Thomas I. Palley - Avoiding Another Depression
15. Oktober 2008 21:11 Uhr
Confidence is critical in capitalist economies. Once unraveled it is hard to stitch together again. It is still not too late for governments to act. Otherwise the world may face the worst economic collapse since the Great Depression.
The global economy is teetering on the edge of a collapse that could be the worst since the Great Depression. That collapse has its origins in the massive U.S. real estate bubble and global trade imbalances of the last decade. The bursting of the U.S. bubble has triggered an implosion in U.S. financial markets and the real economy. That implosion is being felt around the world owing to global accumulations of U.S. financial assets that were built up through trade surpluses with the U.S.
The economic doomsday clock now stands at five minutes before midnight. Radical economic measures coordinated across countries are needed to avoid another Depression.
The American financial system is suffering from a total collapse of confidence in counter-party risk and asset prices. After the collapses of Fannie Mae, Freddie Mac, Lehman Brothers and AIG, no one knows which company will be next. That has produced a complete lock-up of lending. The combination of collapsed confidence and lending lock-up has then become a self-fulfilling prophecy by causing asset prices to fall further and by undermining companies’ ability to continue operating.
Behind the collapse of confidence are real factors, particularly the realization that many companies have become insolvent owing to bad debts. Additionally, there is fear that the U.S. economy is going into recession, which will cause further losses.
Simultaneously, America’s financial problems are ricocheting around the world. Far from decoupling, the world economy is behaving like a concertina. As the U.S. implodes, other economies are crashing in behind.
For the last decade almost every country has run trade surpluses with the United States, and those surpluses have been re-cycled into US financial assets. Now, as US financial prices collapse, those re-cycled holdings are causing a massive financial contagion across countries.
Many countries also had their own home-grown real estate bubbles (Ireland, Spain, the U.K., and Australia) or stock market bubbles (China, Russia), and those bubbles are imploding simultaneously. Meanwhile, U.S. demand for imports is falling, causing economic weakness in countries that have relied on exporting to the U.S. – particularly Europe and East Asia.
Latin America and commodity exporting developing countries have weathered the storm better than much of the world. In part, this is because their accumulation of dollar assets was used to pay down previous debts rather than accumulate new U.S. financial investments. Consequently, Latin America’s trade surpluses strengthened its financial position without creating a corridor for financial contagion. Additionally, commodity prices remain high so that Latin America’s export earnings remain strong.
However, weakness is around the corner. Commodity prices are falling and interest rate spreads on lending to the region have risen dramatically because of increased risk aversion. That is a dangerous combination, as commodity exporting developing economies may soon need to start borrowing again as their export earnings fall.
The governments of the world must coordinate and take radical action to stop the collapse and jump-start the global economy. Those measures will vary with the degree of the problem in each country. The G7 has described some general principles, but that must be followed fast by specific actions.
For the U.S. the following collection of policies are needed: an immediate further one point cut in interest rates; temporarily guaranteeing some liabilities of the financial system, including inter-bank lending; massive temporary provision of liquidity to banks, insurance companies, and the commercial paper market that feeds finance companies and business; bans on short-selling in stock markets; judicious suspension of mark-to-market accounting; recapitalization assistance for financial companies that have an underlying sound long-term position; and measures to stem home foreclosures and the continuing fall in house prices.
These financial measures must be accompanied by massive fiscal stimulus aimed at having a maximum effect on demand. That stimulus should take the form of a temporary suspension of Social Security payroll taxes paid by workers and Federal assistance to state and local governments that are now suffering their own budget crises.
The devastating collapse in global stock markets, despite the recent coordinated half-point interest rate reduction in the U.S. and Europe, reflects the failure of policy to come to grips with the scale of the problem. Policy has been consistently marked by “Too little, too late”.
The Federal Reserve has lowered rates too slowly. The US Treasury failed to recognize the systemic nature of the crisis until it was staring it in the face. And over the summer the U.S. Treasury made a catastrophic blunder in allowing Lehman Brothers to fail as that failure caused ruptures throughout the financial system.
Policy always involves judgment. Given what is at stake, now is the time to err on the side of too much rather than too little. Confidence is critical in capitalist economies and once unraveled it is hard to stitch together again. Policymakers must stop the unraveling in its tracks.
