Friday, October 10, 2008

What should be done?

With the markets, in both US and elsewhere, responding to the series of individual bailout plans and co-ordinated interest rate cuts with even more steeper declines, Paul Krugman feels that the only way forward would appear to be a co-ordinated British type bailout plan.

The British Plan seeks to recapitalize the banks by direct infusion of about 50 bn pounds, in return for Government stake taken through issuance of preferred shares, and providing guarantees for inter-bank lending and banks issuing short and medium term unsecured debt. Until markets stabilise, the Bank of England would continue to conduct auctions to lend sterling for three months and also to lend US dollars for one-week periods against a wider range of collateral. The Bank would also provide at least £200bn under its special liquidity scheme – under which banks can swap illiquid loans for risk-free government securities.

Barry Eichengreen and Richard Baldwin, sums up the recommendations of thirteen economists (full pdf here) commissioned by VoxEU
1. A quick bank recapitalisation with global coordination
2. A guarantee of deposits and/or loans with global coordination
3. Co-ordinated macroeconomic stimulus.

Bradford DeLong calls for immediate and co-ordinated monetary and fiscal expansion with banking sector recapitalizations, and in the long term, policies to make executive compensation incentive-compatible and a more progressive tax system.

As can be seen, the international finance multiplier makes co-ordinated action pre-requisite for any effort to restore confidence in the global financial markets.

However, Casey Mulligan thinks there is no need to panic and the economy really does not need any saving. since we are only in a "financial crisis" and not an "economic crisis", and the economy is resilient enough to tide out the financial turmoil. The basis for this optimism is that the real economy market equivalent of PE multiple for financial markets, marginal product of capital employed, was at a historic high of 10% (profit per dollar of capital invested) in the first half of 2008, and the third quarter profits reports of the non-financial sector private firms are encouraging.

Laurence Kotlikoff and Perry Mehrling argue that with the US Government assuming the role of a unversal banker and insurer of last resort, the worst may yet be over, and most of the physical and human capital are still intact.

But such optimism may be misplaced given the fact that it does not take much for the real economy to get trapped in a stagnant or low growth and jobless equilibrium. The credit squeeze coupled with the recessionary expectations will surely dry up corporate investments, and lead to postponement of hiring decisions. Consumers, facing a "negative wealth effect" will in all likelihood sharply cut back and even stop spending, and use any fiscal stimulus or tax credits to repay their debts. This will impact demand, which will remain weak, and this in turn further depress investment. We have seen it before in the late nineties and early this decade in Japan. No amount of human and physical capital could prevent the financial crisis becoming an economic crisis!

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