Author: Simon Johnson

From Your Far-Flung Correspondents, at MIT

I spent most of the last two days teaching some special sessions on the global crisis at MIT and doing final preparations for a couple of courses that will start next week.

Three relevant points strike me from interacting with students, faculty and other members of the MIT community, which – as you might guess – is a very international set of people.

First, everyone now understands this is a truly global crisis.  The ramifications are already apparent in places that, even a month ago, you would have thought quite distant from the US financial sector, such as small business in India or Australian real estate (the link is of course credit).  There is very little that can, in some sense, shock any more: Chinese growth could stall, credit may tighten further, European medium-term prospects are already being be called into question, and so on.

Second, very few people yet see the complete picture.  We all have some pieces clear in our minds, but it’s only when we talk – particularly in a free-wheeling classroom discussion – that we begin to see how it all fits together.  It’s only when you engage with someone from Iceland, or a person with money in a UK bank, or a student whose income is in a depreciating currency, that you really begin to realize the scale and interconnectedness of the problem.

Third, I’m struck and encouraged by the calmness that follows a really open discussion.  People are worried, but talking about the problems helps them get perspective and start thinking about strategies.  How exactly are they going to cope, what should they do differently, and where will they see the impact on this or that business?

All of this makes me think that we can usefully contribute to each other’s understanding by talking (and arguing) through more dimensions of the crisis and its impact.  In that spirit, we will open up our classroom over the next two months, to bring your views and questions to MIT and vice versa.  We’re still working on the exact details of how best to do this (and we’re very open to suggestions), but as much as possible it will be through this website.  Tell me if it helps.

The G8 called but they didn’t leave (much of) a message

On Wednesday, a colleague drew my attention to the fact that the G8 had issued a statement on the global economy from Grand Rapids, Michigan.  I quickly glanced at their points and thought they didn’t add much beyond what had been said at various G-numbered, EU-type, and other subgroups over the weekend: we’re doing a lot, things will get better, trust us, etc.

Still, I was impressed that the G8 had got together quickly and, of course, the fact that Russia had joined hands with the G7 (this is how you get to 8) might be significant given the strains currently apparent in Russia and apparently looming elsewhere.  So the following morning I opened the Wall Street Journal to learn more about the form of their meeting and background on the context, including any supplementary communication of messages (i.e., any such statement usually comes with spin.)

To my surprise, I found no mention in the Journal that day (sorry if I missed it; let’s say it wasn’t an article the front page, and if it was in the short highlight points, it was in very small print.)  I had an opportunity on Friday to ask someone who tracks the White House closely, and he confirmed the statement came after a phone call or series of calls involving President Bush (who was visiting Michigan) and generally was not much of a news event.

Now, I wouldn’t want to make too much out of this particular incident.  And I do think that, overall, policymakers at the G7 level and their close colleagues elsewhere have had a better week.  But I do begin to wonder if people are relying on G7-G8 stewardship of the global economy as they have in the past.

And rule #4 in the crisis manager’s handbook is quite clear: when you have nothing to say, say nothing.

Sentiment

I’ve spent quite a bit of time over the past week talking with people caught up in the financial crisis, one way or another.  Some of these people are deeply involved in finance, while others are quite far from finance but now see many more connections that they previously realized.

Three thoughts keep reappearing in these conversations:

1) People’s expectations have definitely been shaken up.  For some it was the original Paulson proposal ($700bn to be used at his discretion), coming only days after he and Mr. Bernanke said that the economy was “fundamentally” fine – by which they meant we would dodge a recession.  For others it was President Bush’s first speech on the subject, in which he said that if Congress did not pass the relevant legislation (now called the TARP), there would be very bad consequences.  And for others it was the dramatic sequence of events last weekend, from the meeting of the G7 to the abrupt U-turn on bank recapitalization, first by the Europeans and then by the US.  In any case, pretty much everyone I’ve talked now understands that we are no longer facing “business as usual”.

2) At the same time, there is still great confusion about what is going on, precisely why, and what are the options going forward.  I think this confusion is quite general, and I regard myself as no exception.  In fact, as one of my colleagues at the Peterson Institute for International Economics wisely noted last week, “if someone says they are not confused by the current situation, they are not leveling with you.”  As a result, we start to think about changing things we do, but it is reasonable to hesitate before taking real action.  I was asked earlier this week (for a weekend show produced by Marketplace, which will air on Saturday) what I am doing differently, compared with a month or a year ago.  The answer is nothing much, at least in terms of investment or spending, at least for now.

