We are facing the prospect of global deflation and depression, similar to but potentially worse than the 1930s. That said, I believe the situation could be turned around by adopting a bold and comprehensive program. Unfortunately, Treasury Secretary Geithner did not present a convincing case. I outline the basic elements of such a program in my forthcoming Book, The Crash of 2008 and What it Means. I am providing an excerpt here in the hopes that it will stimulate discussion and help generate the necessary political will for bold action.
The bursting of bubbles causes credit contraction, forced liquidation of assets, deflation, and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.
It can be done by creating money to offset the contraction of credit, recapitalizing the banking system, and writing off or down the accumulated debt in an orderly manner. For best results, the three processes should be combined. This requires radical and unorthodox policy measures. If these measures were successful and credit started to expand, deflationary pressures would be replaced by the specter of inflation, and the authorities would have to drain the excess money supply from the economy almost as fast as they pumped it in. Of the two operations, the second is likely to prove both technically and politically even more difficult than the first, but the alternative--global depression and world disorder--is unacceptable. There is no way to escape from a far-from-equilibrium situation--global deflation and depression--except by first inducing its opposite and then reducing it.
The size of the problem is even larger than it was in the 1930s. This can be seen from a simple calculation. Total credit outstanding was 160 percent of GDP in 1929, and it rose to 260 percent in 1932 due to the accumulation of debt and the decline of GDP. We entered into the Crash of 2008 at 365 percent, which is bound to rise to 500 percent or more by the time the full effect is felt. And this calculation does not take into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. The situation has been further aggravated by the haphazard and arbitrary way in which it was handled by the Bush administration. The public and the business community suffered a shock in the aftermath of the Lehman Brothers default, and the economy has fallen off a cliff. The next two quarters will show rapid deterioration.
To prevent the economy from sliding into a depression, President Obama must embark on a radical and comprehensive policy package that has five major components:
1. A fiscal stimulus package
2. A thorough overhaul of the mortgage system
3. Recapitalization of the banking system
4. An innovative energy policy
5. Reform of the international financial system
I shall briefly discuss each of these elements.
1. A Fiscal Stimulus Package
This is conventional wisdom, and I have nothing original to contribute. The fiscal stimulus package is already well advanced, and it will be the first out of the gate, but it will take time to implement and will serve merely to moderate the downturn. In my view the next two items are indispensable. To turn the economy around, the mortgage and banking systems need to be thoroughly reorganized and restarted.
2. A Thorough Overhaul of the Mortgage System
The collapse of the financial system started with the bursting of the U.S. housing bubble. There is a real danger now that house prices will overshoot on the downside and put further pressure on the banks' balance sheets. To prevent this, foreclosures must be reduced to a minimum and house ownership facilitated both for new buyers and current owners.
But we ought to go even further than that. With the mortgage financing industry in shambles, we ought to subject it to a thorough overhaul and introduce a new system that is free of the deficiencies that are responsible for our current difficulties. It is rare that a systemic change is necessary or even possible; the present is such an occasion.
I advocate adopting, with suitable modifications, the Danish system, which has proven its worth since it was first introduced after the Great Fire of Copenhagen in 1795. Our current system has broken down because the originators of mortgages have not retained any part of the credit risk. They are motivated to maximize their fee income. As agents, their interests are not identical with the interests of the ultimate owners. In the Danish system, the service companies retain the credit risk--they have to replace the mortgages that are in default.
In contrast to our reliance on government sponsored enterprises (GSEs)--namely Fannie Mae and Freddie Mac-- the Danish is an open system in which all mortgage originators participate on equal terms, and it operates without government guarantees. Yet Danish mortgage bonds are traditionally very highly rated; often they yield less than government bonds. This could not be replicated in the United States at present because of the demoralized state of the market, but it may be achieved later.
Danish mortgage bonds are highly standardized, and their distinguishing feature is that they are identical to and interchangeable with the underlying mortgages. House owners can redeem their mortgages at any time by purchasing the equivalent mortgage bond in the market and exchanging it for the mortgage. Since bond prices and house prices normally move in the same direction, this feature--called the principle of balance--reduces the chances of householders having negative equity in their houses. The mortgage originators are strictly regulated, and their interests are closely aligned with those of the bondholders. They pass on only the interest rate risk to bondholders, retaining the credit risk. That is why the bonds are so highly rated.
