Category: Commentary

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.

Mortgage Restructuring at Countrywide

We and other commentators have been saying that in addition to shoring up banks, there needs to be something for the homeowners at the bottom of the food chain. This will need to be a priority for Congress when it convenes in November (as it absolutely must, at this point) and for the next president. However, today, there may have been a small step in the right direction. Bank of America (which bought Countrywide) announced a “homeownership retention program” for customers of Countrywide, which was one of the most aggressive subprime lenders during the housing bubble.

The agreement, which was negotiated with several state attorneys general (who have been investigating Countrywide’s allegedly predatory lending practices), includes several provisions that offer hope to struggling homeowners:

Restructuring of first-year payments to target 34% of household income
Interest rate reductions
Principal reductions for some types of loans
Waivers for some loan modification and prepayment fees
Partial moratorium on foreclosure proceedings for borrowers who may be eligible for the program
$220 million in assistance for homeowners facing foreclosure

The program is supposed to go into effect on December 1. In total, it is expected to provide $8.4 billion in payment relief to homeowners. Of course, a lot will depend on how it is implemented, but at least this time (as opposed to the largely ineffectual HOPE program announced a while ago) there will be a set of attorneys general monitoring the program.

One major potential stumbling block is that “some loan modifications … will require investor approval” – meaning that if a mortgage has been securitized, all of the people who own bits and pieces of that mortgage may have to approve any modifications. This is why systematic government intervention is necessary to force people – if necessary and legal – to participate in loan modifications that do benefit all parties (investors get more than they would get in case of foreclosure; homeowners get to stay in their houses, perhaps just as renters; communities are not devastated by foreclosures). But while waiting for that to happen, this can’t hurt. Most importantly, it shows the recognition (under pressure, of course) by a major player that it is not going to get all of its money out of its borrowers, and that it is better off trying to find a win-win solution.

Paulson’s Bank Recapitalization Plan

The big news today is that Henry Paulson claims to have found, in the $700 billion TARP package passed last Friday, the power to invest some of that money directly in banks to shore up their capital. As one of the people who actually read the bill (OK, I skimmed most of it), I was puzzled by this, because my reading (like everyone else’s) was that Treasury would only be allowed to take equity stakes in companies who participated in the sale of troubled assets to Congress. However, if you look at the comments by Congressmen in the Time article and on Calculated Risk, you’ll see that there are statements in the Congressional record saying that the intent of the bill is to allow direct equity purchases. A curious fact that you learn in law school is that, in interpreting a bill, it is not just the words of the bill that matter; the record of committee and floor discussions can also be used in interpreting a bill. So it seems like, in this case, Congress consciously inserted language into the discussion in order to give Treasury this power, or Treasury is seizing on some passages in the discussion to claim that power.

At this point this is unlikely to generate too much controversy, because most people involved, including the authors of this blog, think it would be a good thing for Treasury to take some of the $700 billion and invest it directly in recapitalizing banks (which is what the UK is doing). Of course there will be issues of detail to be worked out, and the Treasury Secretary has an awful lot of discretion in this matter, but this is definitely a step forward.

Oh, and I should mention: Planet Money broke this story first.

Interest Rate Cuts vs. Recapitalization

Global rate cuts: attacking the symptom?

After yesterday’s move by the Fed into the commercial paper market, today’s big news is a global interest rate cut, including the Fed, the European Central Bank, and the Bank of England, among others. The effect of an interest rate cut should be to reduce borrowing costs across the board, which is a good thing for the real economy. However, the rate cut may not have a direct impact on the crisis at the heart of the financial system, which is that banks are not lending to each other. To put this in perspective, the spread between 3-month inter-bank lending rates and 3-month Treasury bill rates – a measure of how willing banks are to lend money to each other, as opposed to socking it away in risk-free Treasury bills – is running at about 4 percentage points. Ordinarily, it should be about 0.5 percentage points. As a matter of simple arithmetic, a 0.5 percentage point cut in central bank interest rates is small compared to a 3.5 percentage point increase in risk premia. As long as lenders are afraid their borrowers could go bankrupt, lowering the cost the lenders pay for money will only slightly lower the price that they charge for money.

Still, though, today’s move is a valuable signal that the world’s central bankers are on the same page and that they will do whatever they can to fight the crisis. And the good news may have come from the United Kingdom, where the government announced a straight-up bank recapitalization plan, in which 25 billion pounds will be used to buy preferred shares in eight banks, and another 25 billion pounds will be allocated to buy shares in those or other banks. Banks that have more capital are less likely to go bankrupt, making other players more willing to lend to them. As we’ve pointed out before, the Paulson Plan may have the indirect effect of increasing bank capital (because we expect Treasury to overpay for the securities it buys under the plan), but uncertainty over how that will work has diluted its impact on the markets. Explicit bank recapitalization is a more direct way to attack the problem.

