Originally published on 10/23/2008
Governments around the world moved quickly this month to shore up their economies by announcing major rescue plans for their banks. The intention by central banks everywhere is to restore confidence in the financial sector by guaranteeing a source of liquidity. Depositors will know that the protected banks will not be allowed to fail.
Although these actions will keep the major banks solvent, they cannot assure a continuation of business as usual. The real sector of the economy is only beginning to be seriously affected. After watching housing prices tumble over the past year, and share prices tumble even faster during the past month, consumers will naturally begin to reduce their spending. Demand for big screen TVs, new automobiles, and home renovations, to name just a few, will fall swiftly as consumers tighten their belts, in part because they are less wealthy than before, and in part because they will fear a possible job loss in the near future.
Reduced consumer spending will have several effects. The immediate effect is to put numerous firms at risk of failure. Not every TV, automobile or home renovation firm will fail, but some will. Workers in those firms will lose their jobs and unemployment will rise. These changes will reinforce the loss of consumer confidence even among consumers who keep their jobs. Thus, there is a reinforcing effect: a drop in demand causes job losses, which inspire a continued drop in demand.
Reduced spending by consumers may raise available savings in the financial sector. In normal times, the increase in deposits can lead to an increase in lending at reduced interest rates to businesses seeking to expand or to other consumers anxious to spend. Unfortunately though very few businesses will be able to expand with a deepening recession and there will be very few consumers eager to spend. In addition, normal lending is probably a thing of the past for a while. Even nationalized banks, with an assured source of liquidity, will not be quick to lend to others. Recall that the onset of the credit crunch developed because the market for mortgage-backed securities (MBS) disappeared. When the market prices of these securities fell to near zero, using mark-to-market accounting, numerous institutions were possibly insolvent, but no one knew which ones. In this case, even a short-term loan to a major company may not yield a positive return if the company is on the brink of bankruptcy. In addition, lending risks rise because the onset of a recession means that a greater percentage of these firms are going to fail – thus it may be best not to lend, or at the least to be very, very careful.
So what to do about the crisis? Is it appropriate to bail out the banks? Are the bank bailouts enough?
First, the bank bailouts are an unfortunate necessity. It is in everyone’s interest for the financial system to remain sound and to prevent significant bank runs. The conditions in the bailout plans are particularly onerous though, with high interest rates on preference shares, to restrictions on future dividends and caps on CEO salaries. These conditions, while necessary to make the plans politically palatable, also reduce the chances of success. For example, in the original US plan to buy MBS, the legislature added protections to reduce risk to the taxpayers. However, the whole point of intervention is for the government to “assume” the risk so the private sector can get back to business. That’s what is needed to restore confidence. Also, because of time delays, by the time the MBS purchase plan was approved the financial problem had cascaded to a liquidity problem and the US was forced to refocus on bank buyouts. For the moment the “toxic” debt remains on the books though, which means the insolvency problem continues.
Moving forward it is critically important for every political leader to speak confidently about the prospects for a quick recovery. The recession will be longer if policymakers keep squabbling over the details of the rescue plans or if prominent individuals announce that this or that proposal has no chance of working. Most importantly, leaders must assure its citizens that the quick and massive government interventions will prevent the recurrence of a Great Depression. After coordinating policies within and across countries, governments must then project a unified, consistent and positive message. If they do so, the world economy will be back on track within several quarters.