When Mexico wanted to securitize mortgages in order to promote house ownership, it opted, with my assistance, for the Danish system. My proposal was supported by the U.S. Treasury, which was then under the leadership of Paul O'Neill. The Danish model is clearly superior to the GSE model. The question is, how can you get there from here? Originally, I proposed a grand scheme in which all mortgages that are under water (i.e., whose principal amount exceeds the current market value of the house) would be replaced by a new mortgage, incorporating the Danish principle of balance but being insured by a government agency.
This would have had the advantage of removing the incentive to default in order to obtain the benefits of loan modification, but it would have run into insuperable political and even constitutional difficulties. The slicing and dicing of CDOs has created such conflicts of interest amongst the holders of various tranches that neither a voluntary nor a compulsory scheme of reorganization is possible. Abandoning the search for an optimal solution, I have come to realize that a second best solution is readily available.
The GSEs have become effectively government owned, but the government is not exercising its powers of control. They are in limbo, torn between the interests of their shareholders and the public. The prospect of the shareholders emerging with a positive value is imaginary; nevertheless, the GSEs are trying to make a profit from their quasi-monopolistic position, charging heavy fees and imposing restrictive conditions on both refinancing applications and new ones. This is aggravating the housing problem, but it could easily be changed by a newly established regulator asserting its authority and using the GSEs as an instrument of public policy.
The GSEs could then introduce a new type of mortgage contract based on the Danish model. It would be transparent and uniform, and it would incorporate the principle of balance. The GSEs would reduce their fees, extend the limit on the size of mortgages they are willing to guarantee, and introduce a new line of guarantees--up to 90 percent of appraised value at a higher premium--effectively replacing the private mortgage insurance companies that have become inactive.
They would then introduce a streamlined and cheap refinancing process for existing mortgages. That would greatly reduce the cost of conforming mortgages and create a powerful incentive to convert nonconforming mortgages into conforming ones. Owners of defaulting mortgages could avail themselves of the provisions of the Help for Homeowners Act and realize 85 percent of the appraised value. In most cases this would be preferable to going through a costly foreclosure process. If owners failed to choose that route, it could be imposed on them by a judge in a simplified bankruptcy process. One way or another, the number of foreclosures would be greatly reduced, and with mortgages more freely available at lower cost, house prices would stabilize at a higher level than would otherwise be the case. Financial institutions would recover some of their losses on residential mortgages and securities.
It is ironic that the GSEs, which are at the root of the problem, should provide a route to the solution. In the long run the GSEs should be phased out and their portfolios run off. They would become a government agency in charge of mortgage guarantees issued by the government. Eventually, when the modified Danish model becomes firmly established, even that function could be phased out. Under the new system, mortgage origination companies would remain responsible for the first 10 percent of any losses arising out of default. They would be allowed to charge a fee that would be determined by competition. As the system matures, service companies may find it advantageous to accept the entire credit risk and not pay a fee for government guarantees. The system would then come to reflect the Danish model more faithfully.
The sequence of the GSEs first becoming more important and then fading away resembles the sequence that characterizes the entire process--to escape deflation you first induce inflation and then reduce it. In implementing it we should never forget what went wrong with communism: the state did not fade away. The fading away should be part of the plan from inception.*
The whole process could be accomplished by using the GSEs and the new bankruptcy law currently under consideration by Congress. The government already controls the GSEs; all it has to do is to exercise its powers. The cramdown provisions of the proposed new bankruptcy law face active opposition from many financial institutions holding mortgages; it should be possible to persuade them that most of them would benefit from the mortgage reorganization scheme outlined here. The costs to the taxpayers would manifest themselves through the eventual losses incurred by the GSEs, but, considering the impact on house prices and the economy, the net effect is likely to be positive.
