Good bye financial crisis, hello recession

The massive and reasonably well coordinated bailouts undertaken in a large number of countries should eventually bring the financial crisis to its unhappy end. There may be more hiccups and the need for more intervention – and more money – but the British plan has offered a good blueprint. The original Paulson plan sought to relieve banks from their toxic assets, but it never quite managed to find a good way to price them. Instead of attempting to shore up the asset side of bank balance sheets, the British plan focuses instead on the liability side. By undertaking to guarantee bank borrowings, it lays the ground for a restart of the money market. By further offering to inject capital, the plan kickstarts the process of reconstruction of badly damaged banks. It could well be the final best plan combines both.

The success of the plan depends on the willingness of banks to play the game and apply for support. Some will not, because they believe, rightly or wrongly, that they don’t need it. Another reason for them to turn the plan down is that, in some countries, it includes capping bonuses and suppressing dividend payments, thus creating an unholy alliance between managers and shareholders. It would be very problematic if several major banks elect to stay out of the plan, for it would create a stigmatization effect. If some banks claim that they do not need help, those which do may hesitate for fear of being branded as fragile, or mismanaged, or both. That could undermine the whole plan. This is a serious threat in Germany.

With the increasing willingness of central banks to absorb assets of dubious quality – in effect implementing the Paulson plan – we now have a fairly exhaustive bailout in place. If, somehow, most banks buy into it, the virulent phase of the financial crisis should come to an end. This will usher another phase, the picking up of its consequences. We will need to think about better financial market regulation, but the immediate concern is growth. Over the last month, forecasts have turned decisively somber. The slowdown so far has been driven mainly by the surge in oil and commodity prices that took place last year. The effects of the financial crisis have barely started to be felt. Here the worse is clearly in front of us. For several years, the financial markets marveled at their huge “risk appetite”. This flawed concept really combined risk aversion and perceived risk. Risk aversion has probably never changed. What did change was the perception that risk was low. Financiers seem to have believed that they could combine high returns and low risk. That was never possible, as they painfully discovered. They were amassing the huge risks that go hand in hand with huge profits, but they considered risks to be low. Now we hear about low risk appetite. Once again, the same mistake is being made. Exactly as they were underestimating risks, banks now massively overestimate them. As a result, we face a credit crunch. If banks do not act as banks, that is if they do not grant loans to trusted customers, the economy cannot grow. In fact it can only contract. We face a real self-fulfilling prophecy: banks stop making loans because they consider all borrowers to be unreliable, which will prompt bankruptcies and payment defaults and thus validate ex post the bankers’ fears. In response to this major threat, the Fed has started to act as a commercial bank and grant loans to the private sector. In France, the bailout plan includes a clause that requires banks to lend as much as they did last year. Clearly, neither response will substitute for a working banking system. This is why a credit crunch is inescapable and why economic forecasts are gloomy. This may be why stock markets are so volatile, but then wisdom has never been one of their attributes. Their collective ability to switch in no time from depression to exuberance – a syndrome called bipolarity – is proverbial.

On the other hand, the abrupt decline in oil and commodity prices will be of great help to cushion the upcoming blow. It may be a mixed blessing, though. It will help bring inflation down. But, with growth stalling, inflation may fall too much. Deflation is not ruled out anymore. Deflation is a terrifying threat. It encourages people to postpone discretionary spending, which deepens the recession and further pushes price down in a very vicious cycle. It raises the real value of debts, thus pushing previously solvent borrowers into bankruptcy, adding a new blow to the financial system. It knocks off monetary policy once interest rates reach the zero lower bound.

This is why the authorities, which did so much to hopefully bring the financial crisis to its end, have much more to do. Monetary policy may not be very effective in the presence of a credit crunch, but central banks have little choice but to promptly bring interest rates down, very far down. But monetary policy alone will not take us out of the wood. Governments must act quickly and decisively. They have no choice but to adopt sharply expansionary fiscal policies. It is all too easy to anticipate objections. Some will argue that fiscal policy does not work, which is simply wrong. Others will say that public debts are too large to be allowed to grow again. Wrong again. If we go into a recession, deficits will grow anyway. If we go into deflation, debts will grow even without deficits. Fiscal discipline is a fundamental attribute of good government, but now is not the time to enforce it. Preventing misery to afflict millions of hapless citizens is not just a higher order of priority. It is a necessity if we are to avoid a deeply disoriented public opinion from believing in one form or another of populism and its simplistic solutions.

