How to avoid a depression?

September 16, 2008

Wilbur Ross has told CNBC yesterday that one thousand regional banks could fail. He’s basing his opinion on historical record in light of recent developments.

 

What does this mean for the Federal Budget? Morgan Stanley believes it is manageable. (See bottom of the page) 

 

The government is expected to create stimulus packages, take over bank failures, finance the restructuring of the GSE’s, bailout failed financial firms, pursue two wars in Iraq and Afghanistan, provide or maintain tax cuts, and keep spending in order to sustain economic activity in general; and each of those items is at least a hundred billion dollar item.

 

At the same time the government’s revenues are likely to shrink as more bankruptcies and higher unemployment will be a feature of the next few years.  

 

How will the government get out of this without monetising some of these problems? Can the US avoid higher inflation in the long term?

 

Liquidity and the money supply are seen to be the solution by the Federal Reserve, but neither the government nor the private sector have a solid financial position to provide that liquidity. This is a solvency problem, and the cash is in the pockets of exporters, the debt is in the US Treasury. And as the debtor was the creator, and originator of a vast part of global economic activity in the past years, if the world wants to avoid a general economic cataclysm, it will have to bailout the American economy, arguably by continuing to buy increasing amounts of treasuries and other government paper.

 

This is not unprecedented in history. When, after the first world war, Germany faced financial catastrophe, it was the US that organised the bailout of the German state, as it was realised that a complete collapse of that nation was threatening the health of the American and international economies. In today’s case the Chinese and others are sitting on trillions of dollars, which are likely to depreciate significantly, if, as expected, the US does decide to solve its problems through monetisation. More importantly, neither the Chinese economy, nor in fact any other economy in the world is sophisticated enough to create or absorb those enormous sums without creating financial instability: it was a mistake on the part of the Chinese to accumulate that much in reserves, now they must at least make use of them. If they don’t, the US will depreciate its currency in the middle of a global recession, creating more insecurity, more contraction, and no one knows where this would lead us. 

 

In the long run, as I said, in the absence of an international solution, I believe that political reasons will lead the Congress and the administration to choose the path of monetisation, that is, inflation as the cure-all for the private sector’s problems. This is even likelier under Obama, and just today Barney Frank has been urging the government to begin to buy debt and other assets in the market. Indeed there does not appear to be any other solution to this issue. So far I have not heard a single voice providing a solution to the issues facing the economy: usually the suggestion is to let the markets solve their own problems, but politically the costs of this are going to be enormous: certainly double digit unemployment, and thousands of bankruptcies will be the outcome. But more importantly, if panic is allowed to take hold, the feedback loop can create problems that are not imagined today.

 

The United States escaped from the depression of the thirties only through war: the needs of a war economy, coupled with the psychological stimulus of a warlike mentality, allowed the system to grow out of its pessimistic stupor and create economic dynamism. Why did the recovery take so long? Because the collapse in confidence and goodwill after a long and severe bottoming, instead of creating new momentum and optimism, perpetuates the negative attitudes of the previous contraction. People are likely to enter the market to pick bottoms many times over many months, even years, and eventually it will be confidence that suffers the greatest damage. No amount of financial loss can account for the damage that confidence will suffer in a long term financial collapse. And that phenomenon is one of the reasons of Japan’s decades long slump too.

 

 

 

 

 

 

 

 

 

 

 

 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: