Baseline Scenario: Post-G-20 Edition
This long-overdue (and hopefully widely-awaited) version of our Baseline Scenario focuses largely on the United States, both because of the volume of activity in the United States in the last two months, and also because the United States will almost certainly have to be at the forefront of any global economic recovery, especially given the wait-and-see attitude prevalent in Europe.
Global Economic Outlook
The global economy remains weak across the board, with no significant signs of improvement since our last baseline. The one positive sign is that some forecasters are beginning to recognize that growth in 2010 is not a foregone conclusion. The OECD, for example, now forecasts contraction of 4.3 percent in 2009 for the OECD area as a whole-and 0.1 percent contraction in 2010. This is broadly with our previous "L-shaped" recovery view.
Even that forecast, however, expects quarter-over-quarter growth rates to be positive beginning in Q1 2010. (This is not a contradiction: if growth is sharply negative in early 2009, then quarterly rates can be positive throughout 2010, without total output for 2010 reaching average 2009 levels.) While most forecasters expect positive growth in most parts of the world in 2010, those forecasts seem to reflect expected reversion to the mean rather than any identified mechanism for economic recovery. The underlying assumption is that at some point economic weakness becomes its own cure, as falling prices finally prompt consumers to consume and businesses to invest. But given the unprecedented nature of the current situation, it seems by no means certain that that assumption will hold. In particular, with demand low around the globe, the typical mechanism by which an isolated country in recession can recover-exports-cannot work for everyone.
Like the global economy, the US economy only looks worse than it did two months ago, with unemployment up to 8.5 percent and no real indicators of an incipient recovery. (See Calculated Risk's March summary for all the dismal details.) The causes of economic weakness are largely unchanged and widely known:
- Deleveraging by consumers (paying down debt, voluntarily or involuntarily), leading to reduced consumption and increased saving
- Deleveraging by companies, leading to reduced investment
- Reduced supply as well as demand for credit, constraining even those who want to borrow and spend
- Continuing falls in real estate prices
This combination of reduced spending and reduced credit has sharply depressed aggregate demand, creating a classic vicious cycle where reduced demand leads to reduced economic activity which leads to reduced spending power via increased unemployment and reduced corporate profits. In addition, concerns about financial system solvency are constraining the ability of financial institutions to supply the credit needed by the economy. There will likely be a rolling wave of defaults and debt restructurings in the US and around the world over the next couple of years; this is hard to avoid and constitutes a major reason why the recovery will be slow compared with previous recessions.
The Obama administration's responses to date can be grouped into three broad areas: the financial sector, the real economy, and monetary policy. In each case, the administration has made great efforts that either are yet to pay off or will not pay off.
The core problem is that large segments of the financial sector are insolvent, or that many market participants believe that large segments of the financial sector are insolvent. In either case, the problems are situated on the asset side of financial institutions' balance sheets. Although banks have taken hundreds of billions of dollars of writedowns on toxic assets, the fear is that they will need to write down hundreds of billions or over a trillion dollars more as those assets continue to deteriorate in value.
In the early phases of the crisis, concerns focused on structured securities (CDOs, CDOs-squared, etc.) that experienced disproportionate losses as default percentages on underlying assets increased. However, as the crisis has spread from the financial sector into the real economy, increasing default rates are taking their toll even on plain-vanilla assets, such as whole mortgages. (Along the way, the financial sector has moved from a liquidity crisis to a solvency crisis.) Because banks' assets are sensitive to macroeconomic conditions, it is difficult if not impossible to put a bound on their expected losses as long as there is uncertainty about how long and deep the current recession will be.
The core problem today is that there is a gap between the current book value of assets and the real value of those assets, at least as perceived by many market participants. That gap is large enough to threaten the capital cushions of at least some banks. Many people have suggested solutions to this problem, ranging from outright government takeover (followed by balance sheet cleanup and privatization) to cheap government credit insurance.
However, the Obama administration's proposals so far have been relatively modest, perhaps due to unavoidable political constraints. The overall strategy has been to:
- Insist that the banks are fundamentally healthy, and that the market prices of their assets are artificially depressed due to a lack of liquidity in the market
- Continue providing just enough capital on an as-needed basis to keep banks afloat, while avoiding any more aggressive measures, as was done in Citigroup's third bailout
Note that this strategy is not internally illogical: if you believe that asset prices will recover by themselves (or by providing sufficient liquidity), then it makes sense to continue propping up weak banks with injections of capital. However, our main concern is that it underestimates the magnitude of the problem and could lead to years of partial measures, none of which creates a healthy banking system.