It is now commonplace to call this financial crisis the worst ever. This is probably true, and enough to sap the spirits of the most optimists amongst us. But there is good news too. Since the beginning of the crisis in August 2007, the authorities have displayed an amazing ability to innovate. The solutions adopted recently were simply unimaginable a month ago. And the same can be said about the measures adopted a month ago. And so on all the way back to August 2007. The authorities obviously use a lot of what we have learned in countless financial crises. They do so with creativity and, often, surprising boldness. This is why we stand a very good chance of escaping a remake of the 1930s. But if you want to worry, here is a final thought. Many of the measures put in place by the authorities are new, and therefore untested. Unavoidably, some mistakes are being made, whose consequences will be revealed later. It is difficult not to think that some sword is hanging above our necks. Well, still, don’t despair.


Originally published at Finanz Und Wirtschaft and reproduced at Charles Wyplosz’s website and reproduced here with the author’s permission.


7 Responses to "Good bye financial crisis, hello recession"

  1. Bert Roberge   November 23, 2008 at 7:29 am

    So now Obama is wanting to start a post WWII type jobs program. This announcement is being made during one of the worst downturns in the stock market in recent history. Although not a bad idea, the banking and credit issues are currently the main culprits driving the markets down. I wonder how Wall Street will react Monday. It seems that the U.S. government administration will say anything to get the markets to go up – but any intelligent U.S. equities investor will see that Obama’s plan proves how bad of a recession or depression we are about to enter.Bert Roberge, CPAAccounting Solutions & Automation, Inc.Gulf Breeze, Florida

    • Guest   November 23, 2008 at 8:55 am

      Mass public works related job creation plan will likely deter major players in stock market ( eg. hedge funds) from buying. It sure is all smoke and the mirrors thing or a scarcrow / shamanic spell to ward off Great Depression v 2.0. And that’s how it will be received by savvy investors – verbal promise of unrealistic measures to be taken too late anyways: we are into GD v2.0 already……….And right on will they be. We have first symptoms of creation of deflatory envirinment, Fed has one bullet left in their rate cut gun ( maybe two – i.e. one to shoot at economy and one left for themselves….), specter of defaulted derivatives is lurking from behind the corner as financial and manufacturing giants are bound to eat the dust. All of that pointing to GD v2.0 being here already ( media will discover it in 3 – 6 months, markets within weeks).

      • Guest   November 23, 2008 at 10:28 am

        Where do you see market going? S&P at 700, 600, or 500?

  2. Michael   November 24, 2008 at 6:39 pm

    “If banks do not act as banks, that is if they do not grant loans to trusted customers, the economy cannot grow.” Typical oversimplification.Both the Monetarists and the Keynesians faithfully believe that government money-pumping is all it takes to defeat a credit contraction. The reality is that – due to excessive borrowing during the bubble years – many businesses are not creditworthy; and, because we are entering a recession, the businesses that are creditworthy would be foolish to borrow to expand.Flooding banks with money to prop them up from the consequences of terrible past practices and demanding that they lend, lend, lend will have no effect whatsoever on the actual course of the credit contraction and the recession, but it will produce countless distortions in the already-twisted banking industry.

  3. Elias   November 24, 2008 at 7:36 pm

    Ve esto

  4. Anonymous   November 29, 2008 at 3:45 pm

    Government can serve as an economic smoothing function but it can not replace a broken economy which is what we have right now. Misplaced faith in government’s ability to “fix” this mess will only make things worse by having people hesitate in doing the right thing which is to cut back on consumption, discharge bad debt, and move misallocated resources to areas of better productivity. History teaches that government interventions in free markets are invariably the cause of the original problems and are never the solution even though the government will take credit for the market righting itself over time.All of this excess credit was modern alchemy – the attempt to get something for nothing. Nothing artificial lasts forever and this major scam episode by central bankers and their croonie regional banks is officially ending. There is nothing that government can do except flail around while it crashes.

