The Financial Crisis

Posts from Credit Slips

This is a Financial Crisis like Any Other—Treat it Like One

I wanted to thank Bob Lawless, Elizabeth Warren and Credit Slips to invite me back as guest blogger. It seems an appropriate time to discuss topics in two of my areas of expertise—financial crises and retirement income security—as they are directly related to the current financial turmoil.

The markets are crashing. This is a standard financial crisis, as many other countries experienced over the past twenty or so years. In a crisis four risks materialize: default risk, maturity risk, interest rate risk, and exchange rate risk. We are spared from the last one since the dollar dropped well before this crisis. The problem is that we are not adequately addressing the remaining risks.

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More Trusted Salespeople Needed

There is a serious danger that the economy will fall into the dreaded "liquidity trap"—no matter how cheap money is, companies and families will not borrow since they are too freaked out about the future. Worldwide financial rescue packages, central bank liquidity injections, and government equity stakes in private banks are all intended to provide the desperately needed liquidity. Now, it is important to get businesses and households to borrow this money. One important step in this effort will be for trusted spokespeople to calm the fears of businesses and families over their economic futures. If the recent past is any indication, we will need a different set of spokespeople for the econmoy, though, to accomplish this.

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How Long is the Way Out of the Hole?

The stock market just ended its worst week in history. This has sharply eroded families’ financial security. Under rather optimistic expectations it would take about six years before families can hope to achieve the same level of financial security as they had at the end of 2007, before the latest round in the financial market crisis took shape.

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Wealth Destruction by the Numbers

Financial markets went into free fall in late September and early October. The third quarter of 2008 continued the wealth destruction that took place in the previous nine months. This wealth decline is large, broad, and quick.

The primary reason for wealth building is retirement. Many families nearing retirement, though, relied primarily on their homes for their retirement income. According to the Federal Reserve, only 62.9% of families between the ages of 55 and 64, had a retirement account, such as a 401(k) or IRA, in 2004. The typical holding in such accounts was $83,000 in 2004 dollars. In comparison, 79.1% of such families owned their own house with a total typical value of $200,000. In other words, policymakers need to take a comprehensive view at restoring family wealth in an effort to strengthen retirement income security. Much of the policy attention has been on protecting housing wealth. Policy responses, though, need to match the problem, specifically by fostering a pension renaissance and by vastly improving existing retirement savings plans in addition to protecting housing wealth.

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Regulation Cannot Depend on Irrational Markets

At this point, it is all too clear that financial markets can get things wrong. This is not an isolated phenomenon. No, getting it wrong tends to be the name of the game for financial markets. Understanding that financial markets regularly underestimate or overestimate the risks of investing is crucial to the proper design of financial market regulations.

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It’s Still the Economy

You can’t be serious! Federal Reserve chairman Ben Bernanke says what anybody with a passing interest in economics already knows — that it will take time for the economy to turn the corner — and the market tanks. The market seemed punch drunk on the massive stabilization packages — $2.5 trillion and counting — that the industrialized world was showering on failing financial institutions. A mere 36 hours later, though, Wall Street realized that it cannot regain its strength without a healthy Main Street. It was a weakening labor market, following a bursting housing bubble, that contributed to the massive foreclosure wave and to the crisis. No amount of tinkering with the stabilization package will detract from the fact that people and businesses need more income, not loans, to pay their bills and to invest in their future. It should be clear by now to everybody, even extremely myopic financial markets, that the next policy step lies in helping U.S. businesses and families back on their feet through a well designed second economic stimulus.

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That Low Interest Rate May be Higher Than it Appears

The other day I listened to an ad, where a mortgage bank was arguing that, although mortgage interest rates have recently gone up, they are still relatively low at historical rates. Never mind the wisdom of fighting a crisis of too much leverage with more leverage, consumers hopefully have learned their lesson from the past few years that it matters if they can afford the mortgage payments in the future, not just in the first month. And, current economic data show that mortgage payments are probably less affordable now than at any point in the past four years.

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Note to Policymakers: Be Aggressive, but Smart

With Wall Street in turmoil and the economy on a downward slope, policymakers’ ingenuity to help financial markets and the economy is demanded. The response will have to be large, but also smart. Voters will likely not accept an approach that simply throws money at the problem, never mind that the government will eventually run into some hard times itself if policymakers think that more money will fix all that ails us. Undoubtedly, some tax cuts and some spending increases will have to be part of the solution, but given the recent financial rescue package and the need for a short-run money injection to avoid a major recession, policymakers will need to think smartly about other tools at their disposal to help the economy to recover.

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