The main components of the administration's bank rescue plan include:
- Stress tests, conducted by regulators, to determine whether major banks can withstand a severe recession, followed by recapitalization (if necessary) in the form of convertible preferred shares
- The Public-Private Investment Program (PPIP) to stimulate purchases of toxic assets, thereby removing them from bank balance sheets
The stress tests have two main problems. First, they are no longer credible, because the worst-case scenarios announced for the stress tests are no worse than many economic forecasters expect in their baseline scenarios. Second, the administration has as much as said that the major banks will all pass the stress tests, making it appear that the results are foreordained. It is possible that the stress tests will be used to force banks to sell assets as part of the PPIP, which would be a good but unexpected consequence.
We also do not expect the PPIP to meet its stated objective of starting a market for toxic assets (both whole loans and mortgage-backed securities) and thereby moving them off of bank balance sheets. In essence, the PPIP attempts to achieve this goal by subsidizing private sector buyers (via nonrecourse loans or loan guarantees) to increase their bid prices for toxic assets. Besides the subsidy from the public to the private sector that this involves, we are skeptical that the plan as outlined will raise buyers' bid prices high enough to induce banks to sell their assets. From the banks' perspective, selling assets at prices below their current book values will force them to take writedowns, hurting profitability and reducing their capital cushion.
As long as the government's strategy is to prevent banks from failing at all costs, banks have an incentive to sit the PPIP out (or even participate as buyers) and wait for a more generous plan. Again, the key question is how the loss currently built into banks' toxic assets will be distributed between bank sharedholders, bank creditors, and taxpayers. By leaving banks in their current form and relying on market-type incentives to encourage them to clean themselves up, the administration has given the banks an effective veto over financial sector policy. There is a chance that the PPIP will have its desired effect, but otherwise several months will pass and we will be right where we started.
Ultimately, the stalemate in the financial sector is the product of political constraints. On the one hand, the administration has consistently foresworn dictating a solution to the financial sector, either out of deep-rooted antipathy to nationalization, or out of fear of being accused of nationalization. On the other hand, bailout fatigue among the public and in Congress, aggravated by the clumsy handling of the AIG bonus scandal, has made it impossible for the administration to propose a solution that is too generous to banks, or that requires new money from Congress. As a result, the administration is forced to work with a small amount of remaining TARP money, leverage from the Fed and the FDIC, and the private sector.
The Real Economy
With each month, the outlook for the real economy gets worse. It is particularly disturbing that economic forecasts are being revised downward every month as well. However, the administration has at least partially delivered on two major policy measures necessary to help restart the real economy.
The fiscal stimulus package signed in February should help, but it is simply too small given the size of the problem. After deducting the fix to the Alternative Minimum Tax (alternative for stimulus purposes), the package was only about $700 billion, of which a large part was in tax cuts of questionable impact. This will partially compensate for falling private sector demand and improve the economy from where it would have been otherwise, but it cannot be expected to turn around the economy on its own. In an ideal world, the administration would be planning a second stimulus package as a contingency measure for later this year. However, given that the bill passed with zero Republican votes in the House and only three votes in the Senate (those votes bought with major concessions), it seems unlikely that the administration will be able to get Congress to commit another half-trillion dollars anytime soon.
The housing plan announced in early March is also a positive step, albeit one that should have been implemented months before, by the previous administration. The housing plan relies heavily on cash incentives to loan servicers and second-lien holders who are willing to modify mortgages. However, only time will tell whether those incentives are sufficient to actually change servicers' behavior on a large scale. Again, this is far better than nothing, but whether it is enough to counteract the ongoing free-fall in housing prices remains to be seen.
In addition, the Obama administration took a harder line on GM and Chrysler, rejecting their restructuring plans and giving them new, tight deadlines to work out deals with their workers and creditors (GM) or with Fiat (Chrysler). In order to pressure bondholders to make concessions, the administration is trying to signal that it is willing to let the auto companies go into bankruptcy. But from a political perspective, they seem to be in a no-win situation. A Democratic administration that lets GM go bankrupt could face a revolt from one of its core constituencies; but bailing out the auto industry will only increase bailout fatigue from an increasingly resentful Non-Bailed-Out Majority that no longer identifies with autoworkers.
With the economy still stalled and the executive branch struggling with political constraints, the Federal Reserve has seemed increasingly willing to step into the breach. As an independent agency within the government, armed with emergency powers under Section 13(3) of the Federal Reserve Act, the Fed is the one actor that can, to some extent, simply take matters into its own hands. And although everything the Fed does is wrapped in gradualist language to cushion its impact on the markets, the Fed does seem to have embarked on a new, more aggressive phase of monetary policy.
Until late in 2008, the Fed's primary role was to provide liquidity, in the form of short-term lending to financial institutions. Since then, however, it has expanded its role in at least two directions. The Term Asset-Backed Securities Loan Facility (TALF) puts the Fed in the position of deciding where to allocate credit across the economy. And the recent decision to start buying long-term Treasury securities means that the Fed is using new approaches to create money. While there is a debate over whether this constitutes "quantitative easing" or just "credit easing," this represents a major expansion of the Fed's role, which we discussed in our recent Washington Post Outlook article. These actions may help create moderate inflation and prevent the onset of sustained deflation; there is also a danger that inflation will be substantially higher than expected.
Since virtually no one is happy with the current situation, there has unsurprisingly been discussion of how the financial sector should be changed in the future. Treasury Secretary Geithner outlined his proposals in Congressional testimony, with an emphasis on the need for centralized monitoring of systemic risk, and for the power to take over any financial institution that could bring down the system as a whole.
One of the root causes of the crisis, and of the difficulty in resolving it, has been the political power and ideological influence of the financial sector, which we discuss at length in our Atlantic article. Our preferred solution is to have smaller banks. Early indications, however, are that the Geithner plan will go a different direction-allowing large banks, but giving regulators new powers over them. The resolution authority currently being sought by the Administration-and which we support-may have unintended consequences, some of which could ultimately prove positive if handled in the right way.
On a worrying note, the Financial Accounting Standards Board recently caved in to banking industry pressure (transmitted by the House Financial Services Committee) and relaxed the rules implementing fair value accounting. In some circumstances, financial institutions will find it easier to ignore market transactions and use internal models in order to value assets on their balance sheets. We think that fair value ("mark-to-market") accounting has played a small role, if any, in the crisis. However, the full impact of this rule change will not be known until we see how it is applied by batteries of lawyers on Wall Street and in Washington; for one thing, it could change banks' incentives to participate in the PPIP. And the fact that the financial industry, at this moment in history, still has the power to get its way in Washington is disturbing.
On balance, we believe that the Obama administration, and Fed Chairman Bernanke, are making every effort to combat the financial and economic crisis. However, some aspects of the response, most notably the fiscal stimulus, have been underpowered. And a combination of ideological and political constraints has hampered the administration's efforts to rescue the banking system. For these reasons, we still do not see the mechanism that will cause the economy to turn around.
In this context, we interpret the recent stock market rally as indicating that the economic decline is slowing; it does not necessarily denote that rapid recovery is just around the corner. We would also emphasize that credit markets are pricing in a substantial risk of default for some leading brand names, both in financial services and manufacturing-as the system stabilizes and bailouts become harder to justify, the probability of default for large companies may continue to rise.
The lead-up to the recent G-20 summit exposed some of the tensions between the United States (and the United Kingdom) and Europe when it comes to economic policy. To generalize for a moment, Europe (led by Germany and France) favors less fiscal stimulus spending, more fiscal discipline, and lower inflation risk; the United States favors more stimulus and more expansionary monetary policy, at the risk of higher inflation.
We favor the United States position, for a simple reason. Not only is the current global recession very severe, but it is unlike any we have seen before, and therefore we cannot rely on historical patterns to tell us when and how the recession will end. In that context, and with unemployment climbing virtually everywhere, it makes sense to do more rather than less to turn the economy around. The European position is that their more advanced social welfare systems will both limit human misery and provide an automatic fiscal stimulus, both of which are true. However, European economies are just as vulnerable as ours to a prolonged period of deflationary stagnation-a risk that, unlike Ben Bernanke, they seem willing to take.
Given this divide in opinion, there was no chance for a meaningful resolution at the G-20 summit. However, the G-20 did have some notable achievements. First, increasing funding for the IMF to $1 trillion gave it the capacity to actually bail out multiple mid-size economies, which may become necessary as the recession progresses. Second, by eliminating Europe's de facto control over the IMF (and the United States' de facto control over the World Bank), the summit gave other members of the G-20 more of a stake in helping develop and support concerted international solutions to the economic crisis. While this could take months or years to pay off, it is an important first step.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT. This article was originally posted on BaselineScenario.com.