  5. guys background search   March 8, 2009 at 4:26 pm

    STOP THE BAILOUTS and FIX THE BANKS- Solve the loan problem.- Solve the derivative problem.- Reassemble whole loan mortgages.The U.S. economy is shrinking fast, because businesses cannot get loans that they need to operate normally. Banks and lenders already own $ billions in bad loans, and they are afraid to make new loans. The government gave $ billions in bailout money for banks to start lending, but banks hoard the money to save themselves.Our financial system became untrustworthy, because it mixed $ billions in bad loans in with the good loans. Now, banks do not trust any of the loans, and the entire credit market stopped working.The U.S. economy will continue to shrink until we untangle the loans. Once the bad loans are isolated, they can be fixed one at a time. Then trust will be restored. Credit will flow, and the economy will grow.So far, our government is spending $ trillions on bailouts and pork projects, out of ignorance and political ideology. The real solution is much less expensive than that.The USA has fixed this problem before, and it is not hard to fix again.A) Start with the Resolution Trust Corporation (RTC), which our government setup to solve a Savings and Loan problem in the 1980s.B) RTC buys up components and derivatives to reassemble whole mortgages.1. Total securitized mortgage market is estimated at $1.3 Trillion by a Professor of Economics at Ohio State University. (Also see the graph from Deutsche Bank at “The Death of Securitized Mortgages” http://www.nakedcapitalism.com/2008/06/death-of-securitized-mortgages.html )2. Government buys components and derivatives at the lowest market price set via a reverse auction. (Google on “reverse auction”.)3. Squatters, who sit on their derivatives in order to extort big $ from the rest of the system, can be forced to sell. (Law is analogous to eminent domain, or sales forced on cybersquatters that registered the domain names of well-established companies.)4. Government pays derivative squatters at market price set by previous reverse auctions, perhaps with a penalty to the squatters.5. Sellers give up all rights. No new law there.6. Banks, investors, and insurers now have cash instead of questionable loans and derivatives, so the banking system is healthy with cash to lend.7. Credit will flow, and the economy will grow.C) Government reassembles whole loans from securitized mortgage components and derivatives.D) Government sorts the newly reassemble whole loans (mortgages) into groups according to risk/quality.1. Government uses traditional mortgage experts and guidelines to sort the home loans into quality groups, for example, a high quality group would include homeowners with 20% (or more) equity in their house at today’s market price; and house payments that are 25% (or less) of homeowners monthly income.E) Government (RTC) sells groups of reassemble mortgages to traditional mortgage banks.1. This solves the problem of renegotiating home loans with homeowners. Read on.2. Law must be changed so that reassembled whole loan mortgages cannot be securitized into derivatives, again.3. An important purpose is to reconnect each homeowner with his lender, and vice versa.4. It eliminates incentive for mortgage lenders to make predatory and junk loans. If the loan fails, the lender is stuck with a bad loan.5. Government recovers much of the $1.3 Trillion purchase cost, because government sells off the reassembled mortgages.6. Groups of lower quality mortgage would fetch a lower price at auction.7. Mortgage companies that buy the risky groups of mortgages did so at a lower price, and they have room to negotiate with the homeowners.8. Some homeowner negotiations will not succeed. Those homeowners will move into affordable rentals. (The government does not owe everyone a free house.)9. Other renters would like to buy those empty homes at reduced market prices.10. If the government gets stuck with some homes, the government could profit by selling those homes when the housing market recovers.F) Insurers like AIG may be reorganized through bankruptcy.1. Securitized mortgage pools never made business sense, unless they were protected by various insurance schemes.2. Those insurance schemes always were a scam.3. Insurance only works when most of the insured assets are never hit with a disaster. That is why flood insurance does not work in the private market. A major flood ruins all the buildings in a large area, all at the same time. That is the fallacy of securitized mortgage insurance. In an economic downturn, the “disaster” hits all the houses, all at the same time.4. Companies that ran the huge insurance scam will go through bankruptcy.5. Never ending government bailouts for insurers like AIG are just throwing good money after bad.This plan is inexpensive, tried and true. It leaves the banks healthy, with cash to lend. It restores trust in the credit markets, so loans will be made. It reassembles mortgage derivatives into whole loans, and restarts traditional mortgage lending. People can get loans to buy homes. Credit will flow, and the economy will grow. *—————————————————-*(footnote) The economy will grow if President Obama’s massive tax, borrow, and spending plans can be stopped, before he creates another Great Depression. Presidents Hoover and Roosevelt already tried to tax, borrow and spend their way out of a recession in the 1930s. Instead, they created the Great Depression, which lasted 12 years. Straight as he goes, President Obama is doing it, again. Nevertheless, cleaning up the securitized mortgage mess is a great first step.