New recommendations to solve our financial crisis (and I admit that I was wrong)
Summary: Please vote, and do so carefully! This could be one of the most important elections in American history, as continued economic crisis might require a massive (and hopefully temporary) expansion of government power — unlike anything we have seen except during wars.
On September 25 I sketched out A solution to our financial crisis, in three parts.
(1) Stabilize the financial system — Being attempted, probably now it’s too late.
(2a) Stabilize the economy with monetary stimulus– Rates are coming down and money printed, but probably with relatively little effect.
(2b Stabilize the economy with fiscal stimulus — Just now being considered; will work but slow to implement and slow to have effect.
(3) Arrange long-term financing for steps #1 and #2 with our foreign creditors — Unacceptable to our leaders at this time.
Parts 1 and 2 are being implemented, much as described. Part 3 was described as necessary at some point in the future. I said that these probably would not work over the medium to long term, but would mitigate the downturn (slow or even reduce the economic decline, and alleviate the resulting suffering). It appears that I was wrong.
The rate of decline — destabilization of the global financial system – has become so great that these measures will prove insufficient. In my opinion (these are, of course, guesses). Since I doubt our leaders have a Plan B, here is a suggestion:
We need extreme mobilization by the government of our economic resources, as we have done during wars.
For deep theoretical reasons our financial system is collapsing. I have discussed some of the reasons in other posts (see below for links), but the causes are irrelevant now. Whatever the cause of a cardiac arrest, the paramedics’ job is not to advise dieting and exercise — but to restart the heart.
The US economy is sliding into deflation. Deflation trashed Japan’s high-savings economy for a decade; two decades after the crash it remains weak. Deflation is potentially lethal to a high-debt economy like America’s.
The evidence of the early stages of a deflationary contraction is all around us. Just to mention a few: collapsing commodity prices, the price of gold falling, the US dollar rising almost 20% since mid-July, and the collapse of yields on one-year Treasury Inflation Protected Securities (TIPS). All are extraordinary. TIPS were priced for inflation a month ago.
Perhaps the global economy as well, in the downturn of the first global (or most global, ever) business cycle. The center is cracking (the US, the EU, and Japan). So are some nations on the fringes (e.g., Eastern Europe, Argentina, Pakistan). And points in between, also (e.g, Iceland, South Korea). This is a tear in the fabric of the global economy, which accelerates as it grows.
So far only the financial markets have felt its full force, but soon we will see the real world impacts on trade, employment, incomes, etc. Some leading indicators suggest the magnitude of the coming storm, such as the Baltic Freight Index down 90% from its peak on 20 May (to learn about it see Wikipedia, or this Slate article).
Panic is the danger at this point, as more people realize our perilous situation.
Panic drives people to sell risk assets to raise cash. But markets provide liquidity to individuals (a small fraction at one time), not to a large fraction NOW. Panic liquidation would likely force any exchange to close; the closing of a major exchange might spread the panic and force others to close. Already bourses have stopped trading for some period this month in Austria, Brazil, Iceland, Indonesia, Romania, Russia, Thailand, and Ukraine (sources here and here).
Panic means people save more and spend less. Businesses too, cutting both routine spending and investments. Keynes called this the “Paradox of thrift“. A gradual rise in savings rates can help an economy’s long-term performance. A sudden rise in savings rates just reduces everybody’s (i.e., aggregate) income. A rapid rise in the US rate from zero (or less) to 10% (not a large number) would have an unpleasant effect on the economy. (A sign of this: return of “layaway” plans, paying now for future delivery instead of buying on credit now.)
Worse, the very act of the government taking extreme steps — or even rumors that it has plans for such — might incite panic. Preparatory plans to close exchanges, de factor nationalization of industry, large scale stimulus (e.g., in the trillions, not just hundreds of billions) — however prudent, can spark reactions so severe that these measures become necessary.
More savings, less debt, less investment, a flight to safety (no risk capital by lenders or investors). If occurring on a large enough scale, as we see today on a small scale, starve businesses of revenue and capital. On the other hand, the government gains the ability to borrow massive sums at low rates as everyone scrambles for the safety of government bonds.
The result: By default the government becomes the primary economic actor. Its spending and investment decisions drive the economy. Not just immediately, but — as a result of the investments it makes — for many years after normal processes are restored. We saw this in Japan during the 1990′s. It borrowed and borrowed, but frittered the money away on largely unnecessary projects (e.g., bridges to nowhere, train stations in the middle of nowhere). This kept their economy rolling, but the debt remains and they have little to show for it.
