Beyond fiscal stimulus, further action is needed

October 9th, 2012

January 27, 2008

Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession, saw no need for a fiscal stimulus, and thought that inflation fears should constrain monetary policy. Now, Washington is more or less settled on a stimulus package that will exceed $150bn; markets at one point last week expected a Fed funds rate below 2 per cent by September. The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty around economic or financial forecasts. It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further as perceptions of declining growth increase credit spreads and risk premiums in financial markets, leading to reduced lending, borrowing and spending exacerbating the pessimism about growth.

Perhaps inevitably given the complexity of the problems, policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme of measures that offers the prospect of accelerating growth and insures against a prolonged downturn. Until that happens, it will be difficult for confidence to return.

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macro-economic stimulus in the US, there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives; I will address the remainder in the near future.

Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan’s did in the 1990s.

It is therefore tempting to suggest that paper be aggressively marketed so that prices can be “discovered” and uncertainty resolved. More of this needs to happen. But in the current environment few are looking to increase risk and even fewer are willing to finance increased risk-taking. As a consequence, the prices discovered are likely to be very low and to reflect market conditions more than underlying credit quality. This could trigger cascading liquidations leading to panic.

Proper policy regarding valuing assets and forcing their sale depends on distinguishing between prices that reflect fundamentals and prices that reflect current illiquidity. Good policy is art as much as science, depending as it does on market psychology as well as the underlying realities.

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. It is preferable for the economy that banks bolster their capital positions by diluting current owners than by shrinking their lending activities. A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. From this perspective the recent efforts by a number of major financial institutions to raise capital from sovereign wealth funds are constructive. But more will be necessary.

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. Probably it will be necessary to turn in part to those companies that have a stake in guarantees remaining credible because they have large holdings of guaranteed paper. It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. Though there are many differences and the current problem is more complex, the Long-Term Capital Management work-out is an example of successful public sector involvement.

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett’s recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

Normal economic performance will not return without a return to normality in the credit markets. The fear that pervades the markets will not abate of its own accord, nor is there a silver bullet. But consistent, determined approaches to doing what is needed to resolve each of the problems that arise will, in the end, re-establish confidence.

The writer is the Charles W. Eliot university professor at Harvard University

Copyright The Financial Times Limited 2012.