3) And it’s the “at least for now” part that is worrying.  Obviously the “authorities” (jargon for the people who run the country) in G7 and other industrialized countries woke up to the true situation about 5 or 6 days ago, and they took what is – for them – dramatic action.  I have never seen them move so far so fast, and we have tried to recognize and applaud those moves at every opportunity.  But now we wait, holding our breath, to see the effect on confidence.  I look at the US and European stock markets, as does everyone else, and my mood swings with it.  But I also look at what is happening in credit markets, particularly in emerging markets.  This does not look encouraging.  I think it is time to work seriously on measures that will reduce the costs of and speed the recovery from what appears to be a serious imminent global recession.  This is now our priority; to help, please post your ideas as comments here.

Baseline Scenario, 10/13/08 – Analysis

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

Published weekly, The Baseline Scenario is divided into two parts: analysis (this post) and policy (a separate post).  In the analysis section, we first explain how we have updated (or not) our views, based on the major developments of last week.  Then, we state our overall view of how the global economy got into its current situation and where this is likely heading. Readers who remember what we said last week can just look at the updates and then go to policy).  The policy section reports our current view on policies in the US and elsewhere.

Please note that we do not currently publish our upside and downside risk scenarios in detail.

_____________________________________________________________________
Updates

Europe recapitalizes

The most important recent development is the – at least partial – shift in European government attitudes during the past few days.  Over the weekend Europe announced a bank recapitalization program, along national lines.  As we prepare to publish, key details remain vague, but it appears they are trying to provide guarantees only at the margin (for new debt, etc).  Presumably this is because the total balance sheets involved are too large for the governments to take on blanket guarantees.

Continue reading “Baseline Scenario, 10/13/08 – Analysis” →

Baseline Scenario, 10/13/08 – Policy

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

(For an explanation of the baseline scenario and our analysis, go here.)

The U.S.

The key weapon that the United States possesses is that the U.S. balance sheet is credible.  The U.S. is not going to lose its AAA rating.  The U.S. balance sheet cannot save everyone in the world, but if necessary it can be used to draw a line in the sand and restore confidence.

Today, according to the spreads on credit default swaps – which measure the expected probability of default – investors believe a handful of large and medium-sized banks are safe.  However, these safe names may appear at risk in the future. The government needs to have a plan to protect today’s safe banks from self-fulfilling credit panics if necessary.

Continue reading “Baseline Scenario, 10/13/08 – Policy” →

Next Up: Emerging Markets

In Washington this weekend, there seems to be remarkably little realization of the difficulties already facing emerging markets.  Even if things start to go much better in and for the G7 in the next 48 hours, you cannot easily get back to the situation before Iceland’s banks failed and effectively Iceland was left to its own devices.  And, of course, it is impossible to return to where we were before the series of unfortunate events surrounding Lehman and AIG.

But what exactly does this imply for various kinds of emerging markets?  Countries with clear pre-existing vulnerabilities were already in trouble last week, those with any kind of small cracks in their economic armour are now being tested, and even the apparently invulnerable may come under pressure.  According to our analysis, now published in Forbes.com, this will be a stress test like no other.

When’s the Make-Up Test? Tomorrow.

Saturday, October 11, 10pm.

The world’s finance ministers sat for several tests this weekend, and it’s not yet clear how they did.  If we set the bar low enough (i.e., no public criticism of each other), they did OK.  The Italian finance minister did threaten not to sign the communique on Friday afternoon, but this was not particularly meaningful (think about it: if Italy walked out of the G7, how would the markets view Italian risks on Monday morning?)  Everyone else was reasonably polite.

But if we were hoping for specific steps to be announced, then Friday’s list of principles from the G7, and the ensuing vague statements of support from other sets of finance ministers on Saturday have really not taken us very far.

Still, there is time for a make-up test (or two) on Sunday.  The US Treasury is undoubtedly working on some detailed measures to shore up parts or, hopefully, all of the banking system.  Eurozone member countries will be meeting in France on Sunday afternoon, presumably to see how far along they can bring the Germans – particularly with regard to systematic bank recapitalization.  It remains unclear whether anyone in the eurozone will suport the British ideas of blanket bank guarantees at this point.  And it is far from clear if the British will introduce the kind of overall package that in our view could turn the corner, even in a local sense.