3. Recapitalization of the Banking System
I cannot present as clear a picture of what a reformed banking system would look like as I can for the mortgage system because there are no suitable models to invoke. The Spanish banking system has weathered a bigger boom in house construction better than the U.S. banking system, and it has some desirable features, but Spain is even more adversely affected by the Crash of 2008 than the United States. What happened to the U.S. banking system after the Great Depression certainly does not present a desirable model. Banks were put into a straightjacket whose constraints began to be loosened only in the 1970s. We are in uncharted territory.
I summed up the main lessons to be learned from the current financial crisis in the previous edition of this book: Financial markets do not tend toward equilibrium, and deviations are not random. Credit creation and contraction are reflexive and tend to occur in initially self-reinforcing but eventually self-defeating boom-bust sequences. Therefore it is not enough to regulate the money supply; it is also necessary to regulate credit conditions. This involves reactivating policy tools that have fallen into disuse: variable margin and minimum capital requirements, and central bank directives on bank lending to particular sectors. Not only banks but all institutions involved in credit creation must be subject to regulation. The objective is to maintain stability and prevent mispricing and other excesses from becoming self- reinforcing. The same applies to financial instruments: They need to be licensed and supervised to ensure that they are uniform and transparent and do not destabilize markets. Leverage must be used cautiously: It is not enough to allow for quantifiable risks; one must impose an additional safety margin for the uncertainties inherent in reflexivity. Financial engineering, structured finance, and other innovations are of dubious value; insofar as they circumvent regulations or render them ineffective, they can be harmful.
It is clear, in the light of these observations, that the financial sector became far too big and profitable. In the future it will have to shrink and remain within the control of the authorities. While financial markets became global, the authorities remained national. Since global markets are beneficial, the authorities must also become more international and the international financial institutions must serve the interests of all their members more equitably.
Since the publication of the previous edition of this book, financial markets have completely collapsed and had to be put on artificial life support. Keeping them alive and preventing the world economy from sliding into depression has to take precedence over all other considerations. As we have seen, the economy can be turned around only in two steps. The first is to offset the collapse of credit by creating money, writing off bad debt, and recapitalizing the banks. Then, if and when that succeeds, the excess money supply will have to be drained as fast as credit begins to flow. That means the initial policy measures will take us in exactly the opposite direction from our eventual destination. Nevertheless, the ultimate destination ought to inform the design of the initial step. Unfortunately, Treasury Secretary Henry Paulson reacted in a haphazard and capricious manner. That is how the situation spun out of control. After the bankruptcy of Lehman Brothers, he forced through Congress a $700 billion rescue package without any clear idea how it should be used to adequately recapitalize the banks. I explained how it should be done in an article published by the Financial Times online on October 1, 2008, at the height of the Congressional debate. This is what I proposed:
The Treasury secretary would give bank examiners clear guidelines for how assets should be valued. For instance, it would be postulated that commercial real estate will on average lose 30 percent of its value. He would then ask the examiners to establish how much additional equity capital each bank needs in order to be properly capitalized according to existing capital requirements. If managements could not raise equity from the private sector, they could turn to the Treasury. The Treasury would offer to underwrite an issue of convertible preference shares. The preference shares would carry a low coupon (say 5 percent) so that banks would find it profitable to continue lending, but shareholders would be heavily diluted by the convertibility feature. They would be given the right, however, to subscribe on the Treasury's terms, and if they exercised their rights, they would avoid dilution. The rights would be tradeable, and the Treasury would seek to set the terms so that the rights would have a positive value. Private investors, including me, may be interested in buying the shares of some banks on the same terms as the Treasury.
After recapitalization, minimum capital requirements would be lowered to, say, 6 percent. This would encourage banks to lend because they could suffer a further 25 percent depreciation of assets without violating statutory limits. They would be eager to take advantage of the rich margins currently prevailing. The economy would be reactivated. With everyone sitting on a lot of liquidity and suddenly eager to put it to work, there would be a sudden rush into less liquid assets. Deflation would be replaced by the specter of inflation, and liquidity would have to be drained as fast as it had been pumped in. Minimum capital requirements would then be raised first to 8 percent, then higher. In this way, the leverage of the banking system would be reduced, which is a desirable long-term objective.