Federal Reserve Invokes Emergency Powers?

As has been widely reported, the Federal Reserve announced today that it will start buying commercial paper directly from issuing companies. (Commercial paper, as expertly explained in last weekend’s episode of This American Life, is a short-term IOU that companies issue when they need to smooth out the short-term fluctuations in their bank balances; the issuer promises to pay $1 million in 7 days’ time and, for example, gets $999,000 from the lender immediately.) Highly experienced journalists have described this action as using the Fed’s “emergency powers,” although the Fed was itself careful not to use the word “emergency” in its press release. Rather, the terms and conditions released this morning cite the authorization of Section 13(3) of the Federal Reserve Act. That section reads as follows (bold emphasis added; you don’t need to read it carefully, there won’t be a quiz):

3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

(“Discounting” just means that the Fed can loan the holder or issuer of the commercial paper a little less than the face value of the paper.)

So while the phrase “emergency powers” can be frightening, this doesn’t mean that martial law has been declared, or its financial equivalent; just that the Fed identified an “unusual and exigent circumstance” in the market. By this action, the Fed is intervening in the short-term credit market for ordinary companies directly; previously, its actions had been devoted to encouraging banks to provide short-term credit to those companies. We can infer from this that the Fed has decided that the previous strategy wasn’t working, at least not well enough. Because it bypasses the banking sector altogether to provide credit to the real economy, this should reduce borrowing costs for companies, which is a good thing. (The downside is that theoretically it creates exposure for the government, and hence the taxpayer, if any issuers default on their commercial paper.)

Still, though, this latest Fed action points out two concerns. First, the Fed still appears to be reacting to events as they arise rather than plotting a strategy to get ahead of the crisis and stop it in its tracks. (A set of steps that might stop a crisis of confidence, if announced in one fell swoop, could fail to have that effect if spread out over several weeks or months.) Second, there is no Congress in session, and there won’t be until after the election at the earliest. The election is only four weeks away, but as we have seen markets can shift significantly from one day to the next. Today’s action can be seen as a signal that the Fed will do whatever it takes to keep credit flowing until Congress can reconvene and develop a more fundamental set of solutions. Which is a good thing, assuming that Bernanke doesn’t run out of tools in his magic toolbox.

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 Bailout and the Stock Market

One week ago, the House rejected the bailout bill and the Dow fell more than 700 points. That fall was a major reason why public opinion shifted from heavily against the bailout to confused, and why the bill passed on Friday. On Friday, though, the Dow fell another 150 points, and today at 1 pm Eastern it’s down another 500 or so.

Before panicking, though, we have to consider what this means. Broadly speaking, we are faced with two related crises, each of which is approximately represented by a different market. The first is a global economic slowdown that people have been talking about for months. The second is the acute credit crunch that hit after Lehman went bankrupt on September 15.

Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.

Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people’s investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don’t cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll. (See the posts tagged “real economy” for a couple examples of this.)

Now the credit and stock markets are related, because when the credit market freezes up, people’s expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. (As Simon advised me, if you write a post entitled “your money is not going to go poof,” as I did, 20% of your readers won’t see the “not.”)

So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble – given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.

As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy.

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.

The Financial Crisis and Entrepreneurship

If anyone is looking for a silver lining, Michael Fitzgerald has a post called “Bad Times Are Good Times for Entrepreneurs,” and I couldn’t agree more. On September 14, 2001 – at the trough of the technology meltdown, at the beginning of a recession, and on a day when the stock market was not even open because of the 9/11 attacks – I quit my job and co-founded Guidewire Software. It was a great time to start a company for a number of reasons:

There were talented people looking for new opportunities.
The ordinary costs of doing business (space, equipment, etc.) were depressed.
As a private company, you don’t have to worry about quarter-to-quarter performance. Your investors (if you have them) will have a long-term perspective.
Most importantly, when you first start a company, you aren’t expected to sell anything, so the fact that no one is buying doesn’t matter. Your jobs are to research your market, research your potential customers, design your product, build your product, and (if you need it) raise money. Depending on the industry you are in, all of this can take a couple of years. Even then, if the recession isn’t over yet, you are selling to a small number of early adopters, who will not be making decisions based on the overall state of the economy. It will be even longer before you have the kind of sales volume that is susceptible to changes in the economic cycle.
This didn’t apply to us, but if there is enough dislocation in the economy, it is bound to create new business opportunities that can be captured by startup companies.

