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US cannot afford second depression
Punishing wall street will only result in gradual ruin of a financial system crucial to growth.
- By Martin Wolf, Financial Times
- Published: 00:02 October 5, 2008
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It is just over three score years and ten since the Great Depression. That slump was, arguably, the greatest catastrophe of the 20th century: it was, among other things, responsible for the events that led to the Second World War - not least Hitler's rise. One can only imagine what horrors a depression in the US might bring now?
Such foreboding must seem exaggerated. So, I expect, it will be. But that dire outcome is no longer impossible, not because a slump is inevitable, far from it, but because action is needed to prevent one.
We are watching the disintegration of the financial system. The passing of the $700 billion rescue package by Congress on Friday is a step in the right direction. But its implementation holds the key to the financial well-being of the US.
Finance is the web of intermediation binding economic agents to one another, across both space and time. Without it, no modern economy can survive. Yet that is now threatened, with the ongoing collapse in trust and flight to safety.
Even before Congress first rejected the plan before eventually passing it on Friday, the spread in dollars between the London interbank offered rate and expected official rates (as shown in overnight indexed swaps) had reached more than 200 basis points, for a period as short as three months. Prior to the start of the crisis in August 2007, the spread was negligible.
Nor is this all: last Monday, short-term yields on Treasury bills were below one per cent; credit default swap spreads on financial institutions reached exceptional levels and credit spreads on riskier bonds were widening rapidly.
In the aftermath of the plan's rejection, the S&P 500 fell by 8.8 per cent, its worst day since October 19 1987. Nothing can better demonstrate how absurd it is to believe one can punish Wall Street without hurting Main Street.
The two streets meet. That is what streets do.
If the financial system ceases to function properly and a range of fin-ancial institutions collapses, everybody will be hurt, as businesses and households are starved of credit.
Spiral of panic
What is occurring now is a downward spiral of panic in which liquidity-starved financial institutions dump assets, weakening themselves and others, particularly now that their balance sheets are marked to market. This reduces their ability to lend and so undermines asset prices and the economy still more, thereby further damaging asset quality.
This, then, is "revulsion" - the final stage of a bubble when, as the late Hyman Minsky argued, investors are so scarred that they can no longer bring themselves to participate in the market.
Unfortunately, among today's panic-stricken investors are banks. These even wish to avoid lending to one another. The gross liabilities of the US financial sector have soared from just 21 per cent of gross domestic product in 1980 to 116 per cent in 2007.
A huge part of these massive liabilities must be from one financial firm to another. If credit is not extended, collapse will follow. This is why the investment-banking industry disappeared within weeks.
Rejection
So why did the Congress refuse to ratify the plan first time round? It is both understandable and a gross error.
It is understandable because the use of taxpayer money to buy so-called "toxic" mortgage-backed securities from the greedy fools who created the crisis is hard to tolerate.
It is also understandable - even creditable - that those Republicans hostile to "socialism" do not want to bail out the undeserving rich, at least before an election. It is understandable, too, because the plan is designed to deal with a problem of illiquidity in what seems certain to be a growing crisis of insolvency, particularly as house prices fall and the economy continues to weaken.
It is a pity, too, that Paulson, a former titan of high finance, was charged with bailing out Wall Street. Yet it was still a mistake to reject the plan. It seems likely that a number of significant financial institutions will find it hard to fund themselves in the coming days, as their share prices weaken and interbank lending is frozen.
Central banks must make every imaginable effort - and a few unimaginable ones - to make sure liquidity needs are fully met during this period. The Federal Reserve may find itself having to rescue additional institutions. So, alas, be it.
Third, Europeans (among whom I include the British) must recognise they are in the same boat. In times of such peril, even a small cut in interest rates by the European Central Bank and the Bank of England would send a helpful signal. It is now most unlikely to prove inflationary.
Franklin Delano Roosevelt fam-ously said that "the only thing we have to fear is fear itself". In truth, the economic processes unleashed by the bursting of the housing and credit bubbles are real. But fear is also a danger. When confidence collapses, a market economy cannot function. It must now be restored.
The problem is not lack of knowledge of how to do this: we know how to recapitalise and restructure damaged financial systems. The problem is lack of will. Government must start to show it is in control of events.
In the twilight of a failed US administration, that may seem far too much to ask. Winston Churchill, Roosevelt's partner, said: "The United States invariably does the right thing, after having exhausted every other alternative."
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