Economic Quagmire

Paul Krugman directed his readers to The Baseline Scenario today. I decided to read the Baseline Scenario for 2/9/09. It’s really above my comprehension level but I plodded through it anyway. It’s long and it’s deep but it’s worth the effort if you have the time.

Before I post a couple of quotes, let me tell you my baseline. Human nature is always a factor, no matter how smart or educated the people involved happen to be. No one likes to be the bearer of bad news or risk being labeled a “Chicken Little”, running around saying the sky is falling.

I believe the world’s economic house is on fire and most economists are telling everyone to move calmly and in an orderly fashion to the exits. No one wants to scream, “FIRE ! FIRE ! RUN FOR YOUR LIVES !”

As everyone involved will agree, panic has the potential to turn a bad situation into a disaster. The problem -- as I see it -- is that we need to run in an orderly fashion. That may not be humanly possible. To twist the analogy further, by the time we’re willing to admit the garden hose won’t put out the brush fire...that we’ll have to call the fire department and admit we started the fire...it may be too late. Our house might burn down before the fire department can get there.

”First, a substantial fiscal stimulus is already in train. The constraints on this dimension are, first, the ability of the Republican opposition to block legislation in the Senate and, second, the US balance sheet. The US balance sheet is strong relative to most other industrialized countries - private sector holdings of government debt are around 40% of GDP.  But the US authorities also have to worry about increasing Social Security and Medicare payments in the medium term, and so are reluctant to accumulate too much debt.  The underlying problem is that fiscal policy was not sufficiently counter-cyclical during the boom. The federal fiscal stimulus will be helpful, but it will not be enough to prevent a substantial decline or quickly turn around the economy .“

”Looking at the banks more directly, there are no easy answers.  Dramatic bank recapitalization remains controversial because this would imply effective nationalization, which is not appealing to Wall Street (and to many on Main Street).  The original TARP terms from mid-October are no longer available, as they were very generous to banks and there is widespread backlash against bailouts.  Also, the latest Citigroup bailout (from mid-November), recently repeated for Bank of America, is not appealing as an approach for the entire financial system as this was an even worse deal for the taxpayer. A clever financial engineering-type approach of ring-fencing bad assets, with some sort of government guarantee, is unlikely to provide a decisive breakthrough. “

”If, by good fortune, the US and global recession is already at its deepest - as some in the private sector now hold - then we face a tough situation but the difficulties are manageable. However, our baseline view remains that the real economy is not yet stabilized, and hence we will see worse outcomes in Q1 and Q2 of 2009 than currently expected by the consensus.  Such outcomes are not yet reflected in asset prices, and the problems for banks - and the implications for fiscal sustainability - around the world will mount.  We will need to readdress the need to fully recapitalize the banks, but really making progress with this depends on a political willingness to take on the powerful banking lobby. “

As I said earlier, this is much deeper that you will read in a newspaper column or a normal blog. And as simple as this explanation is (in comparison to the problem) it is still above my head. On the other hand, I know how the government reacts to a crisis. The people in charge don’t want to let on just how bad the situation is for fear of creating panic or -- worse -- being blamed for the crisis. Unfortunately, the only way to build the political will needed to address the problem is to educate the public as to just how bad the situation really is.

Trying to convince the taxpayers that we need to spend $ 3 trillion (my arbitrary figure) is tough when most are still warm and cozy in their homes. It will be a whole lot easier when 25 million (versus the current 11+ million unemployed) are standing in a soup line -- cold and hungry. And it will be too late. All the water in the world won’t do you any good after your house has burnt down.

Don Brown
February 17, 2009