A trillion here, a trillion there, soon it adds up to real money

“The Federal Open Market Committee (FOMC) has authorized a $330 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide funding for U.S. dollar liquidity operations by the other central banks. The FOMC has authorized increases in all of the temporary swap facilities with other central banks. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $30 billion by the Bank of Canada, $80 billion by the Bank of England, $120 billion by the Bank of Japan, $15 billion by Danmarks Nationalbank, $240 billion by the ECB, $15 billion by the Norges Bank, $30 billion by the Reserve Bank of Australia, $30 billion by the Sveriges Riksbank, and $60 billion by the Swiss National Bank. As a result of these actions, the total size of outstanding swap lines is $620 billion.

All of the temporary reciprocal swap facilities have been authorized through April 30, 2009.

Dollar funding rates abroad have been elevated relative to dollar funding rates available in the United States, reflecting a structural dollar funding shortfall outside of the United States. The increase in the amount of foreign exchange swap authorization limits will enable many central banks to increase the amount of dollar funding that they can provide in their home markets. This should help to improve the distribution of dollar liquidity around the globe.”

From Brad Setser, “More extraordinary moves: $620 billion is real money, and it isn’t even for American financial institutions”, Council on Foreign Relations Blog (29 September 2008).

http://blogs.cfr.org/setser/2008/09/29/more-extraordinary-moves-620-billion-is-real-money-and-it-isnt-even-for-american-financial-institutions/#more-3826


Brad W. Setser is a Fellow for Geoeconomics on the Council on Foreign Relations and a frequent commentator on international economic and financial questions.

The Federal Open Market Committee is the key monetary policy setting committee of the Federal Reserve. In addition to setting U.S. monetary policy, the FOMC also has a key role, which it shares with the U.S. Treasury, in formulating U.S. policies regarding the exchange value of the dollar, and it intervenes in foreign exchange markets in support of that policy. The FOMC is, after the Joint Chiefs of Staff, the most powerful committee in the United States.

The revised and extended Treasury plan to end the financial crisis, known at Regent as Paulson’s Repackaged Pig, was voted down today by the House in a calculated gamble to improve its terms and avoid giving the government unprecedented powers over the nation’s financial sector. Part of the problem with the Pig was not only that its powers were enormous and the oversight useless, but that no one could say how much it would ultimately cost. The original $700,000,000,000 price tag placed on the Pig was a crude guess (Treasury spokeswoman: "We just wanted to choose a really large number.") and in some quarters a low one (one “financial genius” on Wall Street commented it was nowhere near enough; he called for $5,000,000,000,000).

After the no vote on the Treasury plan the stock market swooned, Paulson lost his temper, and Bernanke announced the Fed would prepare for the apocalypse by throwing another $630,000,000,000 at foreign central banks that acted as offshore banking centers for the U.S. After all, foreigners purchased a lot of risky dollar-denominated American bonds during the good years, and now those assets have collapsed in price and no dollars are left in the coffers of the foreign banks that participated in the fun of a booming market. So now that a downturn as set in abroad, the ever-ready Fed will re-fill their coffers with dollars in a swap arrangement whereby foreign central banks give us some of their currency and we give them some of ours. Needless to say, everyone is praying the real economy does not sink into a depression while Congress gets its act together and tries to produce a bill that focuses on really stabilizing the financial sector here and abroad.

Given its performance to date, one must ask the question, “What if Congress fails to deliver a bill?”

In the first instance, the Fed can on its own provide liquidity to the domestic economy the same way it is providing dollar liquidity to foreign economies. Assuming that the tens of thousands of banks scattered across the country do not want to go out of business by failing to extend profitable loans to solvent and operating companies, they will soon begin to do so on their own. Those that can’t because they have lost too much money will die, and the economy will be cleansed of banks and financial institutions that were heavily into toxic assets and should to go under for reasons of imprudent practices. Overall, the bloated financial services sector will be downsized and made far more efficient than it is today and the era of absurd executive salaries will come to an end, all without any intervention by Congress.

In the second instance, once the government stops trying to prop up prices for financial assets, as Paulson’s Pig tried to do, they will fall to some sensible, economically justifiable level. Housing prices were in a bubble, and it is good that they fell. Why is Congress trying to prop them up? Granted many have lost some of the value of their house but others will now find housing much more affordable. The middle class and the poor, for example, will be able to purchase better houses than they could in the past, and the need for the government to subsidize housing for the poor is reduced. What’s bad about that? Similarly, financial assets such as stocks are now cheaper and therefore more affordable than before. There is no reason to believe that the stream of income they will produce in the future had changed. The same or better return on a cheaper asset. What’s bad about that (at least for the young, who did not suffer the recent capital losses)?

In the third instance, whether a bill in Congress is passed or not makes no difference whatsoever to the fundamentals of the U.S. economy. It has today and will have tomorrow the same labor force with the same skills and experience as it had yesterday. Its commercial buildings, factories, and the equipment and furniture in them are and will be the same as yesterday. It has the same natural resources and capital infrastructure as yesterday. It has the same entrepreneurial skills and management abilities as yesterday. And it has the same networks of domestic trade and international commerce as yesterday. Nothing of fundamental importance has changed and nothing of fundamental importance will change, Congressional bill or not.

In the end, it does not matter if the government spends a trillion dollars to “rescue” the financial sector at home and extends another trillion dollars to foreigners to “rescue” their financial institutions. It is, literally, merely money. The bailouts will be helpful if and only if they allow us to make the adjustments necessary to establish a viable economy, one that provides jobs and incomes that lift people economically in a way they regard as fair and equitable to all. It is not at all clear that the bill in Congress would accomplish that.

Bailout or not, if we suffer an economic setback we have the ability and experience to recover and regain prosperity at home and our position in the world. It depends on us, not Congress, and certainly not this bill.

A trillion here, a trillion there, soon it adds up to real money

“The Federal Open Market Committee (FOMC) has authorized a $330 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide funding for U.S. dollar liquidity operations by the other central banks. The FOMC has authorized increases in all of the temporary swap facilities with other central banks. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $30 billion by the Bank of Canada, $80 billion by the Bank of England, $120 billion by the Bank of Japan, $15 billion by Danmarks Nationalbank, $240 billion by the ECB, $15 billion by the Norges Bank, $30 billion by the Reserve Bank of Australia, $30 billion by the Sveriges Riksbank, and $60 billion by the Swiss National Bank. As a result of these actions, the total size of outstanding swap lines is $620 billion.

All of the temporary reciprocal swap facilities have been authorized through April 30, 2009.

Dollar funding rates abroad have been elevated relative to dollar funding rates available in the United States, reflecting a structural dollar funding shortfall outside of the United States. The increase in the amount of foreign exchange swap authorization limits will enable many central banks to increase the amount of dollar funding that they can provide in their home markets. This should help to improve the distribution of dollar liquidity around the globe.”

From Brad Setser, “More extraordinary moves: $620 billion is real money, and it isn’t even for American financial institutions”, Council on Foreign Relations Blog (29 September 2008).

http://blogs.cfr.org/setser/2008/09/29/more-extraordinary-moves-620-billion-is-real-money-and-it-isnt-even-for-american-financial-institutions/#more-3826


Brad W. Setser is a Fellow for Geoeconomics on the Council on Foreign Relations and a frequent commentator on international economic and financial questions.

The Federal Open Market Committee is the key monetary policy setting committee of the Federal Reserve. In addition to setting U.S. monetary policy, the FOMC also has a key role, which it shares with the U.S. Treasury, in formulating U.S. policies regarding the exchange value of the dollar, and it intervenes in foreign exchange markets in support of that policy. The FOMC is, after the Joint Chiefs of Staff, the most powerful committee in the United States.

The revised and extended Treasury plan to end the financial crisis, known at Regent as Paulson’s Repackaged Pig, was voted down today by the House in a calculated gamble to improve its terms and avoid giving the government unprecedented powers over the nation’s financial sector. Part of the problem with the Pig was not only that its powers were enormous and the oversight useless, but that no one could say how much it would ultimately cost. The original $700,000,000,000 price tag placed on the Pig was a crude guess (Treasury spokeswoman: "We just wanted to choose a really large number.") and in some quarters a low one (one “financial genius” on Wall Street commented it was nowhere near enough; he called for $5,000,000,000,000).

