Simon Johnson: Does The US Still Face An Emerging Market-Type Crisis?

[ProSense]

Does The US Still Face An Emerging Market-Type Crisis?

The US has developed some features more typically seen in an emerging market, including disproportionate power and system-threatening activities in the finance sector. In fall 2007, the US (and the world) experienced the kind of precipitous fall in credit, output, and employment that was, in modern times, seen only in “emerging market crises”. Our first Baseline Scenario was controversial and largely dismissed when it first appeared on September 29, 2008, but many of its arguments and policy recommendations have now been absorbed into official thinking (at least in the US).

<...>

The most compelling evidence for lack of readiness comes from those who are now most articulate in Treasury’s defense. “Congress will not provide any more money” and “you must recognize the political constraints” are sensible points. But think about what they also imply. Treasury is not making the case, full-time and flat-out, for more funding - on a contingency basis - from Congress. At least from my conversations on Capitol Hill, I see no signs that this is Treasury’s top priority. In fact, I would go further and be blunter: no one is ready.

I recognize that this would be a hard sell. And I understand that the mood is shifting away from bailouts and towards attempting to manage some sort of debt-for-equity swap; which seems to be what the WSJ is heavily hinting at this morning. But if you’ve taken nationalization off the table and you have very little cash remaining for anything bailout/rescue-related, you are vulnerable to runs.

The only way to stop speculators is with massive financial firepower (you must be able to scare them; no one way bets on bank defaults) and a credible set of policies that show things are going to turn around (act at the system level; don’t try to handle the banks piecemeal). Don’t let bankers’ past misdeeds (or current power) and market panics ruin the economy and so many people’s lives. Go get the money from Congress - Capitol Hill is full of responsible and responsive people, but the Administration has to make the case, at the highest levels and in the most persuasive manner that saving the financial system from collapse is our top priority.

Don’t make the mistake of Hank Paulson who, until September 17th, always assumed he had more time to prepare (or just prevaricate). When the crisis is upon you, there is no time.

Another interesting piece from April 4:

Ben Bernanke: More Important Than The G20 Summit

<...>

In our view, the Fed’s current ”print the money” strategy (and, yes, I know the Fed doesn’t like this term or even “quantitative easing”) is make-or-break for turning the economic corner any time soon. It’s incredibly risky in terms of potential inflation - more than the Fed would ever concede - but preferable to all the available alternatives.

The power of our big banks presents a profound economic and political problem. Whatever happens - miraculous recovery or prolonged depression - this needs to be fixed. But we also can’t wait around for attempts to break up the banks; the prospects for unemployment and poverty are too dire to tolerate delay. First and foremost, we need to prevent global deflation and begin the difficult process of sustaining a recovery.

Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed - by BMW-type producers - towards providing a parallel monetary stimulus.

There is only one person who can talk the ECB out of its current, ruinous policy: Ben Bernanke.

By Simon Johnson

Update (by James): This article has gotten a fair amount of commentary already.

• Mark Thoma says it depends on whether inflation expectations remain anchored (at 2%, where the Fed wants to peg them).
  
• Tim Duy says that we are making the mistake of confusing “credit easing” with “quantitative easing.” Duy points out (correctly) that Bernanke has repeatedly insisted that the Fed will mop up the excess money when necessary in order to dampen inflation; this means that the Fed is trying to keep inflation expectations where they are, despite the influx of money now. This could be Bernanke’s intention, but I think there’s still a question of whether the Fed will be able to follow through when necessary, and the resulting uncertainty could itself feed inflation expectations.

One thing I want to clarify, which Simon says above but is perhaps not clear in the article, is that we do not think that Bernanke is making a mistake. We think that despite the inflation risk, this is still the right strategy, because of the risk that the other tools used to restart the economy may not have sufficient oomph.