The goal, as you know, is to get a clear strategy in place and well communicated by the time the stock market in Tokyo opens at 8pm (US East Coast time) on Sunday.  Let’s see how they do.

G7/IMF: What’s Going On

As we’ve discussed previously, this weekend’s meetings of the G7 and the IMF are crucial to halting the financial crisis. This weekend, we’ll be updating you on events as they happen.

Update (Friday evening): The G7 statement is pretty much a general set of principles with which it would be hard to disagree, with very little by way of specifics and really nothing that we hadn’t seen before.  Mr. Paulson’s statement today was similarly vague, although Treasury continues to signal that it will launch some sort of recapitalization program.  I know they want to exude calm and confidence, but the sense of urgency that had building in the last couple of days seems to be slipping away from them.

Update (Saturday morning): Reaction from around the world is mostly disbelief.  Could it really be the case that the G7 does not understand that trade credit is under pressure everywhere, that financing for new projects is drying up, and that Iceland’s experience sends a dangerous signal to investors?  Our piece in the Washington Post Outlook section lays out the very real dangers.  Unless the G7, separately and jointly, act more decisively by the end of Sunday (yes, tomorrow), I’m afraid that next week could be quite difficult.

Update (Sunday morning): Reliable sources indicate that the eurozone member countries, who are due to meet today at the invitation of President Sarkozy, may well be able to announce agreement on some sort of parallel bank recapitalization scheme(s).  It is also hard to imagine that the US will let the day go by without a major announcement.  But it will take a great deal of detail in order to be credible at this point.  And the question of who is and is not given a place on the Great Ark for Bankers will be much on our minds.

A Viewer’s Guide for the G7 (Crisis) Meeting Today

For the reasons I laid out last weekend, the G7 meeting of finance ministers today could be pivotal.  The G7 and their close allies are the epicenter of the global crisis, and they most definitely have the financial resources and combined brainpower needed to turn things around, starting with bold, decisive action today.

They cannot do it with a Business-as-Usual approach, and there are already signs that some of them (US, UK) are inching in a more dramatic and even coordinated direction.  It would be unreasonable to expect them to make one gigantic leap today to a complete solution.  Even if major players now think this is the only sensible way to go, such a sudden move would be inconsistent with how G7 governments operate internally or interact with each other.  Nevertheless, there will be unmistakable signs today, in their communique and related communications, regarding how long we will have to wait for decisive action.

Here are three things to look for:

1. The extent of recriminations.  These are obviously unproductive at this stage.  If the German finance minister (Peer Steinbrueck) can refrain from saying negative things about the United States, that would be encouraging.

2. Statement of the problem.  Jointly and separately the language used to describe the severity of the situation is important.  In the Business-as-Usual approach, officials hate to use negative language about the direction of the economy, for fear it would be self-fulfilling.

3. Detail on next steps.  Ideally, there will be a road map, with a timetable on when different countries will adopt various kinds of measures.  If all they can agree on is a vacuous statement of principles, we are in trouble.

Update (by James): PRI’s The World led off Friday’s show with a discussion of the G7 and IMF meetings, including an interview with Simon.

Decisive, United Action

Events of the past several days have convinced us that the state of the global economy is getting worse and we have revised our analysis and proposals accordingly. In short, coordinated, large-scale actions by the U.S. and Europe, including bank recapitalization plans and guarantees of banks’ obligations, are necessary to limit the spread of a crisis that threatens to trigger national defaults in vulnerable countries around the globe.

Editor’s Note: The content below was originally a separate page, linked to from the short blog post above. I have consolidated it into this single post, after the jump.

Continue reading “Decisive, United Action” →

Incrementalism

Let’s say you face a pervasive loss of confidence in your financial institutions, the stock market just fell 7 percent, depositors are (needlessly) rattled and a certain small country is talking about something that sounds ominously like a significant default (it’s Iceland on line 2).  What do you do?

Your instinct might be to go for a broad bold package of measures, throwing a great deal resources in to strike at the root causes of the problems at the same time as addressing some of the more painful symptoms.  But that is because (and part of why) you are not a leading economic policy official in a G7-type industrial country.