After the no vote on the Treasury plan the stock market swooned, Paulson lost his temper, and Bernanke announced the Fed would prepare for the apocalypse by throwing another $630,000,000,000 at foreign central banks that acted as offshore banking centers for the U.S. After all, foreigners purchased a lot of risky dollar-denominated American bonds during the good years, and now those assets have collapsed in price and no dollars are left in the coffers of the foreign banks that participated in the fun of a booming market. So now that a downturn as set in abroad, the ever-ready Fed will re-fill their coffers with dollars in a swap arrangement whereby foreign central banks give us some of their currency and we give them some of ours. Needless to say, everyone is praying the real economy does not sink into a depression while Congress gets its act together and tries to produce a bill that focuses on really stabilizing the financial sector here and abroad.

Given its performance to date, one must ask the question, “What if Congress fails to deliver a bill?”

In the first instance, the Fed can on its own provide liquidity to the domestic economy the same way it is providing dollar liquidity to foreign economies. Assuming that the tens of thousands of banks scattered across the country do not want to go out of business by failing to extend profitable loans to solvent and operating companies, they will soon begin to do so on their own. Those that can’t because they have lost too much money will die, and the economy will be cleansed of banks and financial institutions that were heavily into toxic assets and should to go under for reasons of imprudent practices. Overall, the bloated financial services sector will be downsized and made far more efficient than it is today and the era of absurd executive salaries will come to an end, all without any intervention by Congress.

In the second instance, once the government stops trying to prop up prices for financial assets, as Paulson’s Pig tried to do, they will fall to some sensible, economically justifiable level. Housing prices were in a bubble, and it is good that they fell. Why is Congress trying to prop them up? Granted many have lost some of the value of their house but others will now find housing much more affordable. The middle class and the poor, for example, will be able to purchase better houses than they could in the past, and the need for the government to subsidize housing for the poor is reduced. What’s bad about that? Similarly, financial assets such as stocks are now cheaper and therefore more affordable than before. There is no reason to believe that the stream of income they will produce in the future had changed. The same or better return on a cheaper asset. What’s bad about that (at least for the young, who did not suffer the recent capital losses)?

In the third instance, whether a bill in Congress is passed or not makes no difference whatsoever to the fundamentals of the U.S. economy. It has today and will have tomorrow the same labor force with the same skills and experience as it had yesterday. Its commercial buildings, factories, and the equipment and furniture in them are and will be the same as yesterday. It has the same natural resources and capital infrastructure as yesterday. It has the same entrepreneurial skills and management abilities as yesterday. And it has the same networks of domestic trade and international commerce as yesterday. Nothing of fundamental importance has changed and nothing of fundamental importance will change, Congressional bill or not.

In the end, it does not matter if the government spends a trillion dollars to “rescue” the financial sector at home and extends another trillion dollars to foreigners to “rescue” their financial institutions. It is, literally, merely money. The bailouts will be helpful if and only if they allow us to make the adjustments necessary to establish a viable economy, one that provides jobs and incomes that lift people economically in a way they regard as fair and equitable to all. It is not at all clear that the bill in Congress would accomplish that.

Bailout or not, if we suffer an economic setback we have the ability and experience to recover and regain prosperity at home and our position in the world. It depends on us, not Congress, and certainly not this bill.

In the midst of a terrible financial storm, one economist sings of good news on the real economy

“In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it. The marginal product of capital after-tax is a measure of how much profit (revenue net of variable costs and taxes) that each unit of capital is producing during, say, the last year. When the marginal product of capital after-tax is above average, subsequent rates of economic growth (and subsequent marginal products of capital) also tend to be above average.

Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929. The marginal product of capital was also below average prior to the 1982 recession (in this case, far below average) and prior to the 2001 recession. Thus, the surprise was not that GDP continued to grow 2007-8 despite the bleak outlook from Wall Street’s corner of the world, but that GDP growth failed to be significantly above the average. More important from today’s perspective is that much capital in America continues to be productive, and that this will likely permit Americans to advance their living standards as they have in years past. The non-financial sector today looks nothing like it did in 1930. “

Casey B. Mulligan, “Wall Street will drown alone”, Supply and Demand Blog (28 September 2008).

http://caseymulligan.blogspot.com/2008/09/wall-street-will-drown-alone.html


Professor Casey Mulligan is a faculty member at the University of Chicago's Sloan Center on Parents, Children and Work. His interests include intergenerational mobility and non-pecuniary incentives for behavior.

There is of course plenty of bleak news on the financial crisis and it would be easy to find a Tdj that can tell us how bad Paulson’s Pig is and how it portends the end of free enterprise and will bring on “the end of the world”. I have pontificated elsewhere that it is inevitable we suffer a recession, and a steep and prolonged one at that. I also see the world economy as entering a period of slow and halting growth, with recessions in Europe and Latin America. I have said this even though I do not believe the financial crisis, by itself, is all that bad. To my mind, when all is said and done, at most 10 or 20 per cent of the mortgages in the U.S. will provide to be non-performing and while this is certainly not good, it is not a disaster deserving of the attention it is now getting. The Fed and the Treasury, I would guess, overreacted, and now the financial sector of the U.S. is being radically revamped for reasons we’re not quite sure of. We no longer have investment banks, many securities firms have morphed into bank holding companies, and many firms on Wall Street have closed their doors. I wonder whether all this was really necessary, especially since much of the sub-prime problem can be laid at the door of the Congress, and the loss of financial diversification on Wall Street now underway lowers the ability of the financial system to absorb shocks. To be sure, the financial sector had to shrink and shrink significantly. But given the shocks of recent months and the sudden deflation of capital asset values, what could have been an adjustment spread over many years has now come upon us in a moment, and is being spurred on by the sledgehammer of government intervention.

Fortunately for the U.S. and the world, when it comes to forecasting the future of the economy, I am often wrong. Casey Mulligan is optimistic and he may well be right. As I have said elsewhere, the strength of the real economy in the midst of this financial storm surprises me. Capitalism, as Schumpeter reminds us, is a tremendously adaptive economic system spurred on by the smell of profitable opportunities. If the marginal productivity of capital is on the rise, as Mulligan tells us, nothing -- not a financial crisis and certainly not the hopelessly uninformed attempts of the political class to hinder determined entrepreneurs -- will prevent the economy from expanding or at least holding its own. Profit, after all, as Marx knew (“The magnitude of the profit whets his [the Capitalist’s] appetite for more profit”), is the driving force of Capitalism and the sure spur to its continued growth. If beyond our ken there are developments in the economy we can neither see nor predict, as Mulligans work suggests, the economy will surprise us.

If it does surprise us, let us pray it surprises us for the better.

In the midst of a terrible financial storm, one economist sings of good news on the real economy

“In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it. The marginal product of capital after-tax is a measure of how much profit (revenue net of variable costs and taxes) that each unit of capital is producing during, say, the last year. When the marginal product of capital after-tax is above average, subsequent rates of economic growth (and subsequent marginal products of capital) also tend to be above average.

Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929. The marginal product of capital was also below average prior to the 1982 recession (in this case, far below average) and prior to the 2001 recession. Thus, the surprise was not that GDP continued to grow 2007-8 despite the bleak outlook from Wall Street’s corner of the world, but that GDP growth failed to be significantly above the average. More important from today’s perspective is that much capital in America continues to be productive, and that this will likely permit Americans to advance their living standards as they have in years past. The non-financial sector today looks nothing like it did in 1930. “

Casey B. Mulligan, “Wall Street will drown alone”, Supply and Demand Blog (28 September 2008).

http://caseymulligan.blogspot.com/2008/09/wall-street-will-drown-alone.html


Professor Casey Mulligan is a faculty member at the University of Chicago's Sloan Center on Parents, Children and Work. His interests include intergenerational mobility and non-pecuniary incentives for behavior.

