by Peter Boone, Effective Intervention
and Simon Johnson, Peterson Institute for International Economics
Post on the Wall Street Journal's Real Time Economics
November 24, 2008
© Wall Street Journal
Last week's stock market collapse—and the latest bailout round for Citigroup yesterday—makes it clear that America's greatest banks are still in deep trouble. But the news is actually worse and much more global. The prices of securitized residential and commercial mortgages reached new all-time lows, and most commodity prices continued their rout. The same pattern was seen in European and Asian markets. The default risk priced into Irish, Greek, and Italian sovereign bonds continued to rise, raising questions about the viability of the eurozone. There is an even larger question mark hanging over Switzerland's financial viability due to its highly leveraged large banks. The main star performer of last week was gold, while long bonds rallied as investors anticipated deflation.
This downward spiral of asset prices is creating potential insolvencies on a massive scale. The natural private-sector response is to cut spending and try to repay debts. Citigroup's announcement that it will dismiss roughly 50,000 employees to contain costs is just one example; similar announcements are being made around the world, and piecemeal over-the-weekend "rescues" will do nothing to stop this.
Governments are trying to offset the private-sector contraction. They offer to backstop potentially insolvent banks, provide more benefits to the unemployed, raise expenditures, and increase budget deficits. In essence, governments are risking their good balance sheets to limit the damage from "bad" private balance sheets. For some nations, there are already signs that this strategy could backfire in a serious way. For example, Ireland—the first country to guarantee all liabilities of its banking sector—saw its market-implied risk of sovereign default (within five years) rise from 12 percent to 18 percent in just one week.
Last week's events parallel the early pattern during the Great Depression. The main difference is, compared with the onset of the Depression, we have already embarked on enormous measures to prevent financial collapse, and, so far, these appear to be failing. In economics, ever since Milton Friedman's and Anna Schwartz's great A Monetary History of the United States, we have been taught that overly tight monetary policy was a major factor explaining the Depression—so much so that Ben Bernanke even once apologized on behalf of the Fed for that mismanagement. Now, we can't help but feel a nagging concern that, perhaps, all that teaching was not quite right. Perhaps the events of 1929 produced an unstoppable whirlwind of deleveraging that no set of policy measures would truly have been able to prevent.
We can be sure that deflation will only make our situation worse. If prices actually fall around the world, the solvency problems of banks, households with mortgages, indebted corporates, and most sovereigns will continue to worsen. A falling price level would be associated with lower asset prices and reduced collateral value for loans, while the nominal liabilities would remain fixed. This would open greater holes in balance sheets and reinforce the downward spiral. Further, falling prices mean that both long and short interest rates are low—a flat yield curve. This would exacerbate the financial sector's problems as its lending becomes less profitable.
It is now imperative that strong actions be taken to prevent deflation, and we should use monetary and fiscal policy to start our reinflation. There are some people who think this is not possible: In the midst of rising unemployment and large excess capacity around the world, how can we get prices to rise?
In a brilliant speech in November 2002, Ben Bernanke outlined a game plan to prevent deflation, and it is far more relevant now than it was then. We are already well down his proposed road. He called for open-market operations to lower interest rates, and suggested the Federal Reserve could directly lend to corporates and other nonbanks if needed. None of this, so far, has worked. His next suggestion was to finance new tax cuts and spending increases with money printed by the Federal Reserve. If the money is spent, the economy should start to recover, and the added spending along with easy money just might be enough to raise prices. We have not tried that in earnest yet, but we should and likely will. Over the weekend we heard confirmation of Larry Summers' earlier hints regarding a $500–700 billion spending plan under Obama—this makes sense if it is accompanied with aggressive monetary expansion. The goal should be to aim too big, not too small.
Unlike fiscal policy, which encourages other countries to "free ride" on any US expansion, the attraction of US monetary expansion is that it will force a global response. When the United States expands its money supply, thus putting pressure on the dollar to weaken, Asia and the United Kingdom will quickly follow suit to prevent their currencies from strengthening.
Already, the Bank of England is rapidly reducing rates and talking down the pound. They understand that the only way out of their crisis, which is arguably worse than in the United States, is to cheapen the price of money quickly and encourage depreciation relative to trading partners. Most Asian nations continue to manage exchange-rate policy so their currencies weaken, or at least stay stable, relative to the dollar. While the eurozone will lag, its deep economic and institutional problems mean they cannot afford a strong euro. The European Central Bank must soon cut interest rates sharply and follow along.
If President Obama's team and Mr. Bernanke do manage to instigate a strong global monetary expansion, with newly rising prices, we might just arrest the downward spiral of asset prices and solvency. The collateral value underlying loans and mortgages will rise, or at least stop falling, and the yield curve will steepen, making banks more profitable. This would change the fundamental solvency of our entire financial system, households, and the government. We need to have significant inflation: 2 percent is not enough to improve solvency significantly, and we may experience 5–10 percent for a year or two. Inflation has major drawbacks and creates its own risks, but compared to the alternatives, it would be a relief.
And it would also make the latest round of bailouts more justifiable. Tim Geithner, the incoming Secretary of the Treasury, was at the table with Citigroup this weekend, and he knows better than anyone the actual and contingent liabilities taken on by the government over the past year. This approach to financial-sector bailouts will prove very expensive to taxpayers and may not work unless we have significant inflation. The early signs all suggest the Obama team is confident that enough inflation will produce recovery and ultimately protect the government's balance sheet.
But let us be honest. Attempting to increase inflation may not work, particularly if private-sector spending does not respond. The policy response that is in the works is likely to be massive. But what we have already seen over the past 12 months is unprecedented and, to date, not very effective.
So what do markets think? Last week they weren't sure. At the close on Friday, inflation-linked bonds priced in only 0.2 percent average inflation for the next ten years; this sounds like a deflationary spiral. However, the world's oldest inflation hedge, gold, rose sharply, suggesting that some investors think we will soon be successfully inflating. Let's hope the gold market is right.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.
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