Now we in a situation like Japan circa 1990. Interest rates must go to near-zero. Government spending programs must be rapidly initiated on a scale not seen since WWII. Government decisions will determine what America looks like for the next two decades (at least). Who gets loans, what kinds of infrastructure to build, what kind of training programs for young people and the older unemployed … it is a long list.
Trillion dollar spending programs for 2009-2010. Plus a trillion or so in capital infusions into the financial system. While other nations do the same. The global savings pool might not suffice for to provide so much capital, and the effects of such massive borrowing might destabilize interest rates and currency values. Hence the need for my recommendation #3: the “Master Settlement of 2009“ – a meeting of the major nations to, among other things, reschedule America’s debt and form a new geopolitical and financial global regime.
I doubt any government experiencing these conditions — and there probably will be many — will do otherwise than take extreme actions.
Libertarians and laissez-faire capitalists will advocate elaborate plans for doing little or nothing. What would happen if they took power in Washington January? Who knows? I have little interest in contrafactuals. One might just as well ask what would happen if the Blue Fairy waved her wand and increased the human race’s average IQ by 50 points.
Comparison: now vs. the Great Depression
One advantage we have over the folks of 1930 (and Japan in the 1990′s): we know this song. The response of government leaders since the crisis started in December 2006 (when the mortgage brokers began collapsing) has been slow, reactive, and incremental. In many ways similar to that of President Hoover’s administration between 1929 and 1932. While recognition of our danger has been slow in this cycle (discussed here), action following recognition will be fast.
Also, we understand economics better. Keynes wrote The General Theory of Employment, Interest, and Money in 1936 (although the ideas it presents were in circulation much earlier). Plus we have the work of others during the past 70 years, such as Hyman Minsky and Milton Friedman. This allows a far better response. Perhaps most important, the gross policy errors made during the 1930′s — such as raising taxes and trade barriers — are far less likely today.
Only extreme statists will rejoice at these measures. The need for such result from the accumulated policy errors of the past half-century (or more), a bipartisan orgy of folly. We must do as our ancestors did during adversity: Stay cool, make the necessary decisions as best we can, and move on. These events are just another cycle in the life of a great nation.
Lessons Learned about government for the next cycle
Since 1929 everybody knows that close regulation of banks and brokers is necessary to prevent serious financial crises. We had a bank crisis in the early 1980′s, as they almost went broke due to feckless lending to emerging nations. We had a bank crisis in the early 1990′s, as many folded due to feckless real estate lending. And here we are again. All this despite a large and well-funded state and federal regulatory apparatus, to which we granted draconian powers over the financial sector.
We made a mistake.
“You f**ked up, you trusted us.”
— Otter advising Flounder, from the film Animal House
Update: another voice, similar message
“Roubini Says `Panic’ May Force Market Shutdown“, Bloomberg, 23 October 2008 — Excerpt:
Hundreds of hedge funds will fail and policy makers may need to shut financial markets for a week or more as the crisis forces investors to dump assets, New York University Professor Nouriel Roubini said.
“We’ve reached a situation of sheer panic,” Roubini, who predicted the financial crisis in 2006, said at a conference in London today. “There will be massive dumping of assets,” and “hundreds of hedge funds are going to go bust,” he said. … “Systemic risk has become bigger and bigger,” Roubini said at the Hedge 2008 conference. “We’re seeing the beginning of a run on a big chunk of the hedge funds,” and “don’t be surprised if policy makers need to close down markets for a week or two in coming days,” he said.
If you are new to this site, please glance at the archives below. You may find answers to your questions there, as these posts are best considered as chapters in a book. These matters are too complex to cover much ground in 1,000 words.
Please share your comments by posting below. Please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
For more information from the FM site
To read other articles about these things, see the FM reference page on the right side menu bar. Of esp interest these days:
- about America – how can we reform it?
- about the Financial crisis – what’s happening? how will this end?.
- about The End of the Post-WWII Geopolitical Regime.
- A solution to our financial crisis
- links to Damage Reports from home and abroad
Posts about solutions to our financial crisis
- Slow steps to nationalizing the US financial sector, 7 April 2008 — How this will change our society.
- Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
- How should we respond to the crisis?, 24 September 2008
- A solution to our financial crisis, 25 September 2008
- A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
- The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008
- The last opportunity for effective action before disaster strikes, 3 October 2008
- Prof Roubini prescribes first aid for America’s economy, 4 October 2008
- Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
- Dr. Bush, stabilize the economy - stat!, 7 October 2008
- The new President will need new solutions for the economic crisis, 9 October 2008
- Results from the IMF meeting – just thin gruel, 12 October 2008
- The G-7 meeting was the last chance for action before the global recession, 12 October 2008
- A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008