There is of course plenty of bleak news on the financial crisis and it would be easy to find a Tdj that can tell us how bad Paulson’s Pig is and how it portends the end of free enterprise and will bring on “the end of the world”. I have pontificated elsewhere that it is inevitable we suffer a recession, and a steep and prolonged one at that. I also see the world economy as entering a period of slow and halting growth, with recessions in Europe and Latin America. I have said this even though I do not believe the financial crisis, by itself, is all that bad. To my mind, when all is said and done, at most 10 or 20 per cent of the mortgages in the U.S. will provide to be non-performing and while this is certainly not good, it is not a disaster deserving of the attention it is now getting. The Fed and the Treasury, I would guess, overreacted, and now the financial sector of the U.S. is being radically revamped for reasons we’re not quite sure of. We no longer have investment banks, many securities firms have morphed into bank holding companies, and many firms on Wall Street have closed their doors. I wonder whether all this was really necessary, especially since much of the sub-prime problem can be laid at the door of the Congress, and the loss of financial diversification on Wall Street now underway lowers the ability of the financial system to absorb shocks. To be sure, the financial sector had to shrink and shrink significantly. But given the shocks of recent months and the sudden deflation of capital asset values, what could have been an adjustment spread over many years has now come upon us in a moment, and is being spurred on by the sledgehammer of government intervention.

Fortunately for the U.S. and the world, when it comes to forecasting the future of the economy, I am often wrong. Casey Mulligan is optimistic and he may well be right. As I have said elsewhere, the strength of the real economy in the midst of this financial storm surprises me. Capitalism, as Schumpeter reminds us, is a tremendously adaptive economic system spurred on by the smell of profitable opportunities. If the marginal productivity of capital is on the rise, as Mulligan tells us, nothing -- not a financial crisis and certainly not the hopelessly uninformed attempts of the political class to hinder determined entrepreneurs -- will prevent the economy from expanding or at least holding its own. Profit, after all, as Marx knew (“The magnitude of the profit whets his [the Capitalist’s] appetite for more profit”), is the driving force of Capitalism and the sure spur to its continued growth. If beyond our ken there are developments in the economy we can neither see nor predict, as Mulligans work suggests, the economy will surprise us.

If it does surprise us, let us pray it surprises us for the better.

Is Paulson’s plan the cause of the current financial gridlock?

“I am concerned that the bailout might be the cause of the problem that it purports to solve.

Treasury Secretary Henry Paulson described the problem as follows:

“The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy. When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans and investments that create jobs. As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy.”

The heavy use of the plumbing metaphor almost makes one picture Paulson with his pants riding down a couple inches, leaning over a financial toilet bowl. It is clogged with unwanted securities backed by mortgages, supposedly because the sellers cannot find any buyers.

However, the market could be clogged because the prospects for a bailout are destroying the motivation to sell mortgage securities. If you sell this week and take a big loss, you will look pretty stupid if there is a bailout next week where comparable securities fetch much higher prices.

It could be that a Congressional rejection of the bailout proposal, rather than clogging the markets, will unclog them. If Congress goes home having sent financial institutions a clear signal that there will be no bailout of any kind, then sellers will bring their securities to market, and we will find out what the market thinks they are worth.

In the worst case scenario, the market will assign low values to the securities. Firms that are sufficiently capitalized to hold mortgage securities will earn profits at the expense of weaker companies that have to sell securities or go bankrupt. In the end, it may turn out that the winners really took advantage of the losers. That is capitalism at work in financial markets.”

Arnold Kling, “An Alternative to the Wall Street Bailout”, Pajamas Media (24 September 2008).

http://pajamasmedia.com/blog/an-alternative-to-the-wall-street-bailout/


Arnold Kling is an economist who worked at the Federal Reserve Board in the 1980s and at Freddie Mac in the 1980s and 1990s. He blogs at Econolog.

Dr. Kling could well be right. What has paralyzed financial markets are not toxic securities but the uncertainties surrounding any action the government might take. Anyway, why would the average American want the Treasury (or some agency linked to the Treasury) to buy these securities at a high price when the private sector might buy them at a low price? Why should I care if the assets of some financial institution are sold at a low price? I’m not affected by the transaction? On the other hand, I would be negatively affected if the Treasury bought the securities at a high price and later sold them for much less. Now I’ve lost, because the difference will have to be made up by my taxes.

The government (both the Administration and the Congress are backing this plan, with only the most minor of differences in positions) argues that by buying the securities they will be providing the banking system with the capital they need to function as a financial intermediary and the banks will once again be able to extend the loans non-financial firms and other users of credit need. But even if the presently illiquid securities were sold at a low price, the funds they brought into the banks would help make them make financial viable, and the banks could be further recapitalized by eliminating their dividends for a few years and if necessary floating more stock for additional capital. If the newly issued stock of the banks were considered unattractive investments, Congress might consider waiving taxes on bank profits for a few years if the profits were reinvested in the bank. There are many things that could be done to re-capitalize the banks without dipping into the government’s coffers.

The government has moved to hastily on this matter. Nowhere near enough pressure has been applied to all these financial institutions to fix their problems themselves. As Dr. Kling implies, let the market sort it out. In the end, the market will restore normality to the financial sector as fast as it takes Congress to act and it will do it without a drain on the public purse.

Is Paulson’s plan the cause of the current financial gridlock?

“I am concerned that the bailout might be the cause of the problem that it purports to solve.

Treasury Secretary Henry Paulson described the problem as follows:

“The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy. When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans and investments that create jobs. As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy.”

The heavy use of the plumbing metaphor almost makes one picture Paulson with his pants riding down a couple inches, leaning over a financial toilet bowl. It is clogged with unwanted securities backed by mortgages, supposedly because the sellers cannot find any buyers.

However, the market could be clogged because the prospects for a bailout are destroying the motivation to sell mortgage securities. If you sell this week and take a big loss, you will look pretty stupid if there is a bailout next week where comparable securities fetch much higher prices.

It could be that a Congressional rejection of the bailout proposal, rather than clogging the markets, will unclog them. If Congress goes home having sent financial institutions a clear signal that there will be no bailout of any kind, then sellers will bring their securities to market, and we will find out what the market thinks they are worth.

In the worst case scenario, the market will assign low values to the securities. Firms that are sufficiently capitalized to hold mortgage securities will earn profits at the expense of weaker companies that have to sell securities or go bankrupt. In the end, it may turn out that the winners really took advantage of the losers. That is capitalism at work in financial markets.”

Arnold Kling, “An Alternative to the Wall Street Bailout”, Pajamas Media (24 September 2008).

http://pajamasmedia.com/blog/an-alternative-to-the-wall-street-bailout/


Arnold Kling is an economist who worked at the Federal Reserve Board in the 1980s and at Freddie Mac in the 1980s and 1990s. He blogs at Econolog.

Dr. Kling could well be right. What has paralyzed financial markets are not toxic securities but the uncertainties surrounding any action the government might take. Anyway, why would the average American want the Treasury (or some agency linked to the Treasury) to buy these securities at a high price when the private sector might buy them at a low price? Why should I care if the assets of some financial institution are sold at a low price? I’m not affected by the transaction? On the other hand, I would be negatively affected if the Treasury bought the securities at a high price and later sold them for much less. Now I’ve lost, because the difference will have to be made up by my taxes.

The government (both the Administration and the Congress are backing this plan, with only the most minor of differences in positions) argues that by buying the securities they will be providing the banking system with the capital they need to function as a financial intermediary and the banks will once again be able to extend the loans non-financial firms and other users of credit need. But even if the presently illiquid securities were sold at a low price, the funds they brought into the banks would help make them make financial viable, and the banks could be further recapitalized by eliminating their dividends for a few years and if necessary floating more stock for additional capital. If the newly issued stock of the banks were considered unattractive investments, Congress might consider waiving taxes on bank profits for a few years if the profits were reinvested in the bank. There are many things that could be done to re-capitalize the banks without dipping into the government’s coffers.

The government has moved to hastily on this matter. Nowhere near enough pressure has been applied to all these financial institutions to fix their problems themselves. As Dr. Kling implies, let the market sort it out. In the end, the market will restore normality to the financial sector as fast as it takes Congress to act and it will do it without a drain on the public purse.

Martin Wolf backs Luigi Zingales

“What ... is the challenge [the US financial system faces]? The answer given by Hank Paulson, the all-action US Treasury secretary, last Friday, in announcing his "troubled asset relief programme", is that "the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. .... By creating a market for the toxic assets, Mr Paulson hopes to halt the spiral of falling prices and bankruptcies. ....

Given the recent explosion in leverage [borrowing], the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly. ....

[T]he Paulson scheme ... can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.

... [A] scheme for dealing with the crisis must be able to remedy the looming decapitalisation of the financial system in as targeted a manner as possible. ....

