A new sitrep, as we move into phase 3 of the financial crisis

Summary:  In response to the growing financial crisis, the government at last takes large-scale measures to stop the rip.  These move us ever farther from a free-market system, towards an increasingly centralized and government-dominated economy.  Taken in haste, we will have a long-time to consider the wisdom of these steps.  Few things so effectively panic a people into surrendering their sovereignty like a hot crisis.  Also, remember that that the winners of the November election will have to guide us through this crisis.

In my report on 15 September I described the three phases of the crisis.

  1. Collapse of the mortgage brokers, starting in December 2006 — met with laissez faire (indifference).
  2. Collapse of flawed financial institutions (Countrywide bank, Bear-Stearns, the government-sponsored enterprises) — met with massive intervention and bailouts.
  3. Contagion and failure of healthy institutions.

As we entered phase 3, I said that treatment of the financial system, not its parts, would be needed.  That might include actions such as…

  • massive fiscal and monetary stimulus programs,
  • large scale and explicit nationalizations,
  • coordinated central bank action to adjust relative currency values and control capital flows.

We saw two of these steps initiated on Thursday.

(1)  Coordinated central bank action

Hoping to shore up confidence with a show of financial shock and awe, the Federal Reserve stunned investors before dawn on Thursday by announcing a plan to provide $180 billion to financial markets through lending programs operated by the European Central Bank and the central banks of Canada, Japan, Britain and Switzerland.

— Source:  NY Times.  See Brad Setser’s blog at CFR for analysis of this in a global context.

(2)  Massive nationalization of assets

The head of the Treasury and the Federal Reserve began discussions on Thursday with Congressional leaders on what could become the biggest bailout in United States history.  While details remain to be worked out, the plan is likely to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions. The proposal could result in the most direct commitment of taxpayer funds so far in the financial crisis that Fed and Treasury officials say is the worst they have ever seen.

Senior aides and lawmakers said the goal was to complete the legislation by the end of next week, when Congress is scheduled to adjourn. The legislation would grant new authority to the administration and require what several officials said would be a substantial appropriation of federal dollars, though no figures were disclosed in the meeting.

— Source:  NY Times.

What do we know, as big decisions are taken behind closed doors?

A few things are clear.

(a)  The government is acting without plan, in haste or even desparation.  This greatly increases the odds of policy error, historically what turns a crisis into a disaster.

(b)  This requires skillful execution to avoid generating inflation in the US or a currency crisis in the US dollar.  Or both.  Avoiding both might not be possible.

(c)  The US government does not have the money for large-scale nationalizations.  Nor does the savings poor United States.  We must borrow it.  In today’s environment, the only potential lenders are a small number of foreign central banks.

(d)  This bails out the private institutions responsible for this crisis.  They keep the profits and stick the taxpayers with the potentially large losses.

(e)  Most important, the government is still responding only to the financial crisis.  The US recession, part of a accelerating global slowdown, remains outside their planning focus.  So they remain in a reactive mode, which seldom works well.

The last 3 are esp problematic.

(c)  Have the potential lenders (e.g, China, Japan, Saudi Arabia) been consulted up front, or will they get what is in effect a demand to finance a fait accompli (or else risk trashing the global financial system)?  Either way, how will they react?  We want our existing loans rolled over at low interest rates, our existing massive current account financed at low rates, and now hundreds of billions of dollars at low rates to finance this plan.

(d)  How will we reduce the moral hazard created, as we have shown our large financial institutions that they we will underwrite any losses from their reckless speculation?  I doubt that a severe lecture will do the job.  Vowing to be stern in the next crisis (2028?) might not have much effect.  And let’s hope the American public does not realize that they have been conned — free markets for private profit, socialized losses if the bets do not pay off.

(e)  Excerpt from the economist David Rosenberg’s report of 18 September:

We have been in this credit collapse now for roughly a year, and yet it seems as though we have yet to fain the clarity and transparency that is required to transition to the next positive economic cycle.  A year into this thing and there is still no light at the end of the tunnel … because people still do not comprehend the severity of the asset liquidation and debt deflation process underway.

A cautionary note — Our creditors grow restless

I recomend close attention to the following.  It is is not the first such article, nor will it be the last.  China’s rulers warn us that our line of credit has limits, and the warnings grow more frequent and more explicit.  I suggest we listen to avoid an unpleasant surprise in the future.

China paper urges new currency order after ‘financial tsunami’“, Reuters, 17 September 2008 — Excerpt:

Threatened by a “financial tsunami,” the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.  The commentary in the overseas edition of the People’s Daily said the collapse of Lehman Brothers Holdings Inc (LEH.P: Quote, Profile, Research, Stock Buzz) “may augur an even larger impending global ‘financial tsunami’.”

The People’s Daily is the official newspaper of China’s ruling Communist Party … Its pronouncements do not necessarily directly reflect leadership views, but this commentary by a professor at Shanghai’s Tongji University suggested considerable official alarm at the strains buckling world financial markets.

… “The eruption of the U.S. sub-prime crisis has exposed massive loopholes in the United States’ financial oversight and supervision,” writes the commentator, Shi Jianxun.  “The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States.”

… The commentary suggested China must brace for grave economic fallout and look to alternatives, saying the crisis brings to mind the Great Depression of the 1930s.  “Lehman Brothers announced bankruptcy will not only have a domino effect on the global financial world, it will bring a shock to the world economy,” the front-page comment stated.

Originally published at Fabius Maximus and reproduced here with the author’s permission.