Status report on the financial crisis: we’re at a critical point in time

Summary:  Here is a brief report with conclusions only.  The situation is moving too rapidly and become too complex for explanations.  This post describes the natural evolution of the trends I have written about for the past year, which are now reaching a climax.  Not yet, but soon we will be able to see the shape of the new world ahead in the fog.  As always, we lack the data or reliable economic theory to do more than speculate about these things.  See the archive at the end for posts over the past year describing how we arrived at this difficult spot.

An economic downturn has 3 stages, each with a different goal.

  1. First Aid — prevent the economy from sliding into a depression.
  2. Treatment — mitigate suffering during the recession,  achieve a global recovery in 2010.
  3. Recovery — restructuring and reforms to prepare for the expansion after 2010, and the new world beyond that.

Yes, 2010 is the earliest reasonable date for a recovery IMO from the most severe global downturn since WWII.  Policy errors could length the downturn, of course.

First Aid

This is a worldwide problem, due to two long-term factors.

  1. Globalization has locked us together into the same business cycle, instead of some regions being strong while others are weak.
  2. We all run our economies by the same body of economic theory, Keynesian economics.  No commies (except fringe states like N. Korea), and few socialist ones.

The result is like a monoculture agricultural system, vast fields planted with a generically identical crop.  It is uniformly vulnerable to the same diseases and pests.  We have all contracted the same infection.

The world’s finance ministers are meeting in Washington during the next few days.  This is perhaps governments’ last opportunity to regain control.

Their thinking have run slower than events, leading to inadequate response and disorientation (go here to see more on this).  Large-scale coordinated action by the major nations will be needed to prevent panic as people slowly become aware of the crisis, and restart normal operation of our commercial and financial systems.

Economists are generally agreed as to what should be done, basically recommendations #1 and #2 from my September 25th article “A solution to our financial crisis.”   For detailed proposals see “Rescuing our jobs and savings: What G7/8 leaders can do to solve the global credit crisis“, a collection of 12 essays by leading economists.  It says:

Policy makers must move boldly to stabilise the financial system. The basic elements are:

  • A quick bank recapitalisation with global coordination
  • A guarantee of deposits and/or loans with global coordination
  • Further, coordinated macroeconomic stimulus.

All the authors agreed on the first, many on the second and a good number on the third.

The first two are “first aid”, and will probably be the primary focus of the Ministers.  The third is “treatment”, reducing rates a lot and massive fiscal stimulus (Speaker Pelosi’s call for $150 billion in new spending is just ante in this game).  This list does not include one essential item:  loans from the IMF to nations suffering credit contractions.  See below for more details.

Let’s hope the leaders in Washington act rapidly and wisely.  Tired people acting under pressure make mistakes, such as an inability to force a consensus about collective action, or making policy errors.  Either could have unpleasant consequences.

Treatment

All we have experienced to date are the foreshocks — tremors in the world’s markets before the full effects of the global recession hit.  Some things we can expect:

  1. Fiscal deficits will skyrocket, as government revenues shrink and social expenditures rise. A $2T deficit for US governments (Federal, State, local)?
  2. Unless prevented or until stopped, debt deflation will result in a cascading series of business and personal defaults (plus bankruptcies and unemployment) rippling throughout the economy.
  3. Aggregate demand will decline, as businesses and households reduce spending and boost savings.
  4. We must keep interest rates low, inflation contained, and the US dollar’s value stable (or an orderly decline); doing all 3 will require global help.

For reasons beyond the scope of this post, I doubt that the conventional treatment — fiscal and monetary stimuli — will work.  Inguinuity will be needed.  Let’s hope we have another Keynes waiting in the wings for his opportunity to come onstage.  {For more on this aspect of the situation, see The new President will need new solutions for the economic crisis.}

Many aspects of the necessary treatment remain beyond today’s consensus thinking.  For example, America may require a global “bailout” – new funds and renegotion of our foreign debts, as described in “Effective treatment for this crisis will come with “The Master Settlement of 2009″.”