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system [, and] ... they would require not a penny of public money.”

Martin Wolf, "Paulson's plan was not a true solution to the crisis", Financial Times (24 September 2008).

http://www.ft.com/cms/s/0/a09b317e-898d-11dd-8371-0000779fd18c.html.

Martin Wolf is associate editor and chief economics commentator at the Financial Times. Luigi Zingales' proposal discussed by Martin Wolf here is the subject of the Tdj “One professor says Paulson's bailout of financial institutions follows the wrong approach”. It can be found at: http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf.

Two developments in the ongoing financial crisis over the past few days are of interest: First, opposition to the Paulson Plan seems to be increasing and for the reasons outlined by Zingales. Second, the FBI and SEC have begun an investigate of Fannie and Freddie, Lehman Brothers and AIG looking into misconduct by their executives.

It is by no means clear how this will all work out, either on Wall Street, Main Street, or Pennsylvania Avenue.

Martin Wolf backs Luigi Zingales

“What ... is the challenge [the US financial system faces]? The answer given by Hank Paulson, the all-action US Treasury secretary, last Friday, in announcing his "troubled asset relief programme", is that "the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. .... By creating a market for the toxic assets, Mr Paulson hopes to halt the spiral of falling prices and bankruptcies. ....

Given the recent explosion in leverage [borrowing], the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly. ....

[T]he Paulson scheme ... can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.

... [A] scheme for dealing with the crisis must be able to remedy the looming decapitalisation of the financial system in as targeted a manner as possible. ....

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system [, and] ... they would require not a penny of public money.”

Martin Wolf, "Paulson's plan was not a true solution to the crisis", Financial Times (24 September 2008).

http://www.ft.com/cms/s/0/a09b317e-898d-11dd-8371-0000779fd18c.html.

Martin Wolf is associate editor and chief economics commentator at the Financial Times. Luigi Zingales' proposal discussed by Martin Wolf here is the subject of the Tdj “One professor says Paulson's bailout of financial institutions follows the wrong approach”. It can be found at: http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf.

Two developments in the ongoing financial crisis over the past few days are of interest: First, opposition to the Paulson Plan seems to be increasing and for the reasons outlined by Zingales. Second, the FBI and SEC have begun an investigate of Fannie and Freddie, Lehman Brothers and AIG looking into misconduct by their executives.

It is by no means clear how this will all work out, either on Wall Street, Main Street, or Pennsylvania Avenue.

Nouriel Roubini predicts a severe U.S. recession

“Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent.

The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency …

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors …

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. …
…
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.

The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies. …”

Nouriel Roubini, “The shadow banking system is unraveling”, Financial Times (21 September 2008).

http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html


Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at the Stern School of Business, New York University. The “shadow banking system” discussed by Professor Roubini consists of non-bank financial institutions such as structured investment vehicles, money market funds, investment banks, hedge funds and other financial institutions that are not subject to normal commercial banking regulations. They are often affiliated with, but not kept on the books of, the major banks that make up the commercial banking system regulated by the Fed and given access to its lender-of-last-resort function.

Roubini may well be right about a coming crash. High oil and food prices have sapped consumer purchasing power while a collapse of the housing market and financial sector turmoil has undermined consumer and business confidence. Industrial production is beginning to decline, shipments are slowing and more and more people are being laid off. Firms and consumers cannot gain access to credit. Add to this, American exports have been the only source of growth this year but forecasts for European and Asia growth are being revised downward and some of these countries are clearly headed for a recession. Stock markets abroad are in worse shape than those at home. It is not just the U.S. economy that is headed down, and headed down for an extended period, it is the world economy. A worldwide crash seems inevitable.

It will not be easy to recover and re-establish a stable path of growth. Restoring financial stability and economic growth at home will mean eliminating the extensive national budget and international trade deficits that have characterized the U.S. economy for decades. We have been living beyond our means and finally the bills have come due. We must eliminate these imbalances by restructuring our economy in terms of its spending and saving patterns and in terms of its production and trade patterns. Needless to say, restructuring any economy for growth is difficult but it is doubly difficult at a time when ageing populations, rapid technological advance and changing patterns of international trade are incessantly reshaping the world economic landscape. It is triply difficult when the adjustment must begin during a period of recession. We have as large a challenge before us as at any time since the end of the Second World War when military demobilization and a devastated world economy threatened our economic future.

Today, failure to make significant adjustments of our patterns of expenditures and output and failure to implement a substantial restructuring of our financial markets will threaten not just the future of the U.S. economy but the entire world economy. The U.S. is not simply the world’s largest economy. It is the economy to which the rest of the world links their production and their prosperity. If we fail to meet the challenge of revitalizing our economy, the unprecedented expansion in production and trade the world has enjoyed since the end of the Second World War will come to an end, perhaps never to return.

Nouriel Roubini predicts a severe U.S. recession

“Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent.

The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency …

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors …

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. …
…
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.

The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies. …”

Nouriel Roubini, “The shadow banking system is unraveling”, Financial Times (21 September 2008).

http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html


Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at the Stern School of Business, New York University. The “shadow banking system” discussed by Professor Roubini consists of non-bank financial institutions such as structured investment vehicles, money market funds, investment banks, hedge funds and other financial institutions that are not subject to normal commercial banking regulations. They are often affiliated with, but not kept on the books of, the major banks that make up the commercial banking system regulated by the Fed and given access to its lender-of-last-resort function.

Roubini may well be right about a coming crash. High oil and food prices have sapped consumer purchasing power while a collapse of the housing market and financial sector turmoil has undermined consumer and business confidence. Industrial production is beginning to decline, shipments are slowing and more and more people are being laid off. Firms and consumers cannot gain access to credit. Add to this, American exports have been the only source of growth this year but forecasts for European and Asia growth are being revised downward and some of these countries are clearly headed for a recession. Stock markets abroad are in worse shape than those at home. It is not just the U.S. economy that is headed down, and headed down for an extended period, it is the world economy. A worldwide crash seems inevitable.

It will not be easy to recover and re-establish a stable path of growth. Restoring financial stability and economic growth at home will mean eliminating the extensive national budget and international trade deficits that have characterized the U.S. economy for decades. We have been living beyond our means and finally the bills have come due. We must eliminate these imbalances by restructuring our economy in terms of its spending and saving patterns and in terms of its production and trade patterns. Needless to say, restructuring any economy for growth is difficult but it is doubly difficult at a time when ageing populations, rapid technological advance and changing patterns of international trade are incessantly reshaping the world economic landscape. It is triply difficult when the adjustment must begin during a period of recession. We have as large a challenge before us as at any time since the end of the Second World War when military demobilization and a devastated world economy threatened our economic future.

Today, failure to make significant adjustments of our patterns of expenditures and output and failure to implement a substantial restructuring of our financial markets will threaten not just the future of the U.S. economy but the entire world economy. The U.S. is not simply the world’s largest economy. It is the economy to which the rest of the world links their production and their prosperity. If we fail to meet the challenge of revitalizing our economy, the unprecedented expansion in production and trade the world has enjoyed since the end of the Second World War will come to an end, perhaps never to return.

Paulson's bailout of financial institutions follows the wrong approach

“Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers' money) the distressed assets of the financial sector. But, at what price? ....

The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers' expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. ....

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for- equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers' expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus.

But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.”

Luigi Zingales, "Why Paulson is Wrong", undated 2-page paper.

http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf

Luigi Zingales is Professor of Entrepreneurship and Finance at the Graduate School of Business, University of Chicago. Zingales has a BA in economics from Universita Bocconi in Italy and a PhD in economics from MIT. He is co-author, with Raghuram G. Rajan, of Saving Capitalism from Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (Princeton University Press, 2004).

I have no idea whether Treasury Secretary Paulson’s bailout of the banks is a good idea or not. I suspect not, simply because all bailouts are a bad idea, especially bailouts done in a crisis when no one has the time to think about what they are doing. His response to the situation is exactly what one would expect from Washington: Let’s pass a law, and don’t ask me about the details of the law because the devil is in the details and anyway I don’t know what the details are. We’ll work it out as we go along. Anyway, we’ll include a lot of spending items in the bill, and you’re bound to like some of them. Focus on the “candy” and forget about the costs.

