3 Quick Steps For the Economy

Who could have imagined after years of prosperity that we would be in the throes of the worst financial meltdown in our history, one that has wiped out over $15 trillion of wealth from stocks, bonds, and real estate? Who could have imagined that the entire global financial system would be in distress? Or that the savants running our major financial institutions would inflict life-threatening wounds on themselves as well as on us because they didn't understand their own risks?

The symptoms so far: Brokerages fail to honor wire transfer instructions. Treasury bill transactions don't settle. The bond markets have virtually shut down such that publicly traded short-term debt instruments of high-quality companies can't be sold at almost any price. The refinancing of maturing debt is nearly impossible for non-investment-grade companies. Typically, most companies owing money to banks don't pay it off; they refinance. Now, unless equity can be raised—unlikely in most cases—they can't do that. Stock prices of outstanding companies have been falling in days by more than what is normal for entire years as investors sell long-term instruments to meet short-term cash needs.

Who could have imagined that housing prices would have dropped by 20 percent and yet are expected to drop that much again? Who could have imagined that the Big Three auto companies would all be on the verge of bankruptcy? Or that the five investment banks that survived the Great Depression would disappear within a few months?

The edge. The credit crunch is horrendous. It is the most important single issue facing the country. Only the support of the U.S. government has protected us from the complete vaporization of the financial world. How did it happen? Through the reckless bundling of debt, especially mortgages, into security packets and derivatives of those packages. Mortgage brokers, securitizers, derivative makers, and credit raters were not paid for making good loans. They were paid just for making transactions happen. Since they expected to hold the loans for no more than 45 days before the securitization took place, they ended up lending money to many who couldn't pay it back—all in order to generate fees. They acted as if there were no risk in the over-the-top lending to those seeking to buy or speculate in houses, office buildings, companies, and other financial assets. If the originators had been forced to keep these loans, they might have taken a wholly different viewpoint. But instead, they rushed to sell them to other eager investors and used the cash to make even more dubious loans.

Not only were they playing with Monopoly money, they acted like a Monopoly player on speed whose solvency depends on getting a double six on the next throw (odds against that: 35 to 1). Well, they didn't come anywhere near to beating the odds, and so they had no cash reserves when the bubbles burst in housing and finance. Hundreds of billions of dollars vanished. The government had to rush in. The Federal Reserve became not just the lender of last resort but the lender of sole resort. The Bush administration's initial plan to unclog billions of dollars of tainted mortgage-backed securities held by the banks was well intentioned but misguided. It became perhaps the most unpopular use of public money in U.S. history, seen largely as bailing out overpaid financiers and not helping the public. One result has been to undermine political support for the kind of government help now sought by the automobile industry.

Nor are we done. Saving the financial system from collapse is not the same as stopping the credit crunch. The world of finance cannot perform its role as a money multiplier, generating the liquidity that is several times the amount of reserves and deposits. Banks face new losses in credit cards, car loans, and commercial properties. Rather than lending, banks are husbanding their cash and their capital—including those billions invested by the U. S. Treasury. The problem is that many of the loans on their books made in good times are now intrinsically unprofitable and cannot be rolled over without dramatic losses. When fear of default is so high, the banks simply dare not risk lending. Instead, they have tightened credit on commercial and industrial loans, standard credit cards, and consumer loans, including home equity—restricting the supply of credit across the board. The securitization market, which provided so much of the funding for both corporations and, indirectly, for the consumer, has shut down completely. The attempt to gain liquidity has caused many funds and individuals to sell stocks, hence the volatility in the stock market. We have the first 401(k) crisis for the 50 million Americans whose retirement funds are tied up in a declining market.

Now the real economy is suffering from the virtual cessation of credit. Consumption and investment began to fall in the third quarter, and that trend has only intensified. As consumer demand has slipped, so, too, have commodity prices, with the prospect that the prices of finished goods and even services will drop as well—and that raises the specter of deflation. It is likely that this decline in demand will continue, for without credit, American households cannot consider buying a home, a car, or a major consumer durable. In fact, given how high their debts are in relation to their income, households are building precautionary savings and hoarding cash rather than spending.

