This was the week that the sub-prime lending debacle turned into a full-blown financial crisis. Look beyond the Federal Reserve Board’s new $400 billion special lending facility for the holders of mortgage-backed securities that was announced last week; look beyond its bailout of Bear Stearns. Look beyond the scheduled Tuesday meeting of the Federal Open Market Committee, which is expected to cut interest rates some more.
William White, chief economist at the Bank for International Settlements, in an interview with the Financial Times Thursday, described the difficulties facing economic policymakers as seeming “as great today, if not greater, than at any other time in the post-war period.”
The next day Paul Krugman, of The New York Times, wrote that the situation “looks increasingly like one of history’s great financial crises.” And Martin Feldstein, of
How did the consequences of a residential housing mania in the
Go back, for a moment, to the Bank for International Settlements. Established
BIS pronouncements, especially those of its late June annual report, are thought of as being the ultimate voice of caution in the global financial system. (Chief economist White, incidentally, is stepping down this summer after a dozen years in the job.
So what did the BIS say last year? Nothing to damage its reputation. Like most other discussions of international economics, its report began pondering how the rapid growth, low inflation, low interest rates and global trade imbalances of the last several years had fit together to process several extraordinary years for the world economy. It underscored issues that would become three big stories of the coming year: US home prices that had ceased to rise; the soaring issuance of structured credit products; and the appearance of sovereign wealth funds.
The main sources of risk? “Elevated exposures to real estate, an increase in leveraged finance, including in the booming private equity market, and a worsening in the credit cycle are important areas of vulnerability” of the financial system. No one wanted to roll back the changes in the world financial system that had occurred during the past thirty years, wrote the BIS. “Nevertheless, more skepticism might be expressed about some of the purported benefits of having new players, new instruments and new business models, in particular the ‘originate and distribute’ approach which has become widespread.”
In a conclusion titled “Prevention Rather that Cure?” the BIS signaled its preference that governments, central bankers and regulators should lean against speculative booms rather than simply wait for them to end and hope to clean up afterwards. To be sure, vigorous monetary easing had worked “reasonably well” in many instances over the previous twenty years, notably after the dot.com crash in 2001.
But there had been instances in which monetary policy conspicuously failed to accomplish its goal, the chief case in point being
There are those who say that the Fed acted too slowly to flood the market with liquidity last summer. (The BIS last June expected trouble to materialize only in the medium term, even though Bear Stearns was being forced to bail out two of its hedge funds even as the bank’s report appeared.) Harvard’s Feldstein sounded a loud alarm in August at a central bankers’ meeting in
Since then, the great danger has become the possibility is that the Fed is spread too thin to be able to force Wall Street to fully write down its losses, with the result that an atmosphere of crisis persists and recently has intensified. It’s not that the losses themselves are so great; it’s that nobody knows which confidence where they are. Meanwhile, as it cuts interest rates, the central bank risks accelerating the decline of the dollar, coming ever closer to the dreaded fail-safe point at which the Fed must raise rates sharply in order to stop the fall. And in offering last week to take on board up to $400 billion in illiquid mortgage-backed securities as collateral in order to enable banks to begin confidently lending for housing again, the central bank has loaded up fully half its $800 billion portfolio with assets of dubious worth.
So suppose this really is “one of history’s great crises.” How did it get that way? There can be only one answer here, and it isn’t the bad conduct of monetary policy. It wasn’t Ben Bernanke who put the Fed up there on the high-wire.
Recall the broad outlines of the Bush administration’s economic policy since 2001, when the White House inherited a substantial budget surplus and a rapidly slowing economy. The decision to reverse the
Could the Bush administration have run American economic policy any worse? Welcome to a recession that threatens to be both deep and long, the result of bungling not seen since the presidency of Jimmy Carter.
Chancellor Robert Birgeneau said
It is a hopeful sign for the nation’s highest-ranked public university. Perhaps it will be enough to counter over the next few years the threat reported here last week to one of the nation’s most creative economics departments.