I would simply say this approach will only make matters worse. We are in a deep financial crisis precisely because in the past we have been reckless in our expansion and use of credit. So, how does the Administration intend to deal with the situation: Ever more credit to get increasingly doggy debt off the books of the banks that brought us to this state of affairs so they can continue to do exactly what they did in the past. And, how does the Congress intend to deal with the situation: Ever more spending and ever greater deficits to try and “rescue” all the people who are sinking under the weight of the debts they have accumulated in the past by shifting a mountain of debt to the taxpayer.

One cannot help but fear that the road they have taken will not be helpful. The magnitude of the adjustment required to restore some semblance of balance between saving and investment in this country was large before this debacle. Now it is becoming even wider as a result of (misguided?) efforts to attain temporary calm in what is a raging storm. Both Presidential candidates did the best they could to ignore the looming deficits dooming the proposals they have hawked to voters in the election campaigns. The spending proposals of one side and the tax relief proposals of the other, propped up as policy corpses awaiting burial after the election, are now not just dead but irrelevant to the future of the country.

We shall see if one or the other of the candidates actually produces a program that actually deals with an economy encumbered with too much debt and a government on a track to financial bankruptcy.

Thanks to Larry Willmore and Tyler Cowen for the pointer.

Paulson's bailout of financial institutions follows the wrong approach

“Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers' money) the distressed assets of the financial sector. But, at what price? ....

The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers' expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. ....

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for- equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers' expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus.

But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.”

Luigi Zingales, "Why Paulson is Wrong", undated 2-page paper.

http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf

Luigi Zingales is Professor of Entrepreneurship and Finance at the Graduate School of Business, University of Chicago. Zingales has a BA in economics from Universita Bocconi in Italy and a PhD in economics from MIT. He is co-author, with Raghuram G. Rajan, of Saving Capitalism from Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (Princeton University Press, 2004).

I have no idea whether Treasury Secretary Paulson’s bailout of the banks is a good idea or not. I suspect not, simply because all bailouts are a bad idea, especially bailouts done in a crisis when no one has the time to think about what they are doing. His response to the situation is exactly what one would expect from Washington: Let’s pass a law, and don’t ask me about the details of the law because the devil is in the details and anyway I don’t know what the details are. We’ll work it out as we go along. Anyway, we’ll include a lot of spending items in the bill, and you’re bound to like some of them. Focus on the “candy” and forget about the costs.

I would simply say this approach will only make matters worse. We are in a deep financial crisis precisely because in the past we have been reckless in our expansion and use of credit. So, how does the Administration intend to deal with the situation: Ever more credit to get increasingly doggy debt off the books of the banks that brought us to this state of affairs so they can continue to do exactly what they did in the past. And, how does the Congress intend to deal with the situation: Ever more spending and ever greater deficits to try and “rescue” all the people who are sinking under the weight of the debts they have accumulated in the past by shifting a mountain of debt to the taxpayer.

One cannot help but fear that the road they have taken will not be helpful. The magnitude of the adjustment required to restore some semblance of balance between saving and investment in this country was large before this debacle. Now it is becoming even wider as a result of (misguided?) efforts to attain temporary calm in what is a raging storm. Both Presidential candidates did the best they could to ignore the looming deficits dooming the proposals they have hawked to voters in the election campaigns. The spending proposals of one side and the tax relief proposals of the other, propped up as policy corpses awaiting burial after the election, are now not just dead but irrelevant to the future of the country.

We shall see if one or the other of the candidates actually produces a program that actually deals with an economy encumbered with too much debt and a government on a track to financial bankruptcy.

Thanks to Larry Willmore and Tyler Cowen for the pointer.

A Weakening World Economy Faces a Host of Challenges

As the U.S. financial crisis worsens, it is spreading to the rest of the world, and portends a long period of slow growth, sacrifice and hard work across the globe to restore the foundations for a rapid and widespread expansion of the world economy

The year 2008 has been one of financial turmoil and economic slowdown not only in the United States but across the globe. The deterioration in performance at home has been matched by that abroad, and it is expected to continue and could be severe and long-lasting.

The global boom preceding the downturn of 2008 was mild by historical standards but it was widely shared and until recently appeared to set the stage for an ongoing and long-lasting expansion of the world economy. For more than half a decade, economic activity had increased at average rates well above 5 per cent annually in the developing countries of Africa, Latin America and the Caribbean, Western Asia and South and East Asia. Spurred by high prices for commodities such as oil, gas, metals and cotton, growth was even higher in the transition countries of Russia, the Ukraine, and other countries of the Commonwealth of Independent States. Although slower, the pace of growth in the more economically advanced areas of Europe, North America, Japan and Australia/New Zealand had nonetheless picked up markedly after the world downturn of 2001 and 2002. The widespread upswing since 2003 was bolstered by a very rapid expansion in the volume of world trade, which increased at rates exceeding 10 per cent from 2003 into 2007.

The boom of recent years was brought to an end by accumulating and unsustainable financial imbalances in the United States. A spreading falloff in world growth began in the fourth quarter of 2007 when the U.S. economy weakened markedly due to sub-prime mortgage woes, which greatly damaged its financial sector, and a surge in oil and other commodity prices, which aggravated its already outsized external deficit and lifted inflationary pressures. As credit criteria became tighter and mortgage rates rose, the U.S. housing sector went into a deep decline and housing inventories rose substantially while housing prices fell significantly. High and rising oil prices sapped consumer purchasing power and started an economy-wide adjustment process that negatively affected the auto industry and other energy-dependent sectors of the economy.

Early in 2008, recession fears and concerns about rising default risks spread to the U.S. corporate bond market, and questions were raised about the financial viability of the banking system and the government-sponsored agencies Fannie Mae and Freddie Mac. Confidence in U.S. financial markets fell, the dollar slumped and foreign buyers of U.S. Treasuries and corporate bonds began to sell their holdings as the Federal Reserve eased U.S. monetary policy. As the financial tumult worsened, American banks and financial service firms began to recognize the losses and write-down the value of their securities, leading to the effective bankruptcy of a number of large financial institutions such as Bear Stearns, Lehman Brothers, Merrill Lynch, and the insurance giant AIG. The turmoil continues today.

It is important to note that the difficulties before the U.S. are shared by other countries. Domestic demand in all the more economically developed areas of the world has slowed sharply this year as financial disturbances restrain investment and rising prices weigh on consumption. GDP in the Euro area, for example, fell in the second quarter and the European Commission has just marked down its estimates for growth for all of 2008 in Europe as a whole, with recessions forecasted for Germany and Spain next year on the basis of a host of downbeat indicators, including orders, retail sales, export prospects and inflationary pressures. Reports from Japan’s Cabinet Office indicate that its economy may be deteriorating. The potential for turmoil is building in these countries.

Growth in many developing countries remains robust to date but that may be changing. Capital flows to emerging markets dropped sharply in recent months and equity markets in Russia, China and elsewhere have fallen by more than a quarter since the first of the year. In the deteriorating environment for world trade, export growth has eased in China and the momentum of exports from Latin America, especially Mexico, has slowed markedly. Oil demand by the more economically advanced countries measured in volume terms has been broadly declining for three years and the pace of the decline picked up in 2008; with the recent plunge in crude oil prices revenues into the oil producing countries are sharply off and this will dampen their economic activity and import demand. Finally, industrial production in many developing countries is slowing and there are scattered reports of slower GDP growth in this large region with more than 80 per cent of the world’s population. The transmission of turmoil and slower growth to these countries is underway.

The world economy now stands on the brink of a potentially deep recession. Financial markets in the major developed market economies and many developing countries are in a state of disarray, and the disarray is spreading. The pace of economic activity is slowing in many countries and the strong impetus international trade gave to world production is rapidly waning. The large global imbalances that describe the external accounts of the United States and other countries persist and at the same time prices for primary commodities remain high and hold the potential to aggravate existing inflationary pressures. Risks to the current world economic situation, already difficult and worsening, must be considered high.

The key to overcoming the challenges now before the world economy is to understand that the standard tools of policy intervention – incremental fiscal and monetary policy measures introduced step-by-step – are not sufficient to re-establish the foundations for rapid and balanced world growth in an age of rapid technological advance and fundamental demographic change. Immediate efforts to stabilize the present situation and reform the financial sector, here and abroad, are of course essential to both domestic recovery and the restoration of the channels of international trade and finance on which the prosperity of all countries depends. But they will not be enough. Looking to the longer-term, overcoming the persistent and ongoing fiscal and trade deficits of the United States must be seen as a top priority.

