Thursday, October 30, 2008

Economic Policy Direction Shortcomings

The public policy edge of managing this global financial crisis has been focused on opening up the credit markets and re-establishing solvency in select financial institutions. As emergency interventions, they represent a monumental attempt to resuscitate a seriously damaged global economic system. The actual results, so far, have been only marginally convincing, if at all convincing, as to their successful outcome.

It is more than a little ironic that a primary reason this state of affairs arose is because of imprudent lending decisions. Financial institutions damaged their balance sheets, to the point of impairing their continuing business viability. Credit markets contracted and liquidity dried up. Credit is the lifeblood of our global economic system. Unfortunately, or fortunately as the case may be, prudent extensions of credit are based upon the credit worthiness of the borrower.

It should be fairly clear, by the increasing foreclosures and bankruptcies, that prospective borrowers do not, in general, represent good credit risks at the present time. It is also widely agreed that we are looking at a potentially severe and drawn out recession (depression?). We can reasonably expect that prospective borrowers will find themselves in even more distressed economic circumstances in the near future. As such, one must ask why a lending institution, after already getting its fingers burned through imprudent lending practices, would want to extend credit to prospective borrowers with deteriorating solvency prospects.

Additionally, the question should also arise as to why, a borrower already overextended, and facing a deteriorating economic picture, would wish to borrow more, other than as an act of desperation, or other irrationality. Perhaps it is a case of “if there is nothing left to lose, why not go for broke at the expense of an imprudent lender.”

It is not surprising then that despite massive capital injections, the credit markets are still sluggish. After shoring up their balance sheets, at public expense, lending institutions are possibly returning to their roots of being some of the more rational players (this is not a high bar to cross these days) in their economic and business decisions. The wiser deployment of capital would be to acquire distressed assets rather than extend credit to borrowers with poor prospects.

The dilemma facing policy-makers is still how to prevent, or at least mitigate, a global economic slowdown. What are the drivers of economic growth to be if growing debt financed consumption cannot be counted on? Several possibilities arise. As an example, China, and the Asia region, has the potential of stimulating their own internal domestic consumption. Inflation fears may have restrained efforts in this regard before. Now, however, prospects of an economic slowdown, and a more benign (at least for the time being) inflation outlook may open this up as an expeditious policy direction.

From the perspective of the West, and the United States in particular, there is a great deal that needs to be done to re-establish a strong and competitive economy. There are immense infrastructure needs and well as immense needs to fortify the intellectual capital base of the country through adequate funding of education and research. An assessment needs to occur in order to determine what the competitive and comparative advantage and long-term needs of the United States really are. This needs to be done in the context of the United States as a global citizen and its constructive relationship to other global economic players. Once this is determined focused attention and political will must be directed in this direction.

Sunday, October 05, 2008

Financial Crisis Solutions

Congress has passed the Paulson Mega Bailout Plan. Much of the public dialogue around this issue appears to confuse the two major factors underlying this crisis. These two factors are liquidity and solvency.

The credit markets are the lifeblood of a healthy functioning global economy. This financial crisis has resulted in a “freezing up” of the credit markets. Despite Central Banks flooding these markets with access to funds, the credit markets had remained frozen. The ostensible reason is that there is an underlying fear of institutional insolvency arising from exposure to toxic assets on their balance sheets. Because of the complexity of the financial structure of these assets, valuation becomes, more or less, conjecture. At the very least there is an asymmetric knowledge regarding the real quality of these assets. Probably, however, this even overstates the value assessment of these assets because, apparently, even the holders of these assets have exercised poor judgment regarding their value.

A more nefarious explanation as the why the credit markets continue to remain frozen after hundreds of billions of dollars have been injected into the system, could be a “money cartel strategy”. In this case, the fear generated by this credit crisis provides great cover for the institutional withholding of credit. The resulting worsening of financial market conditions result in more institutional and corporate failures and an increased availability of distressed asset sales for those who have access to capital.

Whichever explanation may be partially, or wholly, representative, the recently passed Paulson Plan is intended, at least at face value, to address the frozen credit market conditions by alleviating the institutional solvency concerns.

Unfortunately, as the point has been made by Roubini, and others, this only partially addresses the real problem which is the crushing personal debt burden. This is an underlying weak point which has lead to the deterioration in home values, and the associated mortgage securities. The idea that making more credit available to an economic system whose members are already drowning in debt seems to leave something to be desired as to this strategy’s future efficacy and effectiveness.

Because of the immense magnitude and pervasiveness of this financial crisis, it is likely that $700 billion will not be sufficient to successfully address this problem because the dollar value is insufficient, and its focus is incomplete. The other aspect which must be addressed is how to provide relief to an overly indebted population who cannot adequately service its debt, and how to do it equitably so that those who have acted prudently do not feel penalized for their more prudent financial behavior.

From my perspective the inevitable public policy which will arise will be monetizing the debt, and creating enough inflation to diminish the real value of the existing debt. This appears the only real option if the global financial system will not collapse in a shambles. This would be the case where the number of losers is maximized, and a result would arise from either an immensely stupid public policy decision, or a monumental geopolitical miscalculation. My inclination is to believe that because the vested interests are at stake of so many who truly are mentally sharp, as well as business and worldly-wise, the inflating option will be the direction we find ourselves going in. Given the monetary and fiscal policy apparatus, mechanisms, and policy maker predispositions, this seems the most probable outcome.

The next step in this would be to more directly address the personal solvency issues. This is a bitter pill to swallow, but this would be a natural consequence of the imprudent financial behaviors on the scale we have witnessed over many years. There are many creative ways in which this could be done. I would think, however, that a policy this is bold, and demonstrably decisive would be what is really required to breathe life back into the system. The follow-up, if we were to really correct the error of our ways would be to put in place regulations as well as financial education, training, and counseling programs, and a rethinking of our values, as to not get ourselves, globally, back into these circumstances.