Guidewire today is a leading provider of software to insurance companies with customers in Russia, Brazil, Japan, the United Kingdom, Australia, and New Zealand, in addition to the United States and Canada. Seven years from now there will undoubtedly be dozens or hundreds of successful companies that were started in the wake of the credit crisis.

Bailout Passes; Hard Work Begins

Our position has been that the Paulson Plan is imperfect but is still a valuable first step toward restoring confidence in the financial markets, and so we are glad that it passed today. One remarkable development over the last two weeks has been a shift among both economists and the public from thinking the plan was an application of massive force to thinking that the plan is a relatively small part of the long-term solution. As discussed in our most recent baseline scenario, the next steps are to work on financial sector recapitalization, housing market stabilization, and fiscal stimulus (and, of course, regulation).

At the same time, though, implementing the Paulson Plan will be a major task, and one that will require oversight both from Congress and from government-watchers. Not surprisingly, Treasury is already moving to use fund management firms as outside contractors in buying securities. There are some valid practical reasons for this, but it creates the potential for conflicts of interest that we warned about in an earlier op-ed on governance; fortunately, the final bill includes much more emphasis on transparency of contracting than did the original proposal. Pricing the assets will be perhaps the trickiest problem, whether it be through reverse auctions (which can be difficult to implement) or through direct negotiations with banks. Price will determine how many warrants the government gets in participating companies, which are another improvement in the final bill. Finally, although the plan specifies multiple forms of oversight, figuring out how to make that oversight effective in a fast-moving environment will be difficult.

So while passing Plan A was a good thing for the financial sector and for the real economy, making it work will require a good deal more effort both inside and outside the Beltway. And the sooner work starts on Plan B, the better.

Financial Crisis and the Real Economy, Part 2

The impact of the financial crisis on the real economy can be divided into two periods: before September 15 and after September 15. Before 9/15, it was clear that we were in an economic slowdown, beginning with the construction industry, and that troubled assets on bank balance sheets would probably lead to a long-term decline in lending, which might push the economy into recession. Since Lehman failed on 9/15, this general problem sharpened into a short-term credit crunch, in which various parts of the credit markets have stopped functioning or come close to it. Still, though, people want to know, what does the credit crunch mean for me?

Bloomberg reported that almost 100 corporate treasurers held an emergency conference call yesterday to discuss the challenges they are facing rolling over lines of credit with their banks. In some industries, lines of credit are the lifeblood of even completely healthy companies. They operate like home equity lines of credit: you draw down money when you need it (like to make payroll), and you pay it back when your customers pay you back. (In most business-to-business transactions, money changes hands some time after goods are delivered; hence the pervasive need for short-term credit.)

Now, however, banks are demanding much higher interest rates, lower limits, and stricter terms when lines of credit expire, or are even pouncing on forgotten clauses in contracts to force renegotiations of terms. Lines of credit are priced in basis points (a basis point is 1/100th of a percentage point) over LIBOR, a rate at which banks lend to each other. One company saw the price for its line of credit rise from 90 basis points to 325 basis points over LIBOR, which is itself running at high levels. The banks aren’t doing this because they think their borrowers are in any danger of not paying them back; they’re doing it because they want to hold onto the money because they are afraid of liquidity runs. “These are very different circumstances than many of us have dealt with before,” said one treasurer. “We’re all having to learn every day about provisions that were buried in documents executed 15 years before.”

This is how fear in the banking sector translates very quickly into higher costs and less cash for healthy companies in the real economy. Fortunately there are clear steps that Washington can take to bolster confidence in the banking sector, which will cause the flow of money through the real economy to pick up.

Bailouts and Moral Hazard

Hazardous Morals

As Daniel Henninger noted in the Journal today, moral hazard is hot right now. This is the stick that commentators of all political affiliations use to beat the Fannie/Freddie bailout, the Paulson rescue plan, any proposal to restructure mortgages, or any other government action that has the effect of protecting someone from his bad decisions.

The concept of moral hazard originated in the insurance industry, and describes the problem that people who are well insured are more likely to take unwise risks. (For example, if you have comprehensive insurance on your car with no deductible, you may not bother locking the doors.) In the current context, the argument is that if the government bails out financial institutions by taking troubled assets off their hands, they will not have an incentive to be more careful in the future. In this usage, moral hazard becomes suspiciously similar to moral indignation pure and simple: many people feel instinctively that banks that took excessive risks deserve to go bankrupt, and the bankers who made lots of money on the way up should lose their jobs. (These people often also believe that homeowners who can’t pay their mortgages should lose their houses).