The domestic economic profile and the international transactions of many countries – not only the United States – are described by huge deficits in their government budget, household, and external trade accounts that go back many years. The world enjoyed an extended period of economic expansion, low inflation, low interest rates and overall macroeconomic stability, dating back to the 1980s. But it was nonetheless accompanied by accumulating internal and external imbalances which raised indebtedness to the point of insolvency. In the case of the U.S., imbalances in its fiscal and trade accounts that reached 5 to 6 per cent of its GDP in recent years. Similar imbalances can be seen in other countries.

Restoring financial stability and economic growth to the world economy will mean eliminating these imbalances at a time when ageing populations and rapidly changing patterns of international trade are already reshaping the world economic landscape. This will require a significant adjustment of patterns of production and a substantial restructuring of Wall Street and other financial markets. No one should underestimate how difficult this will be. Failure to do so will threaten the entire world economy in the months and years ahead. The most important contribution the United States can make is strengthening its financial position by eliminating its outsized budget and trade deficits and supporting similar adjustments by other countries.

Restoring the foundations for growth in the world economy is a challenge that will take many years and involve much sacrifice. If this challenge is not met, the unprecedented expansion in production and trade the world has enjoyed since the end of the Second World War may well come to an end.

A Weakening World Economy Faces a Host of Challenges

As the U.S. financial crisis worsens, it is spreading to the rest of the world, and portends a long period of slow growth, sacrifice and hard work across the globe to restore the foundations for a rapid and widespread expansion of the world economy

The year 2008 has been one of financial turmoil and economic slowdown not only in the United States but across the globe. The deterioration in performance at home has been matched by that abroad, and it is expected to continue and could be severe and long-lasting.

The global boom preceding the downturn of 2008 was mild by historical standards but it was widely shared and until recently appeared to set the stage for an ongoing and long-lasting expansion of the world economy. For more than half a decade, economic activity had increased at average rates well above 5 per cent annually in the developing countries of Africa, Latin America and the Caribbean, Western Asia and South and East Asia. Spurred by high prices for commodities such as oil, gas, metals and cotton, growth was even higher in the transition countries of Russia, the Ukraine, and other countries of the Commonwealth of Independent States. Although slower, the pace of growth in the more economically advanced areas of Europe, North America, Japan and Australia/New Zealand had nonetheless picked up markedly after the world downturn of 2001 and 2002. The widespread upswing since 2003 was bolstered by a very rapid expansion in the volume of world trade, which increased at rates exceeding 10 per cent from 2003 into 2007.

The boom of recent years was brought to an end by accumulating and unsustainable financial imbalances in the United States. A spreading falloff in world growth began in the fourth quarter of 2007 when the U.S. economy weakened markedly due to sub-prime mortgage woes, which greatly damaged its financial sector, and a surge in oil and other commodity prices, which aggravated its already outsized external deficit and lifted inflationary pressures. As credit criteria became tighter and mortgage rates rose, the U.S. housing sector went into a deep decline and housing inventories rose substantially while housing prices fell significantly. High and rising oil prices sapped consumer purchasing power and started an economy-wide adjustment process that negatively affected the auto industry and other energy-dependent sectors of the economy.

Early in 2008, recession fears and concerns about rising default risks spread to the U.S. corporate bond market, and questions were raised about the financial viability of the banking system and the government-sponsored agencies Fannie Mae and Freddie Mac. Confidence in U.S. financial markets fell, the dollar slumped and foreign buyers of U.S. Treasuries and corporate bonds began to sell their holdings as the Federal Reserve eased U.S. monetary policy. As the financial tumult worsened, American banks and financial service firms began to recognize the losses and write-down the value of their securities, leading to the effective bankruptcy of a number of large financial institutions such as Bear Stearns, Lehman Brothers, Merrill Lynch, and the insurance giant AIG. The turmoil continues today.

It is important to note that the difficulties before the U.S. are shared by other countries. Domestic demand in all the more economically developed areas of the world has slowed sharply this year as financial disturbances restrain investment and rising prices weigh on consumption. GDP in the Euro area, for example, fell in the second quarter and the European Commission has just marked down its estimates for growth for all of 2008 in Europe as a whole, with recessions forecasted for Germany and Spain next year on the basis of a host of downbeat indicators, including orders, retail sales, export prospects and inflationary pressures. Reports from Japan’s Cabinet Office indicate that its economy may be deteriorating. The potential for turmoil is building in these countries.

Growth in many developing countries remains robust to date but that may be changing. Capital flows to emerging markets dropped sharply in recent months and equity markets in Russia, China and elsewhere have fallen by more than a quarter since the first of the year. In the deteriorating environment for world trade, export growth has eased in China and the momentum of exports from Latin America, especially Mexico, has slowed markedly. Oil demand by the more economically advanced countries measured in volume terms has been broadly declining for three years and the pace of the decline picked up in 2008; with the recent plunge in crude oil prices revenues into the oil producing countries are sharply off and this will dampen their economic activity and import demand. Finally, industrial production in many developing countries is slowing and there are scattered reports of slower GDP growth in this large region with more than 80 per cent of the world’s population. The transmission of turmoil and slower growth to these countries is underway.

The world economy now stands on the brink of a potentially deep recession. Financial markets in the major developed market economies and many developing countries are in a state of disarray, and the disarray is spreading. The pace of economic activity is slowing in many countries and the strong impetus international trade gave to world production is rapidly waning. The large global imbalances that describe the external accounts of the United States and other countries persist and at the same time prices for primary commodities remain high and hold the potential to aggravate existing inflationary pressures. Risks to the current world economic situation, already difficult and worsening, must be considered high.

The key to overcoming the challenges now before the world economy is to understand that the standard tools of policy intervention – incremental fiscal and monetary policy measures introduced step-by-step – are not sufficient to re-establish the foundations for rapid and balanced world growth in an age of rapid technological advance and fundamental demographic change. Immediate efforts to stabilize the present situation and reform the financial sector, here and abroad, are of course essential to both domestic recovery and the restoration of the channels of international trade and finance on which the prosperity of all countries depends. But they will not be enough. Looking to the longer-term, overcoming the persistent and ongoing fiscal and trade deficits of the United States must be seen as a top priority.

The domestic economic profile and the international transactions of many countries – not only the United States – are described by huge deficits in their government budget, household, and external trade accounts that go back many years. The world enjoyed an extended period of economic expansion, low inflation, low interest rates and overall macroeconomic stability, dating back to the 1980s. But it was nonetheless accompanied by accumulating internal and external imbalances which raised indebtedness to the point of insolvency. In the case of the U.S., imbalances in its fiscal and trade accounts that reached 5 to 6 per cent of its GDP in recent years. Similar imbalances can be seen in other countries.

Restoring financial stability and economic growth to the world economy will mean eliminating these imbalances at a time when ageing populations and rapidly changing patterns of international trade are already reshaping the world economic landscape. This will require a significant adjustment of patterns of production and a substantial restructuring of Wall Street and other financial markets. No one should underestimate how difficult this will be. Failure to do so will threaten the entire world economy in the months and years ahead. The most important contribution the United States can make is strengthening its financial position by eliminating its outsized budget and trade deficits and supporting similar adjustments by other countries.

Restoring the foundations for growth in the world economy is a challenge that will take many years and involve much sacrifice. If this challenge is not met, the unprecedented expansion in production and trade the world has enjoyed since the end of the Second World War may well come to an end.

When regulation fails

“It is easy to assert that the solution to any market failure is better regulation. If regulators were all-knowing and all-powerful; if they were wiser than the chief executives but willing to do the job for a fraction of the remuneration awarded to such executives; if they understood what was happening in the dealing rooms of Citigroup, Merrill or Lehman better than Chuck Prince, Stan O'Neal, or Dick Fuld; then banking regulation could protect us against financial instability.

But such a world does not exist. Market economies outperform planned economies not because business people are smarter than civil servants – sometimes they are, sometimes not. But no one has enough information or foresight to understand the changing environment, so the market's messy processes of experiment and correction yield better results than a regulator's analysis.”

John Kay, "Taxpayers will fund another run on the casino", Financial Times (17 September 2008).

[LW: Wise words from the incredibly wise John Kay.]

