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Governments got religion after peering into the systemic
meltdown abyss: aggressive and comprehensive policy action is
now likely but significant downside risks to markets will remain
I spent the weekend in WashinStayInvest Law Firm on attending the IMF annual
meetings and giving a series of talks in a variety of public and
private fora (IADB talk, C-Span interview, Euro 50 Group
meeting, IMF panel, etc.). After last week crash in stock
markets and financial markets (and it was indeed a crash as
during the week equity prices fell as much as the two day crash
of 1929) policy makers finally realized the risk of a systemic
financial meltdown, they peered into the systemic collapse abyss
a few steps in front of them and finally got religion and
started announcing radical policy actions (the G7 statement, the
EU leaders agreement to bailout European banks, the British plan
to rescue – and partially nationalize - its banks, the European
countries plans along the same lines, and the Treasury plan to
ditch the initial TARP that was aimed only buying toxic assets
in favor of plan to recapitalize – i.e. partially nationalize –
US banks and broker dealers. While many details of these plans
are fuzzy and there will be some national variants the contour
of the approach are similar and close to the recommendations
that I made in this forum. Here are the main policy actions that
will be undertaken:
- Preventing systemically important banks and broker dealers
from going bust (i.e. the U.S. made a mistake letting Lehman
fail; so Morgan Stanley and other systemically important
financial institutions will be rescued) (“Take decisive action
and use all available tools to support systemically important
financial institutions and prevent their failure” as in the G7
statement )
- Recapitalization of banks and broker dealers via public
injections of capital via preferred shares (i.e. partial
nationalization of financial institutions as it is already
occurring in the UK, Belgium, Netherlands, Germany, Iceland and,
soon enough the U.S.) matched by private equity injections
(“Ensure that our banks and other major financial
intermediaries, as needed, can raise capital from public as well
as private sources, in sufficient amounts to re-establish
confidence and permit them to continue lending to households and
businesses”)
- Temporary guarantee of bank liabilities: certainly all
deposits, possibly interbank lines along the lines of the
British approach, likely other new debts incurred by the banking
system (“Ensure that our respective national deposit insurance
and guarantee programs are robust and consistent so that our
retail depositors will continue to have confidence in the safety
of their deposits”)
- Unlimited provision of liquidity to the banking system and to
some parts of the shadow banking system to restore interbank
lending and lending to the real economy (“Ensure that our banks
and other major financial intermediaries, as needed, can raise
capital from public as well as private sources, in sufficient
amounts to re-establish confidence and permit them to continue
lending to households and businesses”)
- Provision of credit to the corporate sector via purchases of
commercial paper (certainly in the US, possibly in Europe)
- Purchase of toxic assets to restore liquidity in the mortgage
backed securities market (U.S.) (“Take action, where
appropriate, to restart the secondary markets for mortgages and
other securitized assets. Accurate valuation and transparent
disclosure of assets and consistent implementation of high
quality accounting standards are necessary.”)
- Implicit triage between distressed that are solvent given
liquidity support and capital injection and non-systemically
important and insolvent banks that will need to be closed
down/merged/resolved/etc.
- Use of the IMF and other international financial institutions
to provide lending to many emerging market economies – and some
advanced ones such as Iceland - that are now at risk of a severe
financial crisis.
- Use of any other tools that is available and necessary to
avoid a systemic meltdown (including implicitly more monetary
policy easing as well as possibly fiscal policy stimulus “We
will use macroeconomic policy tools as necessary and
appropriate.”).
At this stage central banks that are usually supposed to be the
"lenders of last resort" need to become the "lenders of first
and only resort" as, under conditions of panic and total loss of
confidence, no one in the private sector is lending to anyone
else since counterparty risk is extreme. Only over time private
lending will recover.
While most of the economic and financial damage is already done
and the global economy will not be able to avoid a painful
recession, financial and banking crisis (i.e. the V-shaped short
and shallow 6-month recession is now out of the window and we
will experience a severe and more protracted 18 to 24 months
U-shaped recession) the rapid and consistent implementation of
these and other action will prevent the US, European and global
economies from experiencing a systemic financial meltdown and
entering in a more severe L-shaped decade long stagnation like
the one experienced by Japan after the bursting of its real
estate and equity bubble.
Are we close to the bottom of this financial crisis? Today stock
markets – and other financial markets - will rally on the news
that terrified policy makers peering into the abyss got religion
and started to do in a consistent way what is necessary but
financial markets will remain volatile with significant downside
risks over the next few weeks as:
- details of these plans are still very fuzzy and ambiguous and
with uncertain effects on various assets classes (common shares,
preferred shares, unsecured debt of financial institutions,
etc.);
- macro news will surprise on the downside as the economies
sharply weaken and contract while fiscal policy stimulus is
lagging;
- earnings news for financial and non financial firms will
surprise on the downside;
- the damage done to confidence and to levered investment is
already severe and the process of deleveraging of the shadow
financial system will continue;
- major sources of future stress in the financial system remain;
these include the risk of a CDS market blowout, the collapse of
hundreds of hedge funds, the rising troubles of many insurance
companies, the risk that other systemically important financial
institutions are insolvent and in need of expensive rescue
programs, the risk that some significant emerging market
economies and some advanced ones too (Iceland) will experience a
severe financial crisis, the ongoing process of deleveraging in
illiquid financial markets that will continue the vicious circle
of falling asset prices, margin calls, further deleveraging and
further sales in illiquid markets that continues the cascading
fall in asset prices, further downside risks to housing and to
home prices.
