Avoiding a Deep Recession

Everyone is haunted by the fear that our financial crisis might unwind into something like the Great Depression. The world of finance is undergoing a 100-year storm, inflicting the worst destruction of wealth in our history. Diligent readers of this column knew something like this was coming—but it has turned out worse than even the most pessimistic of us imagined.

The inescapable bad news is that a serious recession is inevitable given the damage to the financial sector and the degree to which business and the public have been traumatized. But this does not mean we must spiral to depths rivaling the '30s. The risks are there, all right, in unexploded financial land mines (those toxic assets) and the unprecedented debt of American families and businesses, though so far, we've avoided some of the mistakes of 1929. But much more must be done.

The right moves have involved monetary policy, with the feds injecting over $1.5 trillion into the financial system, increasing deposit insurance, extending it to money market funds, aggressively lowering interest rates, and, importantly, doing that in concert with the other major economic powers. Similarly, in fiscal policy, a generation of economists inspired by John Maynard Keynes in the 1930s learned that the government should not try to achieve a balanced budget in a crisis of demand, as both Hoover and Roosevelt did. This time, the government is running a $500 billion deficit to stimulate demand, and next year it will exceed $1 trillion.

Leverage lunacy. All to the good. But there's also an "all to the bad" element in our present predicament. America is incredibly indebted. The debt in the financial world went from 21 percent of a $3 trillion gross domestic product in 1980 to 120 percent of a $13 trillion GDP in 2007, reflecting an astonishing accumulation of as much as $30 of debt for every $1 of equity in many firms, most noticeably in the unregulated shadow banking system. These leveraged assets, which once produced huge profits, are now bringing huge losses.

Another systemic risk, one that cannot be measured, lies in the opacity and complexity of the exotic securities (those fancy derivatives) that remain on financial balance sheets in amounts that exceed $50 trillion. The exposure here is misunderstood and underestimated, even by the credit agencies. But the losses could yet freeze the financial system. Consider that AIG's managers thought $40 billion would be adequate to bail them out; the government put in $85 billion—and has upped it to $120 billion. In other words, nobody knows what the risks are.

On top of all this, house prices are still plummeting—meaning more foreclosures and a market glut. Today, 12 million homes are worth less than their mortgage, and it may rise to 15 million over the next few months. As many as half of them have mortgages that exceed the home value by over 20 percent. If half these people drop the keys in a box and walk, the losses will be in the trillions and may well undermine the efforts to reliquefy our banking system.

American policymakers have responded unevenly. True, they've been dealing with a crisis on a scale not seen before, one that unfolded with terrifying speed. But by the time they acted, measures that might have restabilized the markets were ineffective. It remains puzzling that our Treasury officials did not foresee that the Lehman failure would be a catastrophic collapse undermining faith in the system. After Lehman, all remaining trust vanished in the financial world.

What next? Here are some proposals:

1. Find a quick and efficient way to sustain more banks with capital injections, not just the major banks.

2. Extend appropriate bank regulations to the shadow banking system.

3. Oblige the newly defined banking system to build up equity capital when its lending is expanding, for financial busts too often follow credit booms.

4. Establish a standard for risk management covering mortgages, derivatives, debt, and even equity and, especially, new financial instruments.

5. Target a fiscal stimulus program—if there is one—on infrastructure and not on tax cuts: These tend to be saved and not spent.

We must get this right. The new administration has to draft the best of our national talent to shape and manage these new policies. Otherwise, the recession will not be U-shaped and relatively short. It will be L-shaped and extend for many unnecessary years.