If TARP (the Troubled Asset Relief Program) had been implemented in this way originally, the banking system could have been recapitalized with $700 billion, or perhaps even less. Unfortunately, half that money has already been spent, and most of the second half of TARP will also be needed to plug the holes that have already developed. What would have been possible then is no longer realistic. That is a distinguishing feature of financial crises and other far-from-equilibrium conditions: What is appropriate at one point in time is no longer valid at the next one.
Adequate recapitalization of the banking system now faces two seemingly insuperable obstacles. One is that Treasury Secretary Henry Paulson has poisoned the well by the arbitrary and ill-considered way he forced through and implemented the $700 billion TARP program. The Obama administration feels that it cannot ask Congress for more money. The other is that the hole in the banks' balance sheets has become much bigger since TARP was introduced. The assets of the banks--real estate, securities, and consumer and commercial loans--have continued to deteriorate, and the market value of banks' stocks has continued to decline. It is estimated that something in the neighborhood of an additional trillion-and-a-half dollars would be required to adequately recapitalize the banks. Since their total market capitalization has fallen to about a trillion dollars, this raises the specter of nationalization, which is politically--and even culturally--unpalatable.
Consequently, the administration is constrained to do what is possible even if it falls short of what is necessary. It plans to carve out up to $100 billion from the second tranche of TARP in order to set up an aggregator bank that would acquire toxic assets from the banks' balance sheets. By obtaining 10:1 leverage from the balance sheet of the Federal Reserve, the aggregator bank could have a trillion dollars at its disposal. That is not sufficient to cleanse the balance sheets of the banks and restart lending, but it would bring some welcome relief. The aggregator bank could serve as a useful interim measure except for the fact that it is liable to make it more difficult to obtain funding necessary for a proper recapitalization in the future. It will encounter all kinds of difficulties in valuing toxic securities and even if these could be overcome it will still end up as a covert subsidy to the banks by bidding up the price of their toxic assets. There will be tremendous political resistance to any further expenditure to bail out the banks. This will make it much more difficult to mobilize additional funds in the future. It would be a pity to take the aggregator bank route, especially when there is a way to adequately recapitalize the banks with the currently available resources.
Let me spell out how it could be done. The trick is not to remove the toxic assets from the balance sheets of the banks but to put them into a "side pocket" or "sidecar" as hedge funds are now doing with their illiquid assets. The appropriate amount of capital--equity and subordinated debt--would be sequestered in the side pocket. This would cleanse the balance sheets and create good banks, but leave them undercapitalized. The same trillion dollars that is currently destined to fund the aggregator bank could then be used to infuse capital into the good banks. Although the hole is bigger, a trillion dollars would be more than sufficient because it would be possible to mobilize significant amounts from the private sector.
In the current environment a good bank would enjoy exceptionally good margins. Margins would narrow as a result of competition but by then the banking system would be revitalized and nationalization avoided. The situation is analogous to a devastating hurricane depleting the capital of property insurance companies, raising insurance premiums, and attracting additional capital into the industry. The scheme I am proposing would minimize valuation problems and avoid providing a hidden subsidy to the banks. Exactly for that reason it is likely to encounter strong resistance from vested interests. Losses would first accrue to shareholders and debenture holders; only if they exceed a bank's capital would the FDIC be liable for the deficiency, as it is already. Shareholders would be severely diluted, but they would be given tradable rights to subscribe to the good bank, and if there is a positive residue in the side pocket, it would also revert to the good bank as of the date of the new issue, giving shareholders the benefit of any subsequent appreciation. The fact that debenture holders may lose money will make it more difficult to sell bank debentures in the future. But that is as it should be: Banks should not be as highly leveraged as they have recently been. Pension funds would suffer heavy losses; but that is preferable to taxpayers taking over those losses.
In addition to restarting bank lending, my scheme would resolve the moral hazard issue for a long time to come. The banking industry is accustomed to turning to the state in a crisis and effectively demanding a bailout on the grounds that financial capital has to be protected to ensure the proper functioning of the economy. Given the aversion to state ownership of banks, the blackmail has always worked. That is how the bubble grew so large. The Obama administration ought to resist the blackmail and adopt the scheme outlined here as a prelude to building a better financial system. Our future depends on it.