These officials are outstanding individuals, who take their jobs seriously, work hard, have the highest standards on all dimensions, and are very smart.  But they have been trained, just as their mentors were, and their mentors before them, to make macroeconomic policy in small steps.  The best way to unsettle the markets, they have learned, is to be overly bold.  Macro management, the mantra holds, needs a steady hand and an unblinking eye.  And policy changes should be incremental: 25 basis points (that’s 0.25%) is a much favored step in interest rates, up or down.

All of this is completely reasonable and makes a lot of sense in ordinary times.  And the times have been ordinary on almost every day over the past 60 or so years.  In fact, if you spend time with long-time practitioners, they are hard pressed to find a close parallel to the circumstances of the past 3 weeks.

And this is the point.  Someone who has had every kind of experience in the US market over the past 35 years, up and down, boom and bust, is in all likelihood not at all prepared for the situation we now face.  What we are seeing now in the United States and, just as amazing, in Western Europe is the kind of situation that, in our lifetimes, has only been seen in middle-income “Emerging Markets” open to capital flows.

It is, of course, the capital flows that make the difference.  If you build an economy in which financial services are large relative to other economic activity and have a high ratio of debt-to-equity (check that box for the US and Western Europe), you are vulnerable to “jumps” downward in confidence.  Of course, you can also get confidence to jump upwards, but this is not so easy.  (This is the fish soup problem.)

Now, I do think that officials in the G7 and other rich countries will eventually figure out what they need to do.  They will take their time, organize big packages (along the lines we are suggesting, at least roughly), and they will show up eventually with overwhelming financial force.  But the odds on this happening soon are slim.  They need more discussion among themselves (which they do a lot), more analysis (they read everything), more reports (very important for shifting the consensus) and – above all – much more by way of downward movement in markets.  We will get there, but not tomorrow and, I’m afraid, not this week.

Days to the election: 29

The Baseline Scenario, 2nd Edition

Our weekly baseline scenario is divided into three parts: updates since last week; our analysis of the current situation; and our policy proposals. First-time readers should begin with the analysis and continue with the proposals; returning readers may want to just read the updates and the proposals. (Or download the complete baseline in PDF.)

Despite what seemed at times to be a week filled with news, we think events remain track within our Baseline Scenario from last week.  A big global contraction of credit is underway and a severe recession is in the cards almost everywhere.  Governments continue to respond too slowly and too partially to this.  Europe in particular remains largely in denial (amazing though that may seem after 10 days of bank failures).

Overall, however, our message remains reassuring.  Policy can turn the situation around quickly, if it is applied in a decisive manner (see our policy proposals).  We are optimistic that political leaders will eventually rise to the occasion.

You have probably heard the term, “Living on Internet Time,” which means to experience life at a hectic pace.  I’m afraid we are now living on Financial Market Time, which is like Internet Time, but with teeth.  It would be better if political leaders could step up sooner rather than later.

Editor’s Note: The original version of this document was a separate page with a link from the short blog post above. I have since consolidated the long document into this blog post. It follows after the jump.

Fish Soup

Lech Walesa, electrician turned President of Poland, famously quipped that, “it is easier to make fish soup from fish than vice versa.”  He was talking about moving from quasi-socialism to a more market-based economy, but the same thought struck me when I read today’s announcement that the British Chancellor of the Exchequer will soon put in place a bank recapitalization scheme.

My first reaction was positive, particularly as this is something we have been arguing for.  But then I began to wonder if the scale would be sufficient, if it would be combined with measures to restructure mortgages for people with negative equity (an important upcoming issue for the UK), and if it would be supported with a sufficient fiscal stimulus.

I don’t know if the market was having similar thoughts, but as I write (very early on Monday, Oct. 6) it seems like more people are thinking in terms of a global recession scenario (e.g., oil is approaching $90 per barrel).  Once people see the need to deleverage (reduce the amount they borrow) and reduce their risks, it is hard to get them to go the other way.  Measures that would have been preemptively brilliant 6 months ago, may now have very little or zero effect.

Increasingly, it seems like only a decisive package of measures will turn things around.  And even then, such a package may not be easy to adopt until the situation is considerably worse than it is today.

Days to the US Presidential Election: 29.

G7 at Bat

All eyes turn to Washington this week for the annual meetings of the International Monetary Fund (and World Bank), which will include the finance ministers of the world (up to 185 of them, plus entourages).