The problem of moral hazard is real. And moral hazard should be taken into account when designing any rescue packages and, more importantly, when the time comes to rewrite the regulation of the financial sector. But there are several reasons why it should not be allowed to simply veto any government action.

Moral hazard is most important in a repeated or continuous context. When you buy an insurance policy at the beginning of the year, you know if you are fully covered, or if you will be responsible for some proportion of the losses you incur, and you behave accordingly. It applies less clearly to retrospective bailouts like the current plan, where it is not clear that a similar situation will ever arise again. For example, perhaps one of the behaviors we want to discourage is leverage ratios of 30 to 1, like those at Bear Stearns and Lehman. Well, there are no more investment banks, and commercial banks have much lower leverage limits. Besides, there is another way to discourage undesirable behavior: regulation.
As Martin Wolf argued in the FT in the long-gone days of the Fannie/Freddie bailout, the moral-hazard argument to punish the shareholders has the perverse effect of discouraging private capital. Given widespread fears that many banks are undercapitalized, it would be a good thing if they could raise capital in the private markets rather than from the government, like Goldman Sachs did with Warren Buffett. But if the government is planning to take the moral high ground and let banks collapse, then no one will step up with the capital.
Most importantly, there is something fundamentally illogical about the moral hazard argument. If we bail out the banks now, it goes, then they will behave in harmful ways in the future. But right now we are facing the greatest danger to the financial system since the Great Depression. What future harm are we worried about that is more serious than the potential harm we are facing right now?

“While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse.” Those words were written by no less a free-market advocate than Nobel Laureate Gary Becker.

Your Money Is Not Going to Go Poof

Readers of this blog will already know that we believe that (a) the credit crisis of the past two weeks is serious, (b) there is a real risk of a global recession, but (c) there are practical steps that governments can take to minimize the damage to the economy. Several of my friends have asked me what this means for them. And I wanted to repeat here what I told them: nothing cataclysmic is going to happen to your money.

First, let’s start with deposit insurance. In general, your checking accounts, savings accounts, and CDs are guaranteed by the FDIC up to $100,000 per account holder per bank, and that is likely to go up to $250,000 shortly. Some people have been pulling money out of banks even though they are below this limit, because they don’t know about the insurance, don’t trust it, or don’t want to deal with the hassle. Now this is something with which I have personal experience. I had a CD (<$100K) at IndyMac Bank when it failed earlier this year. The FDIC took over the bank over the weekend and by Monday everything was exactly the same as on Friday: same web site, same call centers, same CD account, everything. The only change was that the name had changed from IndyMac Bank to IndyMac Federal Bank. I didn’t have to file a claim or even call anyone. My CD is still there, earning interest (at 4.15%, by the way). So if you have an insured account, you shouldn’t worry about it. (Some people have pointed out that the FDIC could run out of money if too many banks fail, but it’s a certainty that the government would put more money in the FDIC in that case.)

Second, you may have investments in stocks or bonds. Individual securities could be wiped out, and some have been already; not only did Lehman shareholders lose their money, but bondholders lost most of their money, too. But stocks are ownership shares in real companies, and most companies are not going to stop operating overnight. They will continue to buy, build, and sell whatever they buy, build, and sell today. Some will go bankrupt, as always happens, and some will lose value, but some will gain value. And it’s not likely that every company in the U.S. will lose all of its value at the same time. So you should be diversified, but you should always be diversified.

Third, there are your debit and credit cards. As long as you have money in your bank account, you will still be able to get at it using your debit card. It is unfathomable that a bank would need cash so desperately that it would block access to deposit accounts (and remember, those accounts are insured). When banks are at risk of failing, they want to preserve as much value as they can to sell to an acquirer. A large part of the value is the base of depositors and the ongoing banking operations. As for credit cards, it is possible that banks will gradually reduce the amount of credit they have extended by offering fewer cards, tightening the terms, reducing credit limits, and even unilaterally canceling some people’s cards. This could affect some people. But again, there is no reason why the credit card system as a whole would fail.

Now, if there is a recession, and that is certainly a possibility, it could have serious consequences for you: you could lose your job, your rate of salary increases could go down, your house could continue to lose value, your investments could lose value, and so on. As we’ve said, there are concrete steps that governments can take to minimize the duration and severity of any recession. In any case, you’re not going to wake up one day and find out that your money is gone. (Unless you keep your money under your mattress, in which case someone might steal it.)

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.