President Obama recently stated that he is a big believer in “persistence,” and he provided examples of how he will persist in many areas of economic policy. That word and his examples gave me more hope for the future of the U.S. economy than I have had in some time.
We are experiencing the mother of all modern financial crises. Real and imaginary counterparty risk, policy uncertainty, and widespread panic have reduced purely private financial transactions to a trickle in many vital markets. Unfortunately, an already complex economic problem is being compounded by an awful political environment, and the prefrontal cortex of our political system is freezing up as well. Politicians and commentators from the left and right are in panic mode and have retrenched to their basic instincts, moving away from reasoned analysis. It is, frankly, scary to hear the right regurgitating the untimely liquidationist claims that Treasury Secretary Andrew Mellon made during the onset of the Great Depression. It is also frightening to see the left going after Wall Street “oligarchs” and the financial institutions they have always hated, which finally are easy prey.
The Legacy Assets Program announced by Secretary Geithner earlier this week has the right elements to deal with a crisis where liquidity and uncertainty problems have greatly exacerbated the structural problems behind the crisis (see my blog reaction here). However, this program also has increased the urgency to activate the CAP (Capital Assistance Program), since otherwise many of the banks may be unable to cleanse their balance sheets for fear of (temporary) insolvency.
We are not out of the woods yet, but the elements of the Legacy Assets program are encouraging. They combine the strengths of the different public institutions involved —Treasury, Fed and FDIC— to produce a powerful combination of public equity, loans and guarantees to leverage private capital in the process of thawing frozen financial markets.
In a few weeks we will know the results of the stress tests. Rightly, the US Treasury and the Fed have pledged that these tests will not be used to liquidate or nationalise banks, but to determine the degree of support that each institution may need. Despite this pledge, the plan has not been favourably received by financial markets for essentially three related reasons:
Suppose it was possible to rewind the clock to the first time we had a strong urge to rewrite economic history. A favourite stopping date would be the days before the Lehman-AIG debacle last year. Until then, we were dealing with localised inefficiencies and predatory behaviour among the main financial institutions. There was plenty to fix but it seemed manageable, mostly a matter of accelerating the medicine and aggressively dealing with problems on a case-by-case basis.
We are running out of time and there is no end in sight unless massive political capital is put at risk now. We have a superb team of economists and technicians, but their voices all seem to have been lost. I recall Larry Summers rightly claiming that if markets over-react, the government has to over-react even more. Secretary Geithner, even in his much criticized first announcement, sounded to me like a man of principles, the right principles: We must stabilize the financial system, regardless of cost, was the message delivered with clenched teeth. However, Geithner’s and Summer’s actions do not match their own strong rhetoric. It is not that they don’t draw lines in the sand when faced with political pressures, but rather, they seem to be spending much of their energy tackling political hurdles rather than facing head-on the financial crisis.
Hope is in short supply during these trying economic times. Nowhere is this clearer than in the financial system. Since Secretary Geithner’s announcements last week, shares of the main financial institutions have yet again imploded. To make matters worse, politics has decidedly entered into the process of economic-policymaking, which makes it all the more likely that we will end up with the wrong policy response; one which is too late anyway. Talk of nationalization has become widespread, as if it were a panacea, further reinforcing the deadly spiral of fear and panic.
In all likelihood, political constraints severely limited the ambition and effectiveness of the new financial stability package. Economists need to unite behind relaxing these constraints. Talking lightly about nationalization, as is increasingly taking place, does exactly the opposite.
The current financial crisis will be remembered for years to come: The financial losses are measured in trillions of dollars; we have witnessed the demise of elite financial institutions; fear and mistrust is widespread among investors and lenders; credit markets have ceased to operate except for those with very short maturities; massive and orthodox policy interventions are an every day occurrence; and we have been, and continue to be, on the verge of a global financial meltdown. How did we get into this situation? What should we do to get out of it and to prevent a relapse any time soon?
World financial markets are being ravaged by uncertainty and fear. The prices of all forms of explicit and implicit financial insurance have skyrocketed and hence, by a basic identity, the prices of risky assets have plummeted or the corresponding markets have disappeared. Nowhere is this scenario more problematic than in institutions with strict capital requirements, such as banks, insurance companies, and monolines. For them, fire sale asset prices quickly wipe out their capital and, simultaneously, destroy their option to raise new capital since equity values implode.