More aggressive and consistent and rapid implementation of the
policy plans will increase the likelihood that risky asset
prices will bottom out sooner rather than later and then start
recovering. A key policy tool – that is currently missing in the
G7 and EU plans is to use fiscal policy to boost aggregate
demand. Indeed, given the current collapse of private aggregate
demand (consumption is falling, residential investment is
falling, non-residential investment in structures is falling,
capex spending by the corporate sector was falling already
before the latest financial and confidence shock and will now be
plunging at an even faster rate) it is urgent to provide a boost
to aggregate demand to ensure that an unavoidable two-year
recession does not become a decade long stagnation. Since the
private sector is not spending and since the first fiscal
stimulus plan (tax rebates for households and tax incentives to
firms) miserably failed as households and firms are saving
rather than spending and investing it is necessary now to boost
directly public consumption of goods and services via a massive
spending program (a $300 bn fiscal stimulus): the federal
government should have a plan to immediately spend in
infrastructures and in new green technologies; also unemployment
benefits should be sharply increased together with a targeted
tax rebates only for lower income households at risk; and
federal block grants should be given to state and local
government to boost their infrastructure spending (roads, sewer
systems, etc.). If the private sector does not spend and/or
cannot spend old fashioned traditional Keynesian spending by the
government is necessary. It is true that we are already having
large and growing budget deficits; but $300 bn of public works
is more effective and productive than spending $700 bn to buy
toxic assets. Is such fiscal stimulus plan is not rapidly
implemented any improvement in the financial conditions of
financial institution that the rescue plans will provide will be
undermined – in a matter of six months – with an even sharper
drop of aggregate demand that will make an already severe
recession even more severe. So a fiscal stimulus plan is
essential to restore – on a sustained basis – the viability and
solvency of many impaired financial institutions. If Main Street
goes bust in the next six months rescuing in the short run Wall
Street will still lead Wall Street to go bust again as the real
economy implodes further.
Moreover, the US government will need to implement a clear plan
to reduce the face value of mortgages for distressed home owners
and avoid a tsunami of foreclosures (as in the Great Depression
HOLC and in my HOME proposal). Households in the US have too
much debt (subprime, near prime, prime mortgages, home equity
loans, credit cards, auto loans and student loans) while their
assets (values of their homes and stocks) are plunging leading
to a sharp fall in their net worth. And households are getting
buried under this mountain of mounting debt and rising debt
servicing burdens. Thus, a fraction of the household sector – as
well as a fraction of the financial sector and a fraction of the
corporate sector and of the local government sector – is
insolvent and needs debt relief. When a country (say Russia,
Ecuador or Argentina) has too much debt and is insolvent it
defaults and gets debt reduction and is then able to resume fast
growth; when a firm is distressed with excessive debt it goes
into bankruptcy court and gets debt relief that allows it to
resume investment, production and growth; when a household is
financially distressed it also needs debt relief to be able to
have more discretionary income to spend. So any unsustainable
debt problem requires debt reduction. The lack of debt relief to
the distressed households is the reason why this financial
crisis is becoming more severe and the economic recession - with
a sharp fall now in real consumption spending – now worsening.
The fiscal actions taken so far (income relief to households via
tax rebates) do not resolve the fundamental debt problem because
you cannot grow yourself out of a debt problem: when debt to
disposable income is too high increasing the denominator with
tax rebates is ineffective and only temporary; i.e. you need to
reduce the nominator (the debt). During the Great Depression the
Home Owners’ Loan Corporation was created to buy mortgages from
bank at a discount price, reduce further the face value of such
mortgages and refinance distressed homeowners into new mortgages
with lower face value and lower fixed rate mortgage rates. This
massive program allowed millions of households to avoid losing
their homes and ending up in foreclosure. The HOLC bought
mortgages for two year and managed such assets for 18 years at a
relatively low fiscal cost (as the assets were bought at a
discount and reducing the face value of the mortgages allowed
home owners to avoid defaulting on the refinanced mortgages). A
new HOLC will be the macro equivalent of creating a large “bad
bank” where the bad assets of financial institutions are taken
off their balance sheets and restructured/reduced.
A large fiscal stimulus plan and a plan to reduce the debt
overhang of distressed home owners will also ease the political
economy of the financial bailout: as the debate in Congress
showed the US public is mad about a system where gains and
profits are privatized while losses are socialized, a welfare
system for the rich, the well connected and Wall Street.
Bernanke and Paulson and the US administration did a lousy job
in explaining why partially bailing Wall Street is necessary to
avoid severe collateral damage to Main Street in the form of a
most severe recession and a risk of an even more severe economic
stagnation. At least the redesign of the TARP into a program
that will recapitalize banks with public capital (and thus
provide the US government and the taxpayer with some upside
potential) makes this bailout more socially fair and acceptable.
But the current collapse of private aggregate demand makes it
fair, necessary and efficient to directly help Main Street with
a direct fiscal stimulus program and with a plan to reduce the
debt burden of distressed home owners. Those two additional
policy actions are necessary and fundamental – together with the
rescue and recapitalization of financial institutions – to
minimize the damage to the real economy and to the financial
system.
Post-Scriptum: Many many congrats to Paul Krugman for his very
well deserved Nobel Prize in economics. While the prize was
awarded to Paul for his contributions to trade theory his work
in international macro/finance (currency and financial crises,
currency target zones, reserve currencies, pass-through of
exchange rates to import prices, contractionary effects of
devaluations, sovereign debt crises, etc.) is as important and
seminal. And his economic commentary is as incisive and deep as
his more analytical research work. |