Recovery

I believe we will recover from this downturn into a new world.  The recovery period will be our opportunity to prepare for it, using what we learned from the recession to restructure our economy.  How well we do in the following generation or two might depend on decisions made during this period.  For example…

  1. Our pension savings (public, corporate, and personal) will be devastated by the recession, and the boomers will be retiring in steadily increasing numbers.
  2. Our financial system will be largely nationalized.  What do we do:  keep it under government control, privatize it under severe regulation, or some hybrid form?

Today we can only guess at the shape of the post-recession world.  Prof Delong said that the 1930’s led to government control of riskless rate of interest (the price of money), and the current crisis will result in government regulation of the risk premium (the price of risk).   A long global recession will drive changes in behavior, beliefs, and structure that we can only imagine today.

Also, the center of gravity probably will shift from west to east, as has been long discussed.  Their ideas of major Asian leaders about the proper structure for mortgage lending might be more important than that of American borrowers.  Unless the US government does most mortgage lending, financed by Asian purchases of US Treasury bonds.

Whatever the result, we will learn much about ourselves.  Periods like this test a people’s strength.  Their character, belief in their core values, and ability to work together.  I am confident that America again will withstand adversity.

Two subjects not to discuss in the comments

A little known clause in the FM site’s comment policy allows limiting discussing during times of extraordinary crisis.  Like now.  Let’s have open discussion of this post, subject to two exceptions (which we will save for a later date, where they can examined in detail at leisure).

(a)  Causes of the problems:

It is irrelevant how we contracted this “disease.”  Save it for church, or for future historians.  Events on this scale have complex causes going back decades, rooted in limitations of our political and economic theory (Keynes did not consider the aggregate debt level a limiting variable) — compounded by a series of public policy mistakes (e.g., misdiagnosis of the 1987 stock market crash in the Brady Report).  Esp absurd are simple single-cause explanation, esp to small events or policies.

(b)  Reforms

By the time things have cooled enough to discuss meaningful reforms — rather than simplistic panaceas to reassure the public – conditions and thinking will have changed from today.  Anything we think of now will be irrelevant; any reforms discussed now will be washed away by the events during the global recession.

A few stories showing the global scale of the crisis

This is a global crisis.  Iceland was only the first casualty.  Hungary and Indonesia may be next.  There are many others to worry about.  Korea and Australia among the developed nations; India and much of Eastern Europe among the emerging nations.  And, of course, the United States.

  1. Pakistan facing bankruptcy“, The Telegraph, 6 October 2008 — “Pakistan’s foreign exchange reserves are so low that the country can only afford one month of imports and faces possible bankruptcy.”
  2. Iceland teeters on the brink of bankruptcy“, AP, 7 October 2008 — And a more recent update on rescue operations from Reuters.
  3. Hungary markets slide on liquidity crunch“, Retuers, 9 October 2008 — “Hungary’s currency and bonds fell sharply on Thursday as concerns grew over the country’s financing and banking system amid the global financial crisis and as the government said it would redraft the 2009 budget.  Liquidity dried up and trading froze in the government bond market…”
  4. Indonesian stock trading frozen to prevent panic“, AP, 10 October 2008 — ” The president of the Indonesian stock exchange says trading will be suspended indefinitely ‘to prevent deeper panic’ after another huge drop on Wall Street.”

For more information from economists

  1. The Wrong Crisis“, Brad Delong, 8 October 2008 — About the unexpected aspects of this crisis.
  2. The world is at severe risk of a global systemic financial meltdown and a severe global depression“, Nouriel Roubini, RGE Monitor, 9 October 2008
  3. Rescuing our jobs and savings: What G7/8 leaders can do to solve the global credit crisis“, 9 October 2008 — A dozen of essays by leading economists about what the G7/8 leaders should do this weekend.

Originally published at Fabius Maximus on Oct 10, 2008 and reproduced here with the author’s permission.

One Response to "Status report on the financial crisis: we’re at a critical point in time"

  1. matthew   October 12, 2008 at 9:30 am

    Despite all the scary news and stats about layoffs, there are still millions of jobs posted on employment sites…www.linkedin.com (networking)www.indeed.com (aggregated listings)www.realmatch.com (matches you to jobs)Good luck to those looking for work.