Martin Wolf: "The government can rescue the economy"

Martin Wolf, in “Why Washington’s rescue cannot end crisis story,” tells us, push come to shove, the government can bail us out of our economic mess, but it would be unwise to stop there. Wolf argues that substantial steps need to be taken to rein in a financial sector that is beyond the understanding of not only the regulators, but the institutions themselves who were deemed to be capable of managing their own risks.

I’m not as optimistic as Wolf. Not that we might not muddle through, but the path out is no where near as simple as he suggests. He sees this as a banking crisis, and anticipates that the remedy would be a repeat of the Resolution Trust Corporation’s good bank/bad bank split and auction operation.

But this is only incidentally a banking crisis. As many commentators have observed, we are experiencing multiple sieze-ups in portions of the credit system remote from regulated banks, and even worse, operating across national borders. Pray tell, what relevance does a “good bank/bad bank” model have to municipalities suffering from the failure of the auction rate securities market? Or to dealing with the festering problem CDOs littered round the world now worth far less than their sales price?

The S&L crisis was confined to institutions that were large in aggregate but inconsequential individually. There were some noteworthy exceptions took hits due to their stupidity: Citigroup nearly went bankrupt due to its aggressive lending of junior debt to commercial real estate projects, particularly in Texas, that turned out to be “see through” buildings. First Boston got stuck with bridge loans that led it to get another equity infusion from Credit Suisse (it had been rescued by them before in the late 1970s) that eventually led to a full takeover.

With the S&L crisis you had similar organizations with similar exposures that wound up in the hands of federal banking regulators. You thus had a central intelligence managing the operation. Because many of the biggest financial institutions were not in terrible shape, there were buyers for the “good bank” franchises and assets. Speculators went for the “bad bank” piece.

Thanks to our new distributed financial model of “package and sell” you have damage occurring in sectors with little regulation or with multiple regulators and unclear mandates. The ability, as in the S&L collapse, for one body to step in and take charge, is largely absent. Look at the mess of the monoline rescue. The state insurance regulators lacked the clout to push the investment banks who were exposed to write checks; they also had limited authority to intervene directly with the monolines, since solvency is not an issue (surprisingly, all, including MBIA capitulated, but given possible problems with MBIA’s financial statements, more may be at issue here than former CEO Greg Dunton’s relationship with Eric Dinallo). That crisis is in abeyance because the rating agencies caved in and investors, understandably, would rather not have a meltdown play out. But how often will “See no evil, hear no evil, speak no evil” solutions work?

And also consider: the institutions are risk are not small fry, but include very large players who are vital to credit intermediation. Again, remember, it is the refusal of the dealers to buy in auction rate paper that precipitated the municipal bond crisis. The big players have already taken substantial writedowns but for the most part, have been able to compensate for the damage through equity infusions from foreign investors. It won’t be so easy for them to replenish their capital if they take further large losses. And more damage will lead to further restriction of their market-making activities.

So if things devolve, we will see rolling crises, most of which will not be easily addressed, which will further erode investor confidence and lead to continued impairment of liquidity.

The only upside is that continued distress increases the odds of the kind of root and branch reform that Wolf believes is necessary. The faith in our current financial structure is so well entrenched that it will take continued demonstration of its failings to build consensus around the need for major reforms.

From the Financial Times:

In an introductory chapter to the newest edition of the late Charles Kindleberger’s classic work on financial crises, Robert Aliber of the University of Chicago Graduate School of Business argues that “the years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises”*. We are seeing in the US the latest such crisis.

All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado. This generates low real interest rates and a widening current account deficit. Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.

With variations, this story has been repeated time and again. It has been particularly common in emerging economies. But it is also familiar to those who have followed the US economy in the 2000s.

When bubbles burst, asset prices decline, net worth of non-financial borrowers shrinks and both illiquidity and insolvency emerge in the financial system. Credit growth slows, or even goes negative, and spending, particularly on investment, weakens. Most crisis-hit emerging economies experienced huge recessions and a tidal wave of insolvencies. Indonesia’s gross domestic product fell more than 13 per cent between 1997 and 1998. Sometimes the fiscal cost has been over 40 per cent of GDP (see chart).

By such standards, the impact on the US will be trivial. At worst, GDP will shrink modestly over several quarters. The ability to adjust monetary and fiscal policy insures this. George Magnus of UBS, known for his “Minsky moment”, agrees with Prof Roubini that losses might end up as much as $1,000bn (FT.com, February 25). But it is possible that even this would fall on private investors and sovereign wealth funds.

In any case, the business of banks is to borrow short and lend long. Provided the Federal Reserve sets the cost of short-term money below the return on long-term loans, as it has for much of the past two decades, banks can hardly fail to make money.

If the worst comes to the worst, the government can mount a bail-out similar to the one of the bankrupt savings and loan institutions in the 1980s. The maximum cost would be 7 per cent of GDP. That would raise US public debt to 70 per cent to GDP and would cost the government a mere 0.2 per cent of GDP, in perpetuity. That is a fiscal bagatelle.

Because the US borrows in its own currency, it is free of currency mismatches that made the balance-sheet effects of devaluations devastating for emerging economies. Devaluation offers, instead, a relatively painless way out of a slowdown: an export surge. Between the fourth quarter of 2006 and the fourth quarter of 2007, the improvement in US net exports generated 30 per cent of US growth.

The bottom line, then, is that even if things become as bad as I discussed last week, the US government is able to rescue the financial system and the economy. So what might endanger the US ability to act?

The biggest danger is a loss of US creditworthiness. In the case of the US, that would show up as a surge in inflation expectations. But this has not happened. On the contrary, real and nominal interest rates have declined and implied inflation expectations are below 2.5 per cent a year. An obvious danger would be a decision by foreigners, particularly foreign governments, to dump their enormous dollar holdings. But this would be self-destructive. Like the money-centre banks, the US itself is much “too big to fail”.

Yet before readers conclude there is nothing to worry about, after all, they should remember three points.

The first is that the outcome partly depends on how swiftly and energetically the US authorities act. It is still likely that there will be a significant slowdown.

The second is that the global outcome also depends on action in the rest of the world aimed at sustaining domestic demand in response to a US shift in spending relative to income. There is little sign of such action.

The third point is the one raised by Harvard’s Dani Rodrik and Arvind Subramanian, of the Peterson Institute for International Economics in Washington DC, (this page, February 26), namely the dysfunctional way capital flows have worked, once again.

I would broaden their point. This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalism in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened. That would be a huge error.

Those who do not learn from history are condemned to repeat it. One obvious lesson concerns monetary policy. Central banks must surely pay more attention to asset prices in future. It may be impossible to identify bubbles with confidence in advance. But central bankers will be expected to exercise their judgment, both before and after the fact.

A more fundamental lesson still concerns the way the financial system works. Outsiders were already aware it was a black box. But they were prepared to assume that those inside it at least knew what was going on. This can hardly be true now. Worse, the institutions that prospered on the upside expect rescue on the downside. They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? If so, how does one sustain broad public support for what appears so one-sided a game?

Yes, the government can rescue the economy. It is now being forced to do so. But that is not the end of this story. It should only be the beginning.