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December 18, 2008 7:27 pm
After the Minsky Moment – where euphoria tips into crisis, named after Hyman Minsky – the capitulation of economic activity has been rapid and severe. The outlook is as dark as the doomsayers assert. The only thing that stands between today’s dire economic prospects and a lost decade similar to Japan’s in the 1990s is the competence and authority of macroeconomic policy. We have a long way to go, but for five reasons, even doomsayers can start to feel the force, so to speak.
First, governments have already acted decisively to preserve the integrity of the formal banking system, while the so-called shadow banking system is collapsing. Over $8,000bn (€5,650bn, £5,150bn) of programmes to stem the collapse in credit and housing have been announced but it is too soon to declare victory. To strengthen banks in the recession and sustain lending, European banks will need a further $100bn-$150bn of capital, while US banks, including regional banks, should quickly be allocated most of the unspent Tarp money of $350bn.
Second, governments must continue to facilitate the enormous task of sustaining credit flows and restructuring debt. Bankruptcies are inevitable but additional direct lending programmes, asset purchases and government guarantees are needed to keep liquidity flowing to good corporate and residential borrowers, especially while bank balance sheets are constrained by the need to soak up bad assets that were previously held off-balance sheet. Equity-for-debt swaps will be required for companies with excessive debt.
Third, the full force of fiscal policy needs to be deployed to contain the depth of the recession and credit losses and the impact on jobs and incomes. British, German and French programmes amount to a little over 1 per cent of their gross domestic product, but much of what is being proposed in the eurozone constitutes window-dressing, while the effectiveness of the UK’s value added tax cut is being lost in the sea of retailer discounting. European nations, including Germany, will need to do more in 2009 as the recession deepens.
The forthcoming US programme, expected to be about $600-$700bn (or about 4 per cent of GDP), will compensate for much of the private sector’s withdrawal of spending and borrowing. President-elect Barack Obama intends to create or save 2.5m jobs by the end of 2010 and advocates the nurturing of technology, green and alternative energy projects, as well as healthcare and education initiatives. The effects of such programmes may not be felt until 2010-11, but this is no reason not to implement them.
Fourth, as a period of (hopefully short-lived) deflation looms, we are about to see if the expected potency of monetary policy – in the form of quantitative easing – is a myth. It did not really work in Japan because it was a decade late and was also inadequately pursued. The Federal Reserve has now promised to keep the policy rate at 0.0-0.25 per cent “for some time”, and said it would use its balance sheet “further” to support credit markets and economic activity. Its assets have already grown nearly threefold to $2,200bn since the Lehman failure, and will be over $3,000bn by the end of the year. As European rates tumble towards 0–1 per cent, other central banks will find they also have to adopt unorthodox forms of monetary policy.
Quantitative easing helps to keep short-term rates near zero and could peg longer-term rates too. The Fed, for example, will buy not only securitised assets but also Treasuries in an attempt to lower credit spreads, the cost of capital and all private borrowing rates. It could eventually buy other private assets, including equities. Ultimately, the Fed could purchase Treasuries directly from the government. Public debt would not rise and concerns about future tax burdens would be negated. The new concern would be higher inflation, but this is a convoluted argument and for another day.
Fifth, when trust has been shattered, economic agents need effective leadership and want confidence in public authorities. We cannot plug these into an economic model, but they matter a lot. Expectations about Mr Obama, his macro-economics team, and the Fed mitigating and then reversing our economic predicament, may have become excessive, but why not? The Fed and Mr Obama possess both competence and authority, and seem prepared to embrace the holistic approach, described here, to address this destructive deleveraging recession.
The writer is senior economic adviser, UBS Investment Bank, and author of The Age of Aging (October 2008)
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