Here’s more on the “ouch” and the “whoa” in the economy, from people who know better than I…
First, from Ken Rogoff, Harvard professor and former Chief Economist of the International Monetary Fund, published in today’s Financial Times (emphasis added):
[D]espite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, yesterday’s $85bn bail-out of the insurance giant AIG.
Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn-$2,000bn...
…A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.
The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.
It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse.
Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.
And Steven Pearlstein in today’s Washington Post reminds us that what we’re experiencing this week is just another symptom of the “super subprime” problem our economy’s been experiencing for years now:
What we are witnessing may be the greatest destruction of financial wealth that the world has ever seen — paper losses measured in the trillions of dollars. Corporate wealth. Oil wealth. Real estate wealth. Bank wealth. Private-equity wealth. Hedge fund wealth. Pension wealth. It’s a painful reminder that, when you strip away all the complexity and trappings from the magnificent new global infrastructure, finance is still a confidence game — and once the confidence goes, there’s no telling when the selling will stop.
But more than psychology is involved here. What is really going on, at the most fundamental level, is that the United States is in the process of being forced by its foreign creditors to begin living within its means.
That wasn’t always the case. In fact, for most of the past decade, foreigners seemed only too willing to provide U.S. households, corporations and governments all the cheap money they wanted — and Americans were only too happy to take them up on their offer.
The cheap money was used by households to buy houses, cars and college educations, along with more health care, extra vacations and all manner of consumer goods. Governments used the cheap money to pay for services and benefits that citizens were not willing to pay for with higher taxes. And corporations and investment vehicles — hedge funds, private-equity funds and real estate investment trusts — used the cheap financing to buy real estate and other companies…
Steven concludes with the hard part about getting ourselves out of this funk, reminding us why it’s always been hard for Americans to get focused on long-term economic goals, because they’re often inconsistent with our short-sighted inclinations:
In the end, however, there is only so much the government can borrow and so much the government can do. The only other choice is for Americans to finally put their spending in line with their incomes and their need for long-term savings. For any one household, that sounds like a good idea. But if everyone cuts back at roughly the same time, a recession is almost inevitable. That’s a bitter pill in and of itself, involving lost jobs, lower incomes and a big hit to government tax revenues. But it could be serious trouble for regional and local banks that have balance sheets loaded with loans to local developers and builders who will be hard hit by an economic downturn. Think of that…as the inevitable second round of this financial crisis that, alas, still lies ahead.
And what about the possibility that the AIG bailout would not end up costing taxpayers anything–despite yesterday’s Treasury announcement of new debt to be issued, to assist the Fed with its cash flow? (Whoa –and yikes.) Well, this Washington Post article (which incidentally quotes David Walker) does not comfort me. Note these two expert opinions:
Even with intervention, economist Allen Sinai of Decision Economics said AIG still could end up in bankruptcy protection. He said the government is likely to lose money on its loan, and the Federal Reserve’s support will contribute to inflation over the long run. Nonetheless, “the cost of doing nothing was probably greater,” Sinai said…
…”What isn’t really clear at this point is — how the government eventually stops owning AIG,” said Rodney Clark, an analyst at the credit-ratings agency Standard & Poor’s. “They haven’t disclosed anything about how those securities are being structured or how the arrangement might one day be unwound,” Clark said.