4. An Innovative Energy Policy
Energy policy could play a much more innovative role in counteracting both recession and deflation. The American consumer can no longer act as the motor of the global economy. A new motor is needed. Alternative energies and energy savings could serve as that motor, but only if the price of conventional fuels is kept high enough to justify investing in them. That might also help to moderate price deflation. A high price on conventional fuels would be beneficial on both counts, but it would be hard to sell to the public. Until now, no politician dared to do so.
President Obama would need great courage and great skill to do the right thing. This would involve putting a floor under the price of fossil fuels by
a) imposing a price on carbon emissions by (a) a carbon tax or (b) auctioning pollution licenses (the former would be more efficient, the latter is politically more acceptable) and
b) imposing import duties on oil to keep the domestic price above, say, $70 per barrel.
The anticipated income from carbon emissions should then be distributed to households in full and in advance. This would compensate them for the higher cost of energy and hopefully make the scheme politically acceptable. It would also act as a temporary fiscal stimulus at a time when it is most needed, although most of it can be expected to be saved rather than spent. Gradually the price of carbon emissions would have to be raised to a level where it would pay to remove carbon from coal. This is indispensable for bringing climate change under control because there is no adequate substitute for coal-fired power plants except clean coal.
It is essential to convince the public that the cost of energy will remain high for some time in order to encourage investment in alternative energy and energy-saving devices. Eventually the cost of energy may decline as new technologies travel down the learning curve. We cannot depend on the price mechanism alone to ensure the development of new technologies. Tax concessions, subsidies, vehicle emissions standards, and building codes are also needed. Even so, neither energy security nor the control of global warming can be achieved without putting a price on carbon emissions. The United States cannot do it alone, but it cannot be done without the United States taking the lead.
5. Reform of the International Financial System
The fate of the United States is intimately interconnected with the rest of the world. The international financial system as it has evolved since the 1980s has been dominated by the United States and the Washington consensus. Far from providing a level playing field, it has favored the United States, to the detriment of the countries at the periphery. The United States exercises veto rights over the international financial institutions (IFIs)--the International Monetary Fund (IMF) and the World Bank. The periphery countries are subject to the market discipline dictated by the Washington consensus, but the United States is exempt from it. This has exposed the periphery countries to a series of financial crises and forced them to follow pro-cyclical fiscal policies, and it has allowed the United States to suck up the savings of the rest of the world and maintain an ever-increasing current account deficit. This trend might have continued indefinitely because the willingness of the United States to run a chronic current account deficit was matched by the willingness of other countries to run current account surpluses. It was brought to an end by the bursting of the housing bubble, which exposed the overindebtedness of the household sector.
The current financial crisis has revealed how unfair the system is because it originated in the United States, but it is doing more damage to the periphery than to the center. This damage to the periphery is a recent development, following the bankruptcy of Lehman Brothers, and its significance has not yet been fully recognized. The countries at the center have effectively guaranteed their bank deposits, but the periphery countries cannot offer similarly convincing guarantees. As a result, capital is fleeing the periphery, and it is difficult to roll over maturing loans. Exports suffer for the lack of trade finance. The IFIs are now faced with a novel task: to protect the countries of the periphery from a storm that has emanated from the center, namely the United States. The IFIs' future depends on how well they cope with that task. Unless they can provide significant assistance, they may become largely irrelevant. Global, multilateral arrangements are in danger of breaking down, turning the financial crisis into global disorder and depression.
Assistance is needed to
The former requires large contingency funds available at short notice for relatively short periods of time. The latter requires long-term financing.
When the adverse side effects of the Lehman bankruptcy on the periphery countries became evident, the IMF introduced a new short-term liquidity (STL) facility that allows countries that are otherwise in sound financial condition to borrow five times their quota for three months without any conditionality. But the size of the STL is too small to be of much use, especially while a potential stigma associated with the use of IMF funds lingers. Even if it worked, any help for the top-tier countries would merely aggravate the situation of the lower-tier countries. International assistance to enable periphery countries to engage in countercyclical policies has not even been considered.