Naturally, before these events there is another meeting that – arguably – is where the real decisions are taken. This is the meeting of the G7 finance ministers, which by tradition takes place in the US Treasury on Friday (with the broader meetings being Saturday through Monday).  To remind you, the G7 is the club of the largest industrialized countries: the US, Canada, Japan, France, Germany, Italy, and the UK.

Some people regard the G7 as the group that is really in charge of the world.  But as you probably noticed by now, no one is really in charge.  Still, the G7’s voice carries considerable weight on many issues.

This is a particularly important week for the G7 for three reasons.  First, the world economy is in worse shape and heading in a more dangerous direction than at any time in the recent past.  Old hands cast their minds back to 1982 for anything comparable in terms of global circumstances.  But 1982 was the beginning of an emerging market crisis, involving default and devaluation in Latin America, Eastern Europe and various other middle and low-income countries scattered around the world.  Now we have a crisis in the core of the system, clearly in the US and Europe and quite possibly more widely.

The second reason to look to the G7 is that, this time, they really can do something.  Their main policy tool is the communique, which is a joint statement that you should look for late on Friday.  This will tell you what they think is going on, and what should be done and by whom.  Of course, the language will be fairly indirect, but at least in this instance it should not be too hard to interpret.  The statement is not binding on anyone, but it will give us an indication of whether they are on the same page.

The third point is that prominent members of the G7 seem already to be on different pages.  The four European members had an unusual pre-meeting today in Paris, and their messages seem to be about the need for more regulation, looser accounting rules, and a change in the compensation system for executives so they take less risks. We’ll see what is the US position by the time we reach Friday; we guess there will be less than full convergence.

At least on one point, there is already a large gap in views opening up.  The Europeans still want to rescue banks on a case-by-case basis, whereas the US has definitively switched to a systemic approach of some kind. Given the gravity of the situation, we prefer the US position at this point, and none of the current European proposals seem to bolster confidence: the problem in Europe was not lack of regulation, but rather failure to enforce existing regulation (fact: European banks bought a lot more collateralized debt obligations than anyone realized); looser accounting rules would open up a massive can of nontransparent worms (a lack of transparency helped get us into this mess, and it’s not clear how less transparency will get us out), and executives in all kinds of incentive systems took on, in retrospect, way too much risk recently.

The G7 could, speaking together, help to decisively break the crisis of confidence that still – at the end of last week – gripped financial markets.  The indications at this moment, however, are that this unfortunately will not be the case.

Don’t Cry (or Cry Out) for the ECB

I would like to express some sympathy for the current predicament of the European Central Bank (ECB).  They will undoubtedly come in for a great deal of criticism in the weeks ahead, particularly following their refusal to move interest rates today – if our Baseline Scenario view continues to hold.

But you have to keep in mind that they, unlike the Fed, have a very explicit mandate focused on just one variable: inflation.  It is true that there is some scope for interpretation both broad and narrow.  The broad scope exists because, for example, if actual growth slows below what is called “potential growth” (a very elusive number), inflation will decline eventually.  So when you think about what inflation should be, you are really thinking about where growth is relative to potential – and this is what interest rates can affect (keep in mind all these effects are lagged, i.e., take between one and two years to work their way through the system).  And the narrow scope means there is some choice over exactly what inflation measure you aim for and whether you can look at other things (such as money supply).  This quickly slips into monetary theology and I’m not going there, at least today.

In any case, the ECB has a pretty clear mandate and it also has a board on which almost all countries that belong to the eurozone get to vote (there are now slightly more members than seats).  The management of the ECB comprises the best minds in the business, with impressive experience in the private sector, academia and central banking.

But the basic point comes down to this.  The ECB is in Frankfurt.  And the real deal is that it represents all that is great and good about post-1945 German monetary policy, with its emphasis on trampling on inflation at every opportunity.  This worked well for Germany for a long time and it might even be a good idea now (although I’m a bit skeptical).

The problem is that it is very unclear that this focus on fighting inflation will be appropriate for all eurozone countries.  Spain and Ireland are clearly slowing down.  The latest data, put out by the European Commission, points to recession in France and Italy.

But the ECB was given a job to do.  They have a clear mandate, and they are not supposed to be flexible (unlike the Fed).  And the German authorities are watching. The ECB will cut interest rates only when they see eurozone-wide recession definitely “in the data”.  Of course, by then it will be too late.  But they are really only doing their job.  And there is nothing in their job description about preventing the world from slipping into depression.