Why a stimulus package must be part of any effective rescue plan
What makes this credit crisis so toxic is that it involves numerous feedback loops with the real economy. This is why simple one-shot solutions such as last week’s rescue plans are not going to be as effective as many people think. Let us look at the present dynamic of this crisis in some detail.
First, the housing market. US house prices have fallen by about 20 per cent. To get back to the long-term real price trend, the market would have to fall by another 10 per cent to 15 per cent. This would also bring price-to-rent and price-to-income ratios closer to a long-term equilibrium. But there is no reason to assume that prices will stay on trend – not if there is a credit crunch, a dysfunctional money market and a deep recession with rising unemployment. The property market is more likely to overshoot, which is what it normally does even without those exceptionally bad circumstances. I do not want to produce a numeric estimate, but without a plan to stabilise house prices – which is not all that easy – we should expect substantial overshooting to take place. The same applies to the UK, Spain and Ireland, where prices have also fallen.
Second, credit cards. In a credit crunch, they are often the last source of freely available credit for many households. The last few weeks have seen large increases in credit default swap spreads for cards and car loans. The securitised market for credit cards is about as large as that for subprime mortgages. As the recession bites, credit card defaults will be rising and securitised credit card products will take a big hit.
Third, corporate bankruptcies and payment defaults. As we have entered a long and brutish recession in the US, a rise in corporate bankruptcies is certain. What is not clear is whether default rates will rise to above 10 per cent, as they did in the last two recessions. I see no reason why this should not happen. Whether the $62,000bn (€46,000bn, £35,800bn) credit default swaps market is going to withstand the fall of Lehman Brothers, one of its biggest counterparties, plus a full-blown recession with double-digit default rates, is not clear at all.
Fourth, valuations of stocks and credit products. The temporary relief from mark-to-market accounting rules amounts to little if present valuations are there to stay after a short period. In that case, no accounting trick will be able to deflect from the fact that many financial firms are, in effect, insolvent.
There are other things that could go wrong, and quite possibly will, such as a contagious hedge fund crisis or an emerging markets meltdown. After Iceland, the crisis is now hitting other countries with serious current account imbalances. The credit crunch is also beginning to disrupt international shipping and there are reports that letters of credit are no longer universally accepted.
So, if you think you see light at the end of the tunnel, you might want to take a second look.
If faced with this set of risks, what then is the optimal policy response? First, given the multiple interactions between the real economy and the credit market, any sensible response would have to address both financial stability and economic growth. To pass an extremely generous financial rescue package but refuse to accept the logic of a fiscal stimulus, as European Union leaders did last week, is both inefficient and inequitable. It is inefficient because an unnecessarily deep recession would have a hugely negative impact on the health of financial institutions. And it is inequitable as the present approach amounts to a large transfer of resources from lower to higher income earners.
There are also imbalances within the packages themselves. Some offer the possibility of a recapitalisation of the entire banking system, a task that is bound to overwhelm the capacity of any state. The British were right to limit this to eight banks. I also wonder whether a de facto guarantee of newly issued paper was necessary. If it was, then the situation might be worse than even I had imagined. But what is completely lacking is an explicit insurance of the interbank lending markets. In the eurozone, many loans and mortgages are tied to money market rates, such as Euribor (the euro interbank offered rate). Central bank interest rate cuts, welcome as they may be, have insufficient effect as long as the money markets remain dysfunctional.
The most likely reason why European governments failed to produce interbank lending insurance was that this could not effectively be done at national level, since interbank lending is a eurozone market. It is a bad reason. The European Central Bank argues that those massive injections of liquidity of varying maturities are miraculously going to revive this defunct market. I am not so sure. It is true that the money market rates came down a little last week, but there was hardly any trading. At the moment, banks get all the liquidity they need from the ECB, but they are still parking their funds with the central bank and not yet lending it to the money market.
As this crisis continues, we will need to fix those imbalances. Targeted recapitalisation, money market insurance and a stimulus package to sustain consumption and allow for some redistribution of income are all needed as part of a comprehensive strategy. Last week’s packages may have prevented an imminent meltdown. But this is not the kind of crisis where we should settle for the usual second-best policy responses.
© The Financial Times Limited 2008