John Kay is a financial columnist for the Financial Times of London.

I agree with Kay that recommending more regulation is not wise. The financial services sector in the U.S. is one of the most heavily regulated and it has done nothing to limit our exposure to a crash. Frankly, I don’t even understand how increased regulation might be implemented. What do the people proposing more regulation expect the regulators to do. Stand directly behind bankers and approve or not approve every decision they make?

I think we have had too much regulation and not enough accountability and not enough suffering on the part of those who should suffer when a business fails: The shareholders. Allowing bankers to be bankers, holding people to high standards and being able to hire and fire to ensure they perform in accordance with the firm’s principles and priorities, and providing shareholders with an incentive to take an active interest in the fate of the investment they have made would, in my mind, be far more effective in avoiding future problems.

When regulation fails

“It is easy to assert that the solution to any market failure is better regulation. If regulators were all-knowing and all-powerful; if they were wiser than the chief executives but willing to do the job for a fraction of the remuneration awarded to such executives; if they understood what was happening in the dealing rooms of Citigroup, Merrill or Lehman better than Chuck Prince, Stan O'Neal, or Dick Fuld; then banking regulation could protect us against financial instability.

But such a world does not exist. Market economies outperform planned economies not because business people are smarter than civil servants – sometimes they are, sometimes not. But no one has enough information or foresight to understand the changing environment, so the market's messy processes of experiment and correction yield better results than a regulator's analysis.”

John Kay, "Taxpayers will fund another run on the casino", Financial Times (17 September 2008).

[LW: Wise words from the incredibly wise John Kay.]

John Kay is a financial columnist for the Financial Times of London.

I agree with Kay that recommending more regulation is not wise. The financial services sector in the U.S. is one of the most heavily regulated and it has done nothing to limit our exposure to a crash. Frankly, I don’t even understand how increased regulation might be implemented. What do the people proposing more regulation expect the regulators to do. Stand directly behind bankers and approve or not approve every decision they make?

I think we have had too much regulation and not enough accountability and not enough suffering on the part of those who should suffer when a business fails: The shareholders. Allowing bankers to be bankers, holding people to high standards and being able to hire and fire to ensure they perform in accordance with the firm’s principles and priorities, and providing shareholders with an incentive to take an active interest in the fate of the investment they have made would, in my mind, be far more effective in avoiding future problems.

What use is a B.A., anyway?

Today’s Tdj comes from Larry Willmore, formerly with the United Nations and now a Research Scholar at the International Institute for Applied Systems Analysis (IIASA), Laxenburg, Austria.

“Economists have established beyond doubt that people with B.A.s earn more on average than people without them. But why does the B.A. produce that result? For whom does the B.A. produce that result? For some jobs, the economic premium for a degree is produced by the actual education that has gone into getting the degree. Lawyers, physicians, and engineers can earn their high incomes only by deploying knowledge and skills that take years to acquire, and degrees in law, medicine, and engineering still signify competence in those knowledges and skills. But for many other jobs, the economic premium for the B.A. is created by a brutal fact of life about the American job market: Employers do not even interview applicants who do not hold a B.A. Even more brutal, the advantage conferred by the B.A. often has nothing to do with the content of the education. Employers do not value what the student learned, just that the student has a degree.
…
Now the great majority of America's intellectually most able people do have a B.A. Along with that transformation has come a downside that few anticipated. The acceptable excuses for not going to college have dried up. The more people who go to college, the more stigmatizing the failure to complete college becomes. Today, if you do not get a B.A., many people assume it is because you are too dumb or too lazy. And all this because of a degree that seldom has an interpretable substantive meaning.”

Charles Murray, "Are Too Many People Going to College?", The American (September/October 2008).

http://www.american.com/archive/2008/september-october-magazine/

http://www.american.com/archive/2008/september-october-magazine/are-too-many-people-going-to-college


Charles Alan Murray (1943-) is an American libertarian political scientistcurrently working as a fellow at the American Enterprise Institute, a conservative think tank in Washington, DC.

Actually, this absurdity has progressed beyond the B.A. to the M.A. and beyond. More than 30 years ago, when I was employed by the Canadian government, I interviewed prospective candidates at Queen's University for economist positions. One candidate was by far the best of the lot, but he had only an undergraduate degree (B.A. honours). The personnel person with me explained that rules did not allow the federal government to hire an economist without at the minimum an M.A. or M.S. degree.

Today that requirement may have increased to a Ph.D., but I do not know. And what comes next? A post-doc requirement?

On the humble B.A., I am reminded of these lyrics from the Broadway musical "Avenue Q":

What do you do with a B.A. in English?
What is my life going to be?
4 years of college,
And plenty of knowledge,
Have earned me this useless degree!
I can't pay the bills yet,
'Cause I have no skills yet,
The world is a big scary place!
But somehow I can't shake,
The feeling I might make,
A difference to the human race!

Robert Lopez and Jeff Marx, "What do you Do with a B.A. in English".

http://www.lyricsandsongs.com/song/601684.html

What use is a B.A., anyway?

Today’s Tdj comes from Larry Willmore, formerly with the United Nations and now a Research Scholar at the International Institute for Applied Systems Analysis (IIASA), Laxenburg, Austria.

“Economists have established beyond doubt that people with B.A.s earn more on average than people without them. But why does the B.A. produce that result? For whom does the B.A. produce that result? For some jobs, the economic premium for a degree is produced by the actual education that has gone into getting the degree. Lawyers, physicians, and engineers can earn their high incomes only by deploying knowledge and skills that take years to acquire, and degrees in law, medicine, and engineering still signify competence in those knowledges and skills. But for many other jobs, the economic premium for the B.A. is created by a brutal fact of life about the American job market: Employers do not even interview applicants who do not hold a B.A. Even more brutal, the advantage conferred by the B.A. often has nothing to do with the content of the education. Employers do not value what the student learned, just that the student has a degree.
…
Now the great majority of America's intellectually most able people do have a B.A. Along with that transformation has come a downside that few anticipated. The acceptable excuses for not going to college have dried up. The more people who go to college, the more stigmatizing the failure to complete college becomes. Today, if you do not get a B.A., many people assume it is because you are too dumb or too lazy. And all this because of a degree that seldom has an interpretable substantive meaning.”

Charles Murray, "Are Too Many People Going to College?", The American (September/October 2008).

http://www.american.com/archive/2008/september-october-magazine/

http://www.american.com/archive/2008/september-october-magazine/are-too-many-people-going-to-college


Charles Alan Murray (1943-) is an American libertarian political scientistcurrently working as a fellow at the American Enterprise Institute, a conservative think tank in Washington, DC.

Actually, this absurdity has progressed beyond the B.A. to the M.A. and beyond. More than 30 years ago, when I was employed by the Canadian government, I interviewed prospective candidates at Queen's University for economist positions. One candidate was by far the best of the lot, but he had only an undergraduate degree (B.A. honours). The personnel person with me explained that rules did not allow the federal government to hire an economist without at the minimum an M.A. or M.S. degree.

Today that requirement may have increased to a Ph.D., but I do not know. And what comes next? A post-doc requirement?

On the humble B.A., I am reminded of these lyrics from the Broadway musical "Avenue Q":

What do you do with a B.A. in English?
What is my life going to be?
4 years of college,
And plenty of knowledge,
Have earned me this useless degree!
I can't pay the bills yet,
'Cause I have no skills yet,
The world is a big scary place!
But somehow I can't shake,
The feeling I might make,
A difference to the human race!

Robert Lopez and Jeff Marx, "What do you Do with a B.A. in English".

http://www.lyricsandsongs.com/song/601684.html

Did you know we're in a period of accelerating prosperity?

“’It was the worst of times, and it was the worst of times.’

I imagine that's what Charles Dickens would conclude about the current condition of the U.S. economy, based on the relentless drumbeat of pessimism in the media and on the campaign trail. In the past two months, this newspaper alone [the Washington Post] has written no fewer than nine times ... that key elements of the economy are the worst they've been "since the Great Depression." ...
...
But that doesn't make any of it true. Things today just aren't that bad. Sure, there are trouble spots in the economy, as the government takeover of mortgage giants Fannie Mae and Freddie Mac, and jitters about Wall Street firm Lehman Brothers, amply demonstrate. And unemployment figures are up a bit, too. None of this, however, is cause for depression -- or exaggerated Depression comparisons.

Overall, the pessimists are up against an insurmountable reality: In the last reported quarter, the U.S. economy grew at an annual rate of 3.3 percent, adjusted for inflation. That's virtually the same as the 3.4 percent average growth rate since -- yes -- the Great Depression.
...
A housing "slump," a housing "crisis"? A "severe" price decline? According to the latest report from the National Association of Realtors, the median price of an existing home is up 8.5 percent from the low of last February. And according to the U.S. Census Bureau, the median price of a new home is up 1.3 percent from the low of last December. Home prices may not be at all-time highs -- and there are pockets of continuing decline in some urban areas -- but overall they've clearly stopped going down and have started to recover. ...

"Turmoil" in the debt markets? Sure, but we've seen plenty worse. According to the FDIC, there have been a total of 13 bank failures in 2007 and so far into 2008. There were 15 in 1999-2000, the climax of the Obama-celebrated era of Clintonian prosperity. And in recession-free 1988-89, there were 1,004 failures -- almost an order of magnitude more than today. Since the Great Depression, the average number of bank failures each year has been 94.
...
Financial market "crisis" and "meltdown"? Yes, from all-time highs last October, the S&P 500 has fallen 20 percent. But that's nothing by historical standards. Stocks have often fallen more than that over comparable spans of time. They fell more than twice that much in 1974 -- which was truly the worst drop since the Great Depression. ...

Some economic indicators -- export growth and non-defense capital goods orders such as industrial machinery, for example -- are running at levels associated with brisk expansion. ...
...
Whatever the political outcome this year, hopefully this will prove to be yet another instance of that iron law of economics and markets: The sentiment of the majority is always wrong at key turning points. And the majority is plenty pessimistic right now. That suggests that we're on the brink not of recession, but of accelerating prosperity.

Maybe this will turn out to be the best of times -- at least since the Great Depression.”

Donald Luskin, “Quit Doling Out That Bad-Economy Line”, Washington Post (14 September 2008)

http://www.washingtonpost.com/wp-dyn/content/article/2008/09/12/AR2008091202415.html


Donald L. Luskin is chief investment officer of Trend Macrolytics LLC, an economics consulting firm based in Menlo Park, Calif.

It is a fair point to make that the “real” economy where the actual production of the goods and services we enjoy every day takes place has held up rather well as the financial sector has experienced increasing turmoil. Industrial production, for example, has slipped a bit the past six months or so, especially in those branches related to construction and building, but the slowdown is modest compared with past experience and the most recent data do not point to a significant downturn. According to the Institute for Supply Management, as another example, the service sector, which includes real estate, construction, health care, finance, insurance and other activities, expanded in August, and the Commerce Department has reported that U.S. exports have been rising rapidly during the year. Recent measures of consumer price inflation have been very low if -- a big if -- one excludes energy and food prices, which have been increasing extremely rapidly but now appear to have moderated their rise somewhat. It is surprising how well the economy is performing in the midst of a continuing financial crisis.

One might add that it is not simply that the data on the economy do not indicate we are now in a recession. More importantly, they point out that the current economic situation must get much worse before the indicators used to define a recession reach the recession threshold. While anything can happen, the U.S. economy continues to prove its resiliency in the face of mounting financial troubles, and it is not beyond the possibility it will pass through this period of turmoil without experiencing a recession in the real economy.

It may be too much to say we are through the worst of our economic woes and are now entering a period “of accelerating prosperity”, as Luskin says. I suspect we will experience continuing problems and slow growth for the next year or two and the longer-term pace of real economic growth may well be lower than the past few decades. It will certainly take many years to restore stability to the banking system. Further adjustments will have to be made in response to our ageing population and they are likely to hamper any rapid expansion of the economy.

But I must say I am pleased the economy is doing as well as it appears to be doing. That is a pleasant surprise.

Did you know we're in a period of accelerating prosperity?

“’It was the worst of times, and it was the worst of times.’

I imagine that's what Charles Dickens would conclude about the current condition of the U.S. economy, based on the relentless drumbeat of pessimism in the media and on the campaign trail. In the past two months, this newspaper alone [the Washington Post] has written no fewer than nine times ... that key elements of the economy are the worst they've been "since the Great Depression." ...
...
But that doesn't make any of it true. Things today just aren't that bad. Sure, there are trouble spots in the economy, as the government takeover of mortgage giants Fannie Mae and Freddie Mac, and jitters about Wall Street firm Lehman Brothers, amply demonstrate. And unemployment figures are up a bit, too. None of this, however, is cause for depression -- or exaggerated Depression comparisons.

Overall, the pessimists are up against an insurmountable reality: In the last reported quarter, the U.S. economy grew at an annual rate of 3.3 percent, adjusted for inflation. That's virtually the same as the 3.4 percent average growth rate since -- yes -- the Great Depression.
...
A housing "slump," a housing "crisis"? A "severe" price decline? According to the latest report from the National Association of Realtors, the median price of an existing home is up 8.5 percent from the low of last February. And according to the U.S. Census Bureau, the median price of a new home is up 1.3 percent from the low of last December. Home prices may not be at all-time highs -- and there are pockets of continuing decline in some urban areas -- but overall they've clearly stopped going down and have started to recover. ...

"Turmoil" in the debt markets? Sure, but we've seen plenty worse. According to the FDIC, there have been a total of 13 bank failures in 2007 and so far into 2008. There were 15 in 1999-2000, the climax of the Obama-celebrated era of Clintonian prosperity. And in recession-free 1988-89, there were 1,004 failures -- almost an order of magnitude more than today. Since the Great Depression, the average number of bank failures each year has been 94.
...
Financial market "crisis" and "meltdown"? Yes, from all-time highs last October, the S&P 500 has fallen 20 percent. But that's nothing by historical standards. Stocks have often fallen more than that over comparable spans of time. They fell more than twice that much in 1974 -- which was truly the worst drop since the Great Depression. ...

Some economic indicators -- export growth and non-defense capital goods orders such as industrial machinery, for example -- are running at levels associated with brisk expansion. ...
...
Whatever the political outcome this year, hopefully this will prove to be yet another instance of that iron law of economics and markets: The sentiment of the majority is always wrong at key turning points. And the majority is plenty pessimistic right now. That suggests that we're on the brink not of recession, but of accelerating prosperity.

Maybe this will turn out to be the best of times -- at least since the Great Depression.”

Donald Luskin, “Quit Doling Out That Bad-Economy Line”, Washington Post (14 September 2008)

http://www.washingtonpost.com/wp-dyn/content/article/2008/09/12/AR2008091202415.html


Donald L. Luskin is chief investment officer of Trend Macrolytics LLC, an economics consulting firm based in Menlo Park, Calif.

It is a fair point to make that the “real” economy where the actual production of the goods and services we enjoy every day takes place has held up rather well as the financial sector has experienced increasing turmoil. Industrial production, for example, has slipped a bit the past six months or so, especially in those branches related to construction and building, but the slowdown is modest compared with past experience and the most recent data do not point to a significant downturn. According to the Institute for Supply Management, as another example, the service sector, which includes real estate, construction, health care, finance, insurance and other activities, expanded in August, and the Commerce Department has reported that U.S. exports have been rising rapidly during the year. Recent measures of consumer price inflation have been very low if -- a big if -- one excludes energy and food prices, which have been increasing extremely rapidly but now appear to have moderated their rise somewhat. It is surprising how well the economy is performing in the midst of a continuing financial crisis.

One might add that it is not simply that the data on the economy do not indicate we are now in a recession. More importantly, they point out that the current economic situation must get much worse before the indicators used to define a recession reach the recession threshold. While anything can happen, the U.S. economy continues to prove its resiliency in the face of mounting financial troubles, and it is not beyond the possibility it will pass through this period of turmoil without experiencing a recession in the real economy.

It may be too much to say we are through the worst of our economic woes and are now entering a period “of accelerating prosperity”, as Luskin says. I suspect we will experience continuing problems and slow growth for the next year or two and the longer-term pace of real economic growth may well be lower than the past few decades. It will certainly take many years to restore stability to the banking system. Further adjustments will have to be made in response to our ageing population and they are likely to hamper any rapid expansion of the economy.

But I must say I am pleased the economy is doing as well as it appears to be doing. That is a pleasant surprise.