolution framework. We’re about to find out if this was a good idea – or if we are just on the brink of more unconditional bailouts.
An edited version of this post appeared Thursday morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.