The fact is that the IMF simply does not have enough money to offer meaningful relief. It has about $200 billion in uncommitted funds at its disposal, and the potential needs are much greater. What is to be done? The simplest solution is to create more money. The mechanism for issuing Special Drawing Rights (SDRs) already exists. All it takes to activate it is the approval of 85 percent of the membership. In the past the United States has been the holdout opposing it. Creating additional money supply is the right response to the collapse of credit. That is what the United States is doing domestically. Why not do it internationally? Ironically, SDR would not be of much use in providing short-term liquidity, but it would be very helpful in enabling periphery countries to engage in countercyclical policies. This would be done by rich countries lending or, preferably, donating their allocations to poor countries. The scheme has the merit that the IFIs would retain control over the disbursement of the lent or donated funds and ensure that they are spent in accordance with the poverty reduction programs that have already been prepared at the behest of the World Bank. This would especially benefit poorer countries that are liable to be hardest hit by the worldwide recession.
If it were implemented on a large scale--say $1 trillion--the SDR scheme could make a major contribution to both fighting the global recession and fulfilling the United Nations' Millennium Development Goals. This seemingly selfless act by rich countries would actually serve their enlightened self-interests because it would not only help turn around the global economy but also reinforce the market for their export industries. Since the SDR scheme is not of much use in providing short-term liquidity to periphery countries, that task would have to be accomplished by other means, notably the following three:
a) Chronic surplus countries could contribute to a trust fund that supplements the new STL facility. This would greatly enhance the value of that facility by removing the five-times-quota limitation. For instance, under STL Brazil can draw only $23.4 billion, while its own reserves are over $200 billion. A more flexible supplemental fund would give the STL facility more heft. Japan held out the promise of $100 billion. Other chronic surplus countries probably would not contribute unless the quota issue was reopened. Holding out the prospect of higher quotas could serve as an inducement to put together a supplemental fund that would be large enough to be convincing.
b) The central banks of the developed world should extend additional swap lines to developing countries, and they should accept assets denominated in local currencies to make them more effective. The IMF could play a role by guaranteeing the value of assets denominated in local currencies.
c) In the longer term, international banking regulations should facilitate credit flows to periphery countries. In the short term, the central banks of the developed countries should exert pressure on commercial banks under their aegis to roll over credit lines. This could be perhaps coordinated by the Bank for International Settlements.
With regard to enabling periphery countries to engage in countercyclical policies:
1. The major developed countries should, in addition to donating their SDR allocations, jointly guarantee, within agreed limits, longer-term government bond issues of periphery countries. Regional arrangements should be encouraged, provided they are within an international framework. For instance, the European Investment Bank and the European Bank for Reconstruction and Development should finance public works in Ukraine in conjunction with the IMF package. China's interest in Africa and other raw material-producing areas should be encouraged, provided China observes the Extractive Industries Transparency Initiative and other international standards.
2. The chronic surplus countries could be induced, by offering them additional voting rights, to invest a portion of their currency reserves or sovereign wealth funds in longerterm government bonds of less developed countries. This could be connected with the proposed trust fund supplementing the STL facility.
None of these measures is possible without opening up the vexed question of quota redistribution. This would be in the enlightened self-interest of both the United States and the European countries that would give up some of their voting rights, because in its absence the newly rich countries would have no interest in cooperating with the IMF. They would turn to bilateral or regional arrangements, and the IMF would become largely irrelevant. The question probably cannot be avoided anyhow, but it will take a long time to settle. The best course would be to obtain support for a large-scale SDR scheme by agreeing to open negotiations. President Obama would be fulfilling the world's expectations by championing this course. The main opposition is likely to come from Germany, but with U.S. leadership and broad international support it could be overcome.
In addition, many other international arrangements are needed:
This is a condensed, almost shorthand, account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is. It remains to be seen whether any of ideas laid out here are adopted as policy.
"The Crash of 2008 and What It Means " will be available in paperback on March 30th.
The eBook edition is available now at this link and wherever eBooks are sold.
The eBook edition is available now at this link and wherever eBooks are sold.