The economic statistics are all going in the wrong direction. The consumer has an increasingly pessimistic view of the economy; the consumer confidence index is the lowest since records began in 1967. It is understandable that the consumer is on a buying strike when he is concerned about losing his job, his home, or his wealth. Housing prices are also continuing their decline because they remain overvalued relative to people's incomes or to rentals. Sales of new cars and trucks have plummeted to an annual rate of 10.5 million units in October—the lowest reading since the early 1980s and down by a third from the rate of just a couple of months earlier.

Job losses. The inevitable consequence of all of the above is that many firms are laying off people, whose wages represent their highest costs. The unemployment rate has jumped to 6.5 percent. The more inclusive measure of unemployment, which includes those forced to work part time rather than full time, has climbed to 11.8 percent. This reflects in part a sharp decline in the closely watched ISM manufacturing index, as well as new orders, a key leading indicator. The credit crunch is taking a growing bite out of all economic activity. It is doubtful that we can avoid a recession that will very likely be deeper than the 1990-1991 or the 2001 downturns.

What can be done? It's essential to keep the broad supply of money growing. The financial authorities must find a way to do that in the face of a rapidly deleveraging financial and banking system that is pushing down the money multiplier at an even greater rate than the Fed is boosting the monetary base, as recently described by the economist John Makin. The Fed is absolutely right to offer virtually unlimited money to commercial banks. We must avoid a drop in the money supply such as the one that occurred between 1929 and 1932 and accelerated the transition from recession to prolonged depression. But monetary policy alone won't get us out of this hole. It's essential, but it cannot have much immediate traction when there is so little lending. Three other steps must be taken with minimum delay.

First, we must have a large fiscal stimulus. The package should err on the side of being too large and should be at least $500 billion, in order to contain the deepening economic slump and to offset the sharp drop in income and spending from U.S. households and businesses. It must be structured to maximize the "bang for the buck." This means spending. In other words, tax cuts are not effective since most of them would be saved or depleted by spending on imports. Better to extend unemployment benefits along with food stamp payments because they will both be spent. Grants and loans should be made to hard-pressed state and local governments so they don't cut their spending for infrastructure or raise taxes: Many of them will be forced to do that because their constitutions call for balanced budgets (an unwise loss of flexibility in times of economic turmoil). The good news is that state- and city-level infrastructure programs that would support the economy are ready to be launched without delay. On the fiscal front, there is one counterintuitive exception to this stimulus thrust. Collapsing energy prices provide the chance to impose a significant tax on gasoline that should go into effect in 18 months. The proceeds should be devoted to the development of energy-efficient technologies.

Second, the government must define a policy to relieve homeowners from foreclosures. It was encouraging to hear President-elect Obama stress this in his interview on CBS's 60 Minutes (and to acknowledge, as he did, that the Democrats are not without blame for the crisis). Foreclosed homes thrown on the market threaten to precipitate more downward pressure on house prices than is justified by normal supply and demand—and that spiral can suck in the financial system.

Third, financial markets must be kept open and liquid by whatever measures it takes.

As for regulation, the shadow banking system must now be appropriately regulated. It clearly hasn't been up to policing itself. The regulation must be broader and more comprehensive, with a clear mandate.

We have never before had to deal with the simultaneous bursting of bubbles of excessive debt that have plagued the financial system, the American consumer, and the American housing world. Nobody knows where the bottom is. People who say they do know are either ignorant or are serving their own interests.

When President Bush spoke at the meeting of the G-20 industrial nations, he said his advisers warned him that we may face a depression greater than the Great Depression. President-elect Obama and his treasury secretary must face up to this once-in-a-century crisis with urgency, resolve, and ingenuity. Unless they can stabilize the economy, the 44